Self-employed rejoice in home-business deductions

An estimated 30 million U.S. taxpayers work full- or part-time from their owned or rented residences. Whether you are employed, working at home for the convenience of your employer, or if you are self-employed, you may be entitled to significant tax saving deductions for part of your household expenses.

Deductible examples include part of your residence rent, utilities, insurance repairs, painting, property tax, mortgage interest, depreciation, and even business equipment costs.

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HOME-BASED EMPLOYEES HAVE A SPECIAL TEST. If you are an employee, such as an outside salesperson or a computer programmer working from your home, you have a special test to pass before you can deduct home business expenses.

This test requires your work at home be for the “convenience of the employer.” That means your employer doesn’t provide suitable work space and expects you to work primarily from your residence. However, if you rent part of your residence to your employer at a fixed rent, you won’t qualify.

If you are an employee who prefers working from home, such as a school teacher who enjoys grading papers and preparing lesson plans at home rather than at school, you don’t meet the “convenience of the employer” test. But some teachers can meet this test, such as teachers whose schools are not safe after school hours, or where the teachers are required to leave the premises after class hours.

THE PRIMARY BUSINESS LOCATION TEST FOR SELF-EMPLOYED BUSINESS OWNERS. Whether you operate a full- or part-time home business, you can probably qualify for the important home business tax breaks allowed by Internal Revenue Code 280A.

For example, if you are a real estate broker with an office in your home, you qualify if that is your only location. However, if you are an independent contractor realty agent working for a real estate brokerage that provides you with a desk and a phone, your home office expenses aren’t tax deductible.

Full-time or part-time self-employed business owners must be able to prove their residences are either (1) used to meet or deal with patients, clients, or customers, or (2) if they have no other fixed business location, the residence is the principal business location used for administrative activity.

The leading court decision on this issue was the 1993 U.S. Supreme Court case involving Dr. Nader Soliman (113 Sup.Ct. 701). Soliman deducted part of his condominium home office expenses where he spent many hours handling administrative work and reading professional medical journals. But he administered anesthesia to his patients at several nearby hospitals where he spent most of his working hours. The U.S. Supreme Court ruled Soliman was not entitled to deduct his home office business expenses because he spent most of his work time at the hospitals.

As a result of this case, in 1999 Congress changed the tax law to allow self-employed taxpayers, such as Soliman, to deduct home business expenses when their residence is their primary business location.

Thanks to Soliman and Congress, if you don’t meet business patients, clients or customers at your residence, you can deduct home business expenses if your residence is your principal business location used for administrative activity, although you spend most of your time working elsewhere. An example would be a plumber who receives customer calls at home and operates his business from a separate room, but spends most of his work day on service calls.

AN “EXCLUSIVE HOME BUSINESS AREA” IS REQUIRED. Presuming you passed the applicable home business use tests explained above, the next hurdle requires having an “exclusive home business area.” It need not be a full room, but can be part of a room, such as where you have your business equipment and supplies.

However, it cannot be shared use. Using your dining room table to do your bookkeeping clearly won’t qualify if you also have family meals there. Another non-qualifying example occurs if you occasionally entertain business clients at your home which is used by your family most of the time.

EVEN A PART-TIME BUSINESS USE CAN QUALIFY. The leading U.S. Tax Court decision in Dr. Edwin Curphey (73 T.C. 61) shows how a full-time employee can also deduct home business expenses for a part-time business. Curphey is a full-time dermatologist at a hospital. But he also managed his rental properties, part-time, from his home office. Because he had an exclusive home business area, Curphey’s home office area met the residence business deduction test.

The area used for storage of inventory or business equipment can also qualify. To illustrate, if you are a part-time Amway or Avon salesperson using part of your garage to store inventory and supplies, that exclusive business area meets the test.

However, part-time use of your home for your occasional investing won’t qualify. In the Joseph Moller case (553 Fed.2d 1071), Moller earned 98 percent of his income by investing in stocks and bonds from his residence. But the U.S. Court of Appeals denied his home business deductions because he was a passive, long-term investor rather than an active “day trader” with frequent transactions.

HOME BUSINESS AREA SQUARE FOOTAGE DETERMINES YOUR DEDUCTIONS. Whether you are self-employed or a qualified “convenience of the employer” employee using a designated home business area, the amount of your home business deductions depends on the business square footage area of your residence.

IRS Form 8829 (Expenses for Business Use of Your Home) is the place to calculate your square footage and the percent of home business deductions. The old room count method is no longer available.

For example, suppose you own or rent a 1,800-square-foot house or apartment. Your exclusive business area is 600 square feet. The result is 33 percent of most of your household costs become tax deductible. That means 33 percent of your homeowner’s or renter’s insurance, utilities, repairs, mortgage interest, and property taxes are deductible business expenses.

However, 100 percent of some home business costs are fully deductible. To illustrate, all of your business phone expenses are fully deductible. If you paint and renovate the business area, all the cost is a deductible business cost. Your business insurance premiums would also be fully tax deductible.

CLAIM BUSINESS DEPRECIATION IF YOU OWN YOUR RESIDENCE. Homeowners and condo owners who use part of their residence for qualified business use can claim depreciation for the exclusive business area of their residence. Using the above example, where the business area occupies 33 percent of the residence, that means you can depreciate 33 percent of your home’s purchase price (excluding land value) on the 39-year commercial property straight-line depreciation schedule.

However, when you sell your residence at a profit, the special 25 percent federal tax rate applies to your recaptured depreciation deductions. But IRS regulation 2002-142 says that when selling your principal residence, even its “business area” can qualify for the $250,000/$500,000 tax exemption of Internal Revenue Code 121.

GENEROUS NEW HOME-BUSINESS EQUIPMENT DEDUCTIONS. Effective with the 2003 tax year, home business owners can deduct up to $100,000 for business equipment purchases. The result is no need to depreciate equipment expenses, which cost less than $100,000 total, even if the purchase was completed on Dec. 31, 2003. However, if the annual total business equipmentpurchases were greater than $100,000, the excess must be depreciated over the equipment’s depreciable life.

BUSINESS AUTO EXPENSES START AT YOUR FRONT DOOR. Another home business expense advantage is, if you begin your business day at your home office, your automobile or truck expenses are tax-deductible after you leave your home office. If you keep a record of business trip mileage, the IRS allows 36 cents per business mile for 2003.

WATCH OUT FOR HOME BUSINESS DEDUCTION LIMITS. If your home business deductions exceed the home business income, the excess cannot be used to create a tax loss to shelter other income, such as interest and dividends.

To illustrate, suppose your part-time home business had $10,000 net income before the IRS Form 8829 home business use deductions, which total $15,000. In this example, you can deduct only $10,000 of home office expenses, but the remaining $5,000 can be carried forward to a future tax year.

SUMMARY. Home business expenses are often overlooked by full-time and part-time business owners who operate primarily from their residence. Qualified employees who are expected by their employers to work from their homes often are unaware of these tax saving deductions. For more details on the home business tax deductions, please consult your tax adviser.

Next week: Realty investors enjoy special tax breaks.