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Home office: Tax perk or trap?
A third of the U.S. employees regularly work out of a home office but most don't claim a deduction.
February 17, 2005: 2:19 PM EST
By Sarah Max, CNN/Money senior writer

SALEM, Ore. (CNN/Money) – If getting ready for work means rolling out of bed and putting on fuzzy slippers, join the club.

Nearly a third of the U.S. workforce, or about 44 million people, regularly worked at home in 2004, according estimates from In-Stat/MDR.

Yet, come tax time, less than a quarter of these workers are likely to claim home office deductions. According to the Internal Revenue Service, only 2.5 million tax filers claimed the deduction for the 2002 tax year, with the average deduction around $2,500.

Many at-home workers simply don't meet the IRS's strict criteria for claiming the home office deduction.

Others qualify but don't take the deduction because they think doing so is the equivalent of writing "audit me" across the top of their return.

"I'd say it's a pink flag, not a red flag," said Martin Nissenbaum, national director of personal income tax planner for Ernst & Young. "It's not necessarily going to get you audited, but you have to be careful."

Still others are simply confused. "There are a lot of little wrinkles as to how exclusive the use of the office has to be," said Mark Luscombe, principal analyst for CCH Associates.

Another wrinkle shows up when it's time to sell the house. If you live in your house for at least two of the five years and your profit is less than $250,000 if you're single or $500,000 if you're married filing there shouldn't be any tax implications for claiming the home office deduction, according to Kathy Burlison, a tax pro with H&R Block.

"But there are exceptions," she said.

Before you worry your pretty little uncombed head about all that, first see if you even qualify for the deduction. (Click here for the IRS's full explanation.)

Principal place of work

If you're self-employed, consider your home office your principal place of work and have no other place to conduct your business affairs, you should pass the first litmus test of the home office deduction. Just keep in mind that the gross income generated by your business must be more than your related deductions.

If you're an employee of a company, on the other hand, you can only deduct the home office if it is for "the convenience of your employer," said Nissenbaum.

So if you're among the growing number of employees who are encouraged to work at home to save the company office space, you should be able to claim a deduction for the expenses your company doesn't reimburse.

But if your boss allows you work from home a few days a week because you begged or negotiated for the perk? No dice.

Exclusively for work

If your home office doubles as a guest room or your dining room table doubles as your home office, you probably won't pass the IRS's rule of exclusive use. Your office doesn't necessarily have to be confined to four walls, but it should be a "separately identifiable" space used only for business purposes.

Assuming you do have an exclusive home office space, the IRS allows you to deduct a portion of your home's expenses, including mortgage or rent, repairs, utilities, insurance and taxes.

You can also claim depreciation on a portion of your home's purchase price, calculated by dividing the purchase price by 39.5 and dividing that amount by the portion of your house used for business.

To figure out what this portion is, you take the square footage of your office space and divide it by your home's total square footage. A 200-square-foot office in a 2,000 square foot house, for example, allows you to deduct 10 percent of your housing expenses.

Can you add your bathroom or your kitchen to the equation? Speaking from experience, those rooms are pretty essential if you're working at home all day.

"It would still have to be used exclusively for business," said Burlison explaining that a separate bathroom for clients or patients might qualify. "As for the kitchen, if might be hard to argue that you use one burner on your stove exclusively for making tea during working hours."

What are the cons of deducting a home office?

What happens if you sell the house in which you've claimed an office deduction? In August 2004, the IRS released final regulations on the topic.

As long as you live in your house for two out of the last five years and the proceeds of the sale are less than $250,000 for single filers and $500,000 for couples filing jointly, you don't have to pay capital gains taxes on any part of your house.

"The only exception is if your office is a detached structure," said Nissenbaum. In that case, you would have to pay capital gains taxes on that portion of the house, unless you use it for personal reasons at least two out of the last five years.

Also, if you depreciated your home office, you'll need to add up the total amount you depreciated and claim that as ordinary income.

"You're basically paying back a deduction you got to take earlier," said Burlison. "If you're self employed you don't have to pay back self-employment tax."

Are you still with us?

Well, there's another loop – or loophole – in the equation.

The IRS recently put out guidelines for homeowners who don't qualify for the capital gains tax exclusion (because they didn't live in the house at least two years or made too much money on the sale) to defer some of their capital gains taxes by using a 1031 "like-kind" exchange.

Burlison has considered how this will affect owners of investment property but she hasn't even begun to think of how it will affect those taking the home office deduction.

"It does get a little complicated here," she said.

Taxes? Complicated? You've got to be kidding.

Now, get dressed and get back to work.  Top of page

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