Tax IQ: Home Office Deduction
Updated: Dec 4, 2022
Time to clear up some common home office misconceptions!
The path to the home office deduction has pitfalls to avoid and hurdles to be cleared!
A home office deduction is similar to a marble labyrinth
Part I: Requirements
#1️ The home office must be used exclusively for business purposes.
There can be no personal use in your home office area. Anticipated Taxpayer Response: "That's not fair; any logical person knows it is impractical to have an office in the home with no personal use in it." This rule is unpractical, illogical, and unfair, but welcome to the US Tax Code. It is what it is, deal with it.
....hey! That is Peter J Reilly's #1 Rule of Tax Planning
Combining personal and business use of the same space torpedos the entire home office deduction; you don't get part of the deduction if you use the space partly for personal reasons. It's all-or-nothing.
🤏🏻 Some de minimis personal use is allowed, but not much
Example #1: Carl Hughes Jr. claimed a home office deduction for the walk-in closet of his studio apartment. In order to get to the bathroom, Carl had to walk through his closet. The Tax Court ruled that is use of the closet to walk-through was de minimis and didn't violate the exclusive-use requirement. 🏆Taxpayer win! Example #2: Mr. Culp stored his lawnmower in the garage he claimed as his home office. The Tax Court stated: "This may be true, but we believe that whatever space was occupied by the mower was de minimis and does not alter the fact that the garage was used exclusively for business." 🏆Taxpayer win!
😖 Don't confuse minimal use & de minimis use
Example #3: Jeffery Rayden claimed 71% home office but was granted only 43% by the Tax Court but Mr. Rayden violated the exclusive-use rule. Mr.Rayden had a den, vestibule, and an adjoining bar area that was used "maybe once or twice a year" when he was hosting visiting family. "Exclusive use of a portion of the taxpayer's dwelling unit means that the taxpayer must use a specific part of the dwelling unit solely for the purpose of carrying on his trade or business. The use of a portion of a dwelling unit for both personal and for carrying on of a trade or business does not meet the exclusive use test. " ❌Taxpayer loss. Example #4: Mrs. Langer ran a piano business from her home. She had a special area set aside for the business, and she claimed exclusive business. Mrs. Langer's mistake was that she had an "open house", the way it is described sounds like a house party for friends and family. The business area was used for the party and the Tax Court disallowed the entire home office deduction. ❌Taxpayer loss. Example #5: Paul M. Sengpiehl claimed his dining room as office space, noting that personal activities go on in downtown law offices after working hours. He admitted to the Court that he and his family used the dining room for Saturday & Sunday dinners. The Tax Court ruled that Mr. Sengpiehl's family dinners violated the exclusive-use rule. He was disallowed the home office deduction. ❌Taxpayer loss.
🙋🏻♂️ Exception #1: Storage of Inventory or Product Samples
You do not need to meet the exclusive-use test if, and only if, you are in the business of selling products at retail or wholesale AND you are storing inventory or product samples.
Example #1✅: Your home is the only fixed location of the business, which involves selling mechanics tools at retail. You regularly use half of your basement for storage of inventory and product samples. You sometimes use the area for personal purposes. The expenses for the storage space are deductible even though you do not use this part of your basement exclusively for business.
Example #2❌: Dr. Smith practiced dentistry in a downtown medical building but retained dental records of more than 3,000 patients in 36 file drawers in the attic of his home. Other parts of the attic were used for personal purposes.
The Tax Court ruled that Dr. Smith may not treat the storage area of his home-office expenses because the records were no inventory of samples & Dr. Smith did not operate a wholesale or retail trade or business from his home.
#2 The home office must be used regularly.
The office must be used on a continuous and regular basis. "Incidental & occasional business use is not regular use." - IRS Audit Manual The IRS does not offer much help with this definition but some court cases do:
👩🏻⚖️ Tax Court Case Results
Example #1: Max Frankel of the New York Times used his home office after business hours to speak with politicians and aides. He averaged one call per night and each such discussion might require several actual telephone calls to complete. The Tax Court ruled in favor of Mr. Frankel in regard to the regular-use test. 🏆Taxpayer win! Example #2: John Green could not be reached during much of the day, because many of his callers could not themselves make telephone calls during the data he was required to receive a substantial number of telephone calls from clients at his home after regular working hours, averaging 2 hours a night, five nights a week. The Tax Court ruled in favor of Mr. Green and concluded the time spent met the requirements for regular use of his home office. 🏆Taxpayer win! Example #3: Anthony Cristo lost his home office battle because he did not have any information support regular use (unlike Mr. Frankel & Mr. Green above) ❌Taxpayer loss.
Some jobs will inherently have corroborative, time-stamped evidence such as emails, texts, or a phone call log. These can be used to support regular and continuous use.
However, if you do not have the above items to corroborate your regular use, then you need to keep a time/guest log. Peter J Reilly's #13 Rule of Tax Planning: "Being right without substantiation can be as bad as being wrong."
#3 Four types of home office spaces
🏠 Principal Place of Business
You must perform substantially all of your administrative and management activities in your home office (this is important if you have a fixed location office in addition to your home office; not as important if your home office is your only office).
The IRS lists the following as administrative and management:
•Billing customers, clients, or patients
•Keeping books and records
•Setting up appointments
Things that won't disqualify your home office as being your principal place of business:
•Having others conduct administrative or management activities at locations other than home
•Conducting administrative or management activities at locations that are not fixed locations
•"Occasionally" conducting "minimal" administrative or management activities at a fixed location outside the taxpayer's home.
•conducting "substantial" non-administrative or non-management business activities outside the home (e.g. meeting with clients at outside locations) and
•choosing to conduct administrative or management activities at home even though the taxpayer has suitable space to conduct them outside the home.
***A 'principal place of business' home office has some additional perks (discussed below)***
🤝🏻 Physical Meet & Greet
A non-principal place of business (a place used by patients, clients, or customers in meeting or dealing with you in the normal course of your trade or business.
🏢 Separate, Detached Structure
A non-principal place of business (a separate structure that is not attached to the dwelling unit but is used in connection with the taxpayers trade or business).
📦 Storage of Inventory or Product Samples
We discussed this above; this is a circumstance in which you do not need to meet the exclusivity test.
You do not need to meet the exclusive-use test if, and only if, you are in the business of selling products at retail or wholesale.
Part II: All is Not Lost
You might be discouraged into thinking that the home office deduction is not obtainable, but there are aspects that can work for the taxpayer.
#4 'Principal Place of Business' Home Office is Extra Special
🎒 Why it is extra special
In addition to the home office deduction, making your home your principal place of business can create thousands of dollars in vehicle deductions.
🚗 Commuting miles 101
Commuting miles from your home to your outside-the-home office are nondeductible personal miles.
When your home office is your principal place of business, the miles driven to your outside the home office are tax deductible.
Example #1: Let's say you drive a vehicle that costs $1 to drive. Further, let's say that your personal commute to and from your office is 24 miles a day, 5 days per week, 48 weeks per year. That's $5,760 in new deductions.
Example #2: You drive a $50,000 vehicle 40% of the time for business, but by replacing your nondeductible commuting miles with deductible business miles, your business use increases 80%. This increases your depreciation deduction from $20,000 to $40,000, an increase of $20,000.
🚗🚗 Additional miles
Also, all the trips you take from home for business purposes are deductible business miles.
#5 A Tiny Office is Okay
⬇️ Small Space, ⬆️ Big Deductions
A home office can create deduction in two ways:
1) a percentage of your home expenses, such as rent, utilities, repairs, etc.
2) the miles you drive back on forth from your principal office (home) to your outside-the-home office (see above).
🚫 No Walls Needed
According to tax regulations, your office space does not have to be an entire room. You can use any part of a room, and you do not have to mark the area with a permanent partition.
🤏🏻 You Can Have a One-Square-Foot Office
•Step #1: Buy a storage cabinet or shelf that extends all the way to the floor.
•Step #2: Use the cabinet only to store business items such as files and business supplies.
•Step #3: When you work at home, pull a table or a desk next to the cabinet and do your work there.
•Step #4: When you are finished working, you can remove the table if you need the space.
✅ You can engage in personal activities everywhere except the cabinet space.
✅ You are eligible to claim only the space for the cabinet, which will be a small deduction but
✅ This could pave the way for a very lucrative vehicle deduction.
🚨Most Important Takeaway
It's better to have a small (or even tiny) home office space that you can defend 100% business use than it is to have a large home office space that could be completely invalidated because of a small amount of personal use.
Remember it's all-or-nothing, so err on the small side that can be more easily defended.
#6 A Second Work Area is Beneficial
🙌🏻 Supports Your Case
Having a second area where you do personal work helps support that your main home office is dedicated exclusively to business.
👨🏻💼 Change Your Behavior
If you have been using your home office for personal reasons, then change your behavior now. Do your personal work or activities in another area of the home (if you are able).
#7 Three Methods to Calculate Office Space
1️⃣ Method #1: Square footage
Divided the area used for business by the total area of your home.
2️⃣ Method #2: Number of Rooms
If the number of rooms in your home are all about the same size, you can divide the number of rooms used for business by the total number of rooms in your home.
3️⃣ Method #3: Net-Square-Footage Method
Under this method, you subtract out unusable space:
•water heaters and
•heating and cooling equipment
This reduces the denominator, making your home office area larger.
(Business Area) / (Total Area - Unusable Space) = Home Office Percentage
This method is proposed and supported by Bradford Tax Institute: July 2016 "Tax-Saving Tip: Use Net Square Footage to Increase Home-Office Deductions"
#8 What is Deductible?
📃 List of Home Office Deductions
•Homeowners' or renters' insurance
•Utilities (electric, gas, water)
•Repairs done to the entire house**
•Cost of home is depreciated over 39 years***
•Improvements & renovations are depreciated over 39 years
🔍 Fine Print
*The principal portion of your mortgage payment is not deductible, so your monthly mortgage payment is not enough information to calculate your home office deduction.
**Repairs done directly to home office are 100% deductible and not subject to the home office percentage.
***A portion of the purchase price must be allocated to land, which is not depreciable. We typically use the County's website allocation.
🌱 Special Note About Lawncare
Lawncare, landscaping and outdoor maintenance is only deductible if you have patients and clients come to your home.
Part III: Speical Situations
#9 More Than One Business
If two business activities use the same home office space, then both businesses need to qualify for the home office in order to deduct the home office deduction.
If either business fails, then the deduction is lost for both businesses. See Hammacher V Commissioner 1990
A spouse using the same home office space as the taxpayer is treated the same as above; both spouses need to qualify for the deduction or the deduction is lost for both the taxpayer and the spouse.
🏫 Planning Tip
If one spouse qualifies, but the other spouse does not qualify, keep the non-qualifying spouse away from your home office space in order to preserve the deduction.
#10 S Corporation Employees
🏢Additional Requirement: Convenience-of-the-Employer Rule
🚨 The employee must be working from home "at the convenience of the employer".
If the employee is working from home for their own convenience and not the employer's, then the home office reimbursement is not allowed.
Reasons why your work might need to be carried out at home:
to protect the confidentiality of the payroll & accounting records.
to ensure that your work at the office focuses on sales (patient care, production).
because the office has inadequate space to accommodate the payable records, invoices, receipts, and so on.
to facilitate uninterrupted attention to business plans & budgets.
🏫 Planning Tips
1️⃣ If possible, do all the administrative/management activities at home.
2️⃣ Have open-use work stations for your employees at your outside-the-home office. This would support not being able to private administrative work in the outside-the-home office (i.e. you need your home office for privacy).
❌ What Not To Do
❌ Rent your home to the Corporation (I.e. pay rent)
IRC 280A(c)6 disallows tax deductions for the home office on rentals by employees to their employers. Thus, owner-employees do not achieve home-office deductions on the rental of an office in the home to their corporations.
❌ Claim Home Office as Employee Business Expense
This has many downsides, not the least of which being that Employee Business Expenses are not deductible from 2018-2025. The other downsides being 2%-floor & Alternative Minimum Tax (AMT)
✅ Best Method
✅Accountable Reimbursement Plan
The Corporation needs to have an "Accountable Reimbursement Plan" in place.
The accountable plan requires you, the owner-employee, must:
•incur the expenses in the performance of your duties for the corporation and
•substantiate the expenses to the corporation in accordance with the requirements imposed by law.
To meet this requirement, your substantiation must show:
✔️ exclusive and regular use of the office in your home
✔️ use of the office for the convenience of your employer
✔️ use of the office as a principal place of business or other qualified use under the regulations and
✔️ expenses to be reimbursed, including depreciation