September 07, 2010
Update On The Home Office Deductions
An interesting phenomenon over recent tax seasons is the increase in taxpayers who supplement employment income by using their talents in other venues. This may give rise to mixed use expenditures, expenses allocable between business and personal use. Which expenses are allocable? How are those expenses allocated between personal and business? How does an individual maximize the benefit of the deductions?
The Internal Revenue Code, IRC, classifies allowable deductions in three areas: deductions relating to a trade or business, deductions incurred in the course of a profit seeking activity that is not a trade or business, and certain personal expenses. Trade and business expenses are described in IRC §162 - ordinary and necessary expenses that are the costs of producing income. IRC §212 allows deductions for expenses incurred for the production or collection of income in a profit seeking activity that is not a trade or business, i.e. investment or rental property. Various IRC sections define deductible personal expenses. Mixed use expenditures are generally the business expenses allowable under IRC §162 and personal expenses specifically allowed as deductions.
The home office deduction is comprised of both categories of expenses. The taxpayer who carves out a section of the home which, per IRC §280A(c), “is exclusively used on a regular basis” for business may qualify for this home deduction. A tax advantage to the home office is that nondeductible personal expenses may become deductible in so far as they are associated with the home office or maintaining the home. Rent, utilities, home owners insurance, repairs and maintenance are all nondeductible personal expenses that become deductible within prescribed limits. Real estate tax and qualified home mortgage interest, already deductible personal expenses, become allocable between deductible personal expense and trade and business expense. Generally, the allocation is made based on square footage of the office in home as a portion of the square footage of the entire home. Note that home equity loan interest must be distinguished from other mortgage interest and may or may not be allocated using the square footage method. Interest tracing rules apply first when calculating the portion of home equity loan interest allocable to the home office. Home equity loans used for home improvement result in deductible home office interest expense directly or proportionately allocable to the home office based on the improvement made. The interest from home equity loans used for purposes other than home improvement or direct business expense is solely a deductible personal expense subject to the limitations of home equity debt.
Typically, allocating the expenses using the square footage method as described above is sufficient but the taxpayer should be alert to over or understating expenses. For example, if the taxpayer increases home owners insurance to cover business equipment the incremental premium is a direct business expense and should not be allocated between business and personal use. Conversely, expenses that are unrelated to the home office, such as painting the kitchen, are not deductible as a home office expense.
Before taking any home office expense deduction it is important that the taxpayer confirm the regular and exclusive use requirement imposed by IRC §280A(c). The home office must be used regularly as the principle place of business and the area designated as home office must be used exclusively for trade or business. Personal use of the area or use of the area for a profit seeking activity that is not a trade or business, i.e. investment or rental, will disqualify the deduction. Qualification as principle place of business is determined by examining facts and circumstances. Use of the home office for administrative and management activities when there is no other location where these duties may be performed qualifies the home office as the principle place of business. The fact that the tax payer renders service to clients outside the home does not disqualify the home office deduction. There are two special circumstances when the home office will qualify for a deduction even if it is not the principle place of business. They are if the home office is used as a place for physically meeting clients or dealing with customers in the normal course of business or, if the home office is a structure separate from the main dwelling and that structure is used in connection with the business.
Telephone expense, land line or mobile, is a commonly abused mixed use expense. Basic local telephone service, including tax, for the first telephone line of the residence must be treated as a personal expense per IRC §262(b). Only additional charges can be allocated between personal and business use or directly identified as a business expense. Incremental service charges and associated taxes to increase the calling area, addition of a second line for business purposes and business long distance phone calls are expenses directly deductible from business income. Care must be exercised when claiming a deduction for the mobile or cell phone. A cell phone is listed property. Listed property has stringent substantiation requirements per IRC §274(d)(4). Adequate records or sufficient evidence for cell phone use must be kept or the taxpayer’s deduction may be disallowed. Records should list the following:
- Amount of the expense;
- Time and place of the expense;
- Business purpose of the expense; and
- Business relationship of the other party.
The substantiation requirements for listed property also apply to travel expense, which can be a dual purpose expense. In the case of overnight travel one looks to the primary purpose of the travel to determine the nature of the deduction. If the facts and circumstances indicate that the primary purpose of the travel is business then the travel expense is deductible as a business expense even if some portion of the trip is personal. Meals and lodging during the trip are allocated to business or personal use depending on the activity engaged in at the time of the meal and lodging. If the taxpayer is engaged in a business activity then the meals and lodging are deductible business expenses.
These rules apply regardless of the number of profit seeking activities in which the taxpayer is in engaged. In contrast, the generally nondeductible status of commuting expense is significantly affected when the taxpayer has more than one job or a trade and business and the principle place of business is a home office. Under these circumstances the expense of traveling between the home office and another work location in the same trade or business becomes a deductible expense. Likewise travel expenses between a main job and second job are deductible commuting expenses.