Many entrepreneurs think working from a home office will be a dream come true-- until they give it a try. The reality of working from home, however exciting the prospect, can be a shock to the system.

It's not all about fuzzy bunny slippers and skipping the day's shave.

A disciplined and focused person can save valuable time and money using a home office. But for others, working from home can be a big time-waster.

"If you are not disciplined enough, you can be much more inefficient than if you were at work," says Howard Hook, a certified financial planner and certified public accountant with Access Wealth Planning in Roseland, N.J.

Here's what you need to know before you dive into a home office.

The Taxes
If you create a home office space in your home, do it right. The IRS has very strict rules surrounding home offices because they give businesspeople valuable deductions.

Your home office must be used exclusively and regularly for business. That means the room you choose can't be used for both business and personal purposes, such as doubling as a guest bedroom.

An auditor may never know if you occasionally let your kids watch television in your home office, but you could be violating the "exclusive" rule if it happens regularly.

The deduction doesn't have to be for an entire room, if that section of a room is not used for personal purposes, says Cynthia Turoski, a certified financial planner and certified public accountant with Bonadio Wealth Advisors in Albany, N.Y.

"There is an exception to this for wholesale and retail sellers who use a portion of their home for storage of inventory and product samples if certain criteria is met," she says.

Check with your tax preparer if you're not sure you qualify for a particular deduction. Below are some additional tax items to consider:

  • Direct and indirect expenses: There's a distinction made between direct expenses and indirect expenses, Hook says. Direct expenses are those attributable only to the business portion of the home, such as a separate phone line and business equipment. Indirect expenses are expenses for the entire property, which cover both personal and business, such as utilities, rent and insurance. These are treated differently as deductions.
  • Recordkeeping: The burden of proof is on the taxpayer, says Hook, and good recordkeeping can indicate to an IRS agent the legitimacy of the business. This is especially helpful for businesses that may be experiencing losses, as losses may indicate more of a red flag.
  • Depreciation on your home: Normally when you sell your home, you may be eligible for an exclusion on the full gain, but if you use part of your home for business, some of the gain may be taxable, Turoski says. "You can't exclude the part of the gain equal to all the depreciation you deducted, or were eligible to deduct, since May 6, 1997," she says.

    "However, if you have adequate records that can show you deducted less depreciation than you were allowed to deduct, the portion of the gain that would be taxable would be up to the amount of depreciation you actually deducted." (See sidebar for more on depreciation.)

The Clients
Not every business type is suited to a home office. If you use your office strictly for paperwork or you don't need to regularly see clients, it's pretty simple to make a home office suit your needs.

If you do need to see clients, you'll need more than a computer and a desk. You'll need a professional atmosphere.

The easiest way to maintain professionalism at home is to imagine this space as you would an outside location. Rather than couches and end tables, furnish the space with business furniture and enough seats for your clients. A "business only" entrance and even a waiting room would be ideal if your home allows.

If you won't be seeing clients in your home office, you should still treat the space like an office. Maintain a separate phone line, for example, so you don't have to worry about a call-waiting interruption from your mother-in-law during an important telephone meeting.

You should also try to have a professional state of mind.

"Even when working out of your home, you should still pretend you are going to work somewhere else," Turoski says. "It just happens to be that the office you are going to is right down the hall instead of down the road."

If you have children, you'll need to make special arrangements so your clients don't hear Barney or squabbles between siblings when you're on the phone. Trying to work and parent at the same time can be stressful for you as you're torn between two masters. As a solution, consider a babysitter or day care for your working hours. If your children go to school, try to get done the work that requires phone calls when they're out of the house.

The Emotions
If you cherish time at the watercooler with colleagues, you may miss the social aspect of working outside the home. You'll need to balance that with your added productivity without distractions from co-workers.

Increased productivity aside, you might get a little lonely.

"I hear from some people who work in seclusion out of their home that it gets to be too quiet after a while," says Turoski. "They become starved for conversation and can't help but wear down their spouse when he/she gets home with all the pent-up conversation."

Plan lunch meetings and attend networking events to alleviate the feeling of isolation.

While co-workers may distract you at the office, your home may offer other distractions, so it's important to set a work schedule and stick to it.

A schedule will help keep you on track if you're tempted to throw in a load of laundry or organize a messy closet when you should be writing a report or balancing the books. It can also work the other way around, and you may find your work life creeping into your home time, such as if you can't help but answer the business phone during a family dinner.

Depreciation

Depreciation reduces your cost basis on assets, says CFP and CPA Howard Hook. This is done so that when the asset is either sold or disposed of, the portion depreciated is not deducted again.

A taxpayer who sells their primary residence must reduce their original cost plus improvements by the amount of depreciation taken on the business use of the home.

For example, Bob sells his home for $500,000. Bob purchased the home in 1995 for $250,000. In the past, he had taken $50,000 of depreciation deduction against the portion of the home used for business. Therefore, his adjusted basis in the home is $250,000 minus $50,000, or $200,000. This is called "recapture" because the previous depreciation is being "recaptured" at sale. This is taxed at ordinary income tax rates, and the balance of the gain is taxed at capital gain rates.

So in this example, Bob had a $300,000 gain ($500,000 minus $200,000). Of the $300,000, $50,000 is taxed at ordinary income tax rates and $250,000 would be subject to capital gains tax rates.

However, primary residences carry with them an exclusion of gain of $250,000 ($500,000 if married filing jointly) if the owner meets certain tests. Hook says the IRS does not require that the gain be allocable to business and personal uses. Instead, it can be allocable to the primary residence exclusion. The exception is that the portion of the recaptured depreciation cannot be excluded. In Bob's example, the $250,000 of gain could be excluded under the qualified primary residence exclusion, and Bob would still have to recapture $50,000 of the depreciation.