3 rules of home-office deductions
It's easy to be hazy about just when you can write off housing expenses if you're self-employed. Here's are three key rules you should know.
NEW YORK (CNNMoney.com) – Tax experts always say you should take all the deductions to which you're entitled if you work at home.
One of the biggest is writing off a portion of your rent or mortgage costs, not to mention utilities and other related housing expenses. The advantage of doing so, of course, is to reduce your taxable income and hence, the amount of self-employment tax you owe.
But knowing whether you are eligible to write off a portion of your home as a business expense is tricky. The key is in knowing what the words "exclusive," "regular" and "principal" mean. But don't bother whipping out the Webster's for this one.
June Walker, author of "Self-Employed Tax Solutions" and a tax advisor who works exclusively with the self-employed, maps out the three basic IRS rules that determine eligibility -- your work space must comply with all three.
Meeting the "exclusive use" rule
Rule No. 1: "The part of your home used for business must be used exclusively for business."
That means a space devoted solely and wholly to your business and nothing else. It does not mean a space that you also use for other activities.
So if you and your spouse each run your own home business and share the same room as an office, neither of you has "exclusive" use of the work space. Hence, neither of you gets to take the deduction.
Or, let's say you do your work at the dining room table, the very same table at which you host dinner parties. According to Walker, you can't take any deduction for the dining room.
The two exceptions to this rule are running a daycare business out of your home and using a part of your house to store business inventory.
What you can do is to allocate a portion of a room exclusively for work -- e.g., a 3'x2' desk in the bedroom. If you use that desk for nothing but your business, you may be eligible to deduct the cost for those six square feet of space, assuming the desk also meets rules 2 and 3 below.
Personal events like the birth of a baby or the addition of Grandma Jones to the household can mean changing where you work in your home in the course of year. That's why Walker recommends taking time-stamped pictures of your exclusive work spaces, so that if they change, you have proof that, say, for the first half of the year, you worked in the basement and for the second half you worked at a desk in the bedroom.
Meeting the "regular use" rule
Rule No. 2: "The part of your home used for business must be used on a regular basis for business."
You're self-employed and rent an office or studio outside of your home. But sometimes you use a room in your house to conduct some business – perhaps to bring clients by to see your work. Since the room isn't your regular place of business, you may not deduct it.
If, on the other hand, you designate one room in your house for the exclusive purpose of having regular meetings with clients because, say, your office or studio is always a mess, then you may deduct it.
Meeting the "principal place of business" rule
Rule No. 3: "Your home office, studio or workshop must be your principal place of business."
To meet the "principal" rule, Walker says, your place of business has to meet one of three criteria: it's where you do your administrative tasks like bookkeeping; it's the place where you bring clients; or it's a separate structure.
It does not mean the place where you do most of your business.
So you may rent an office in town, but use a portion of a room in your house to do your bookkeeping. The costs for that portion of the home, assuming it's used exclusively and regularly for bookkeeping, may be deducted.
Writing off equipment
Whether or not you're eligible to write off a portion of your housing costs as a business expense, you may be eligible to write off the cost of equipment you use at home in the service of your business, such as a fax machine or a second phone line dedicated to business calls.
But it gets tricky when a piece of equipment can be construed as one you also use for personal activities.
For instance, you may not deduct the first phone line in your home, even if it's your only phone line. That's because the assumption is that your only phone is for personal use. You may, however, deduct the bells-and-whistles you add for business purposes, such as call-waiting. And you may deduct the cost of individual business calls.
If you only have one computer and you use it for business, you may be able to write off a part of its cost, but writing off 100 percent may not be wise, Walker said. In the event of an audit, it may be hard to prove that you don't use the computer for personal reasons as well.
Speaking of audits, there is what Walker calls "an old husband's tale" that deducting a portion of your housing costs will be a red flag to the IRS. Based on her two decades of experience working with the self-employed, she has not found that to be the case.
But there may be other elements on your return that do present a red flag. She gives the example of a taxpayer who might have a salaried job making $100,000 but a side business as a photographer for which he deducts a portion of his housing costs. What may trigger an audit is not that deduction, she said, but rather his reporting $200 in income, but $5,000 in expenses.
Walker advises clients to never hide income, to only deduct legitimate expenses and to keep meticulous records to back up their deductions. That way, if the IRS ever does audit you, you won't be penalized.
But if the auditors -- either through a home visit or a meeting with you in their offices -- determine you fraudulently claimed a deduction, you'll be subject to a penalty for fraud in addition to other interest and penalties for taking a deduction to which you're not entitled.
To find out more about the ins and outs of home-office deductions, click here.