Home Offices
A home office is a space within an individual's personal residence that is used for business purposes. It may be a corner of a spare bedroom equipped with nothing more than a desk. Or, it could be one whole floor of a house filled with the latest in computer and communications devices. Whatever its size and composition, however, the home office is increasingly common in American business today. A majority of the estimated 40 million Americans who work from their homes are self-employed small business owners. In addition, many professionals maintain two offices, and a growing number are equipping their home computers with modems that allow them access to their office computer files. Many large corporations are also expanding experiments in "telecommuting," which enables employees to work from home, using modem-equipped computers, just as they would in the office.
Establishing a home office involves a number of important considerations. For example, individuals interested in working out of their homes must gather information on local zoning restrictions, find and set aside an appropriate work area, and gain the support of family and neighbors for the home office. Other considerations include whether the home office will offer sufficient privacy, will be convenient for customers and vendors, and will provide room for future expansion and growth. The expense involved in furnishing a home office and purchasing necessary computers, office supplies, and other equipment is another factor to consider.
The use of part of a home as a business office may enable an individual to qualify for tax deductions. The "home office deduction" allows individuals who meet certain criteria to deduct a portion of mortgage interest or rent, depreciation of the space used as an office, utility bills, home insurance costs, and cleaning, repairs, and security costs from their federal income taxes. Although the Internal Revenue Service (IRS) has set strict regulations about who qualifies for the deduction, about 1.6 million people claim the deduction each year. According to Gloria Gibbs Marullo in an article for Nation's Business, the savings can be considerable: a sole proprietor living in a $150,000 home stands to save about $2,500 in actual taxes annually.
HOME OFFICE TAX DEDUCTION
The most important aspects of setting up a home office are the potential tax and legal implications. Home office operators may claim a deduction for those offices on IRS Form 8829 (Expenses for Business Use of Your Home), which is filed along with Schedule C (Profit or Loss From Your Business). There are restrictions, however, which are covered in IRS Publication 587 (Business Use of Your Home). Failing to abide by these restrictions may put a red flag on a home office user's federal income tax return, which could result in an audit.
In general, a home office deduction is allowed if the home office meets at least one of three criteria: 1) the home office is the principal place of business; 2) the home office is the place where the business owner meets with clients and customers as part of the normal business day; or 3) the place of business is a separate structure on the property, but is not attached to the house or residence. The deduction is figured on the size of the home office as a percentage of the total house or residence. For example, if the total house size is 2,400 square feet and the home office is 240 square feet, 10 percent of the total house is considered used for business. That would allow the business owner to deduct 10 percent of the household's costs for electricity, real estate taxes, mortgage interest, insurance, repairs, etc. as business expenses.
Be warned, however, that the home office deduction cannot be used by everyone who has a home office. A 1993 United States Supreme Court decision made the home office deduction more difficult to apply outside of these very carefully worded circumstances. In the case in question, a doctor worked in three different hospitals, but did not maintain an office in any of them. Therefore, he established a home office, which he claimed was necessary to keep up with his billing and patient records, and claimed a home office deduction. But the Supreme Court ruled that since the doctor spent most of his working hours visiting patients, the hospitals were his principal place of work, and his home office deduction was denied.
This ruling, which more narrowly defined the concept of "principal place of business" affected a large number of people, particularly professionals such as sales agents who see customers at the customers' places of business. Since the demonstration and sale of the merchandise occurs away from the home office, the IRS ruling says that those offices are not critical to conducting that business. As a general rule, if the income-producing activity takes place away from the office, a deduction is not allowed. On the other hand, a second job conducted exclusively from the home office may qualify for the deduction. The key is that the income must be generated from the home office.
A home office deduction is still possible, however, if the space is set aside exclusively to meet with clients or customers, even if it is not always the principal place of business. The IRS uses an example of a lawyer who works three days in an office and two days at home in an office set up so that clients can come to his home. The last test for an unchallenged home office deduction is that it can be a separate structure—such as a studio or garage apartment—that is essential for running the business. For example, a floral shop owner who runs a greenhouse on her property would qualify under this rule.
In July 1997, responding to the concerns of small business advocates, the U.S. Congress passed a tax bill that effectively overturned the 1993 Supreme Court ruling. The legislation redefined an individual's "principal place of business" to include a home office that meets the following two criteria: 1) it is used to conduct the management or administrative activities of a business; and 2) it is the only place in which the small business owner conducts those management or administrative activities. When this change became effective on January 1, 1999, it was expected to enable many business owners who perform services outside of their homes to claim the home office deduction.
