Although many business owners work out their homes, most never seriously pursue the possibility of claiming a home office income tax deduction. The perception is that it is difficult to qualify for a home office deduction and that the IRS is more likely to subject returns claiming a home office deduction to closer scrutiny or even an audit.
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While these concerns are not completely without merit, there is good reason for entrepreneurs who work out of their homes to at least consider the possibility of claiming a deduction for a home office.
To claim a home office deduction, the entrepreneur or employee must use a home work space that passes two tests:
1. Principal place of business
The first test dictates that the home workspace must be the primary place of work for the business owner or employee. If it is a space that used occasionally for work, but not regularly, then it does not qualify.
Special rules apply for various kinds of businesses. For example, contractors are allowed to claim home office deductions if they do all their administrative and management functions in the space, even though the majority of their actual work takes place offsite.
In some cases, employees may also be able to claim a home office deduction if their use of a home office is done for convenience of the employer, and not at the request of the employee.
2. Exclusive work-related use
Most entrepreneurs and home-based employees find the second test the IRS requires for a home office deduction more difficult to meet than the first one. In addition to being the primary work space, the IRS also requires the home workspace to be used exclusively for work-related activities.
This eliminates the possibility of taking a deduction for using your kitchen table or spare bedroom for work - unless you are willing to dedicate that space exclusively for work purposes.
Some people solve the home workspace issue by converting the basement, the attic, or the garage to a usable and dedicated work environment. Fortunately, the IRS does not require you to set up a workspace in any specific area of the house, only that it be clearly identified as separate from your living space. So, as long as it will be used exclusively for work-related activities, you are free to set up your office wherever you like.
If your workspace meets both of these requirements, the IRS allows you to deduct a portion of your house-related related expenses (based on square footage) against the income you generate. These expenses can include a portion of your rent, mortgage, utilities, real estate taxes, insurance, and repairs. You may also be able to depreciate a portion of home's purchase price.
It goes without saying that you shouldn't play games with the IRS when it comes to deciding whether or not you should take a home office deduction. Before making any plans, consult your tax preparer for professional advice.