Question: Is it true that people who claim home office deductions are audited more frequently than those who don't?

Answer: The IRS has limited resources, so it tries to make its audit program as efficient as possible. It does this by selecting returns for audit that appear to be the best prospects for adjustments. For years before 1999, if you were a service provider and those services were traditionally performed at a location away from your home office, it is unlikely that your home office qualified as your principal place of business. In this situation, claiming home office deductions for those years increased your risk of audit. However, beginning in 1999 it is possible for virtually everyone who does business from their home to qualify for home office deductions. If you qualify and report those deductions properly on your return, it is unlikely that your risk of audit is increased at all. An audit is always a possibility, though. So be sure to maintain proper records and keep those records for at least three years after the due date of your return, or after you file your return, whichever is later.

Question: Under what circumstances is it okay to deduct home-office expenses?

Answer: As a result of legislation that took effect in 1999, home-office deductions are now available to virtually everyone who does business from home. There are three business uses of your home for which home-office deductions are allowable if the use is regular and exclusive. They are 1) as your "principal place of business," 2) as a place where you meet with clients or customers, and 3) with respect to a separate structure, on your property, as a place that is connected with your business. There are two additional business uses that qualify if the space is used regularly, but it need not be used exclusively. They are 1) as storage for inventory or product samples, and 2) as use in the business of a day-care center. Deductible home-office expenses are generally limited to the net income from your business.

Beginning in 1999, the term "principal place of business" includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business, if there is no other fixed location where the taxpayer conducts substantial administrative or management activities of that trade or business. So if your home office is the primary place in which you perform your administrative and/or management activities, it will qualify as your principal place of business, even if most of your important work is done out of the office or at a separate office located outside the home. This revised statutory definition of principal place of business allows home-office deductions to millions of home-based business owners who were previously denied them.

Question: What are the rules on selling a principal residence with a home office?

Answer: The old deferral of gain on the sale of a principal residence rule has been repealed effective for sales after May 6, 1997. The exclusion of gain provision that was previously available only to people over 55 has been expanded for everyone who owns a home and lives in it for two out of the five years preceding the sale. The exclusion is up to $250,000 of gain for single taxpayers and up to $500,000 of gain for married individuals filing a joint return.
Under the old deferral of gain rules, if you claimed home office deductions in the year of sale, you were required to treat the sale as two separate sales and report any gain allocable to your home office as taxable gain on Form 4797. However, if home office deductions were not claimed in the year of sale, you could report the entire gain on Form 2119 (now obsolete) as the sale of your principal residence, and were not required to separate the gain attributable to your home office.

Under the new rules, even if you claim home office deductions in the year of sale, you can exclude part of the gain attributable to your home office if your business if your business use was no longer than three years out of the five years preceding the sale. However, the new exclusion does not apply to depreciation claimed for business use attributable to periods after May 6, 1997. You must pay tax on this portion of the gain at the maximum rate of 25 percent.

Question: What specific expenses are disallowed if my home office does not meet one of the business use tests for home-office deductions?

Answer: If your home office does not meet one of the business-use tests described in the previous question, only "home-office" expenses are disallowed. This is a fairly narrow category of deductions that are described in the Code as deductions "with respect to the use of a dwelling unit" which is used as your principal residence. Excluded from this category is any expense connected with your residence that would be allowed if you didn't have a home office — meaning property taxes, home mortgage interest and casualty losses. So only those deductions that are directly related to owning your home, and would otherwise be nondeductible personal living expenses, qualify as "home-office" expenses. These include depreciation on the business portion of your home, home-owners insurance and utilities allocable to your home office. Other business expenses, like supplies, travel and depreciation of furniture and equipment, are generally not affected. However, if your home office does not qualify as your principal place of business, the deductibility of your local transportation costs from your home office to another place of business might be limited.

Question: Under what circumstances does my home office qualify as my principal place of business?

Answer: It is now extremely easy to qualify your home office as your principal place of business, even if you maintain another office outside the home. The law has been changed for tax years after 1998, so here is the old rule and the new rule.

The rule before 1999: Your home office had to be used regularly and exclusively in your business, but that was often not enough. According to the Supreme Court, your home office had to be the most important place in which you conducted business. That means the activities performed in your home office had to be more important than your other business activities. You determined which activities were most important by considering the nature of your business. If you were in sales, for example, your most important business activity was selling; if you were a plumber it was doing the plumbing work; if you were a doctor, it was actually doing the doctoring. If your main business activity was conducted both in your home office and elsewhere, then you had to spend more time performing the activity in your home office than at any other location. Therefore, if your main business activity was the performance of personal services, and those services were performed primarily outside your home office, your home office was not your principal place of business. This was so even if your home office was the only place you had in which to do management and administrative tasks.
The current rule: Effective for years after 1998, the Taxpayer Relief Act of 1997 provides that the term "principal place of business" includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business, if there is no other fixed location where the taxpayer conducts substantial administrative or management activities of that trade or business. So under the new rule, if your home office is the primary place in which you perform your administrative activities, it will qualify as your principal place of business, even if most of your more important work is done somewhere else. This opens up home office deductions to millions of home-based business owners who were previously denied them.

Question: Are there restrictions on claiming depreciation on personal business property used in a home office?

Answer: Most depreciable business property used in a home-based business (other than the residence and improvements to the residence) is 5–year or 7–year property, and the method available is generally the 200% declining balance method. If an item is used only partially for business, the basis for depreciation is only the business-use portion of the cost.
Also, purchased tangible personal property used in your business, such as computers, furniture, books, etc., is generally eligible for immediate expensing under Internal Revenue Code (IRC) Section 179. The expensing election is only available if more than 50 percent of the property's use during the entire depreciable life of the property is for business.
Certain property, called "listed property," that is not used more than 50 percent in a qualified business for its entire depreciable life must be depreciated using the straight line method. Listed property includes automobiles and certain other transportation property, computers and peripheral equipment, any property used for entertainment or recreational purposes, and cellular phones. However, computers and recreational equipment are only regard as listed property if your home office does not meet one of the first three business-use requirements discussed in a previous question.

Question: What local transportation expenses are deductible if I maintain a home office?

Answer: If your home office qualifies as your principal place of business under Internal Revenue Code (IRC) Section 280A, you can deduct daily transportation expenses incurred in going between your home office and another work location in the same trade or business, regardless of whether the other work location is regular or temporary, and regardless of the distance.

The deductibility of transportation costs gets a little more complicated when your home office does not qualify as your principal place of business. The expenses are treated differently depending on whether you have a regular work location outside your home office.

Regular work location. If your home office does not qualify as your principal place of business, and you have one or more regular work locations outside of your home, transportation between your residence and the regular work locations is considered nondeductible personal commuting. Nevertheless, the IRS allows you to deduct daily transportation expenses in going between your home and temporary work locations in the same trade or business, regardless of the distance. For example, if you are a doctor working regularly at an area hospital, your transportation between your home and the hospital is nondeductible. But if you pay daily visits to a patient at the patient's residence for a short period while the patient is sick, the transportation is deductible, even if you started from home to make the visits.

No regular work location. If your home office is not your principal place of business, and if you have no regular work location outside your home, then you cannot deduct the cost of transportation between your home and any temporary work locations within the metropolitan area. However, you can deduct daily transportation expenses incurred in going between your home and a temporary work location outside the metropolitan area where you live and normally work. For example, if you live in Los Angeles, California, and you drive to a business seminar in Long Beach for the day, your transportation is deductible. But a short run to the office supply store in Los Angeles from your home is not deductible.