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Is Your Home Office Deduction a Red Flag?

With more people working from home, the IRS has become surprisingly benevolent.
June 15, 2010
URL: http://www.entrepreneur.com/article/207022

About half of the business owners I talk to think that if they deduct their home office on their income tax return they will raise a red flag with the IRS. "I don't want to be audited!" is the battle cry.

This may have been a big concern in the 1990s, but it's not today. Here's a little history to enlighten you.

In the early 1990s, Dr. Nadir Soliman lost his home office deduction during an audit of his income tax return. He fought the decision all the way to the Supreme Court and lost. The IRS had determined that Dr. Soliman, an anesthesiologist, was not using his home office as his principal place of business. Dr. Soliman claimed that none of the three hospitals that subcontracted to him provided office space. He therefore had to perform his administrative duties, do his medical research, and consult with other medical professionals out of his home office, which only qualified under the exclusive-use test. The office he used in his three-bedroom apartment was not used for any other purpose. But he had failed the other test--principal place of business. Obviously, the hospital operating theatre was his principal place of business.

It didn't matter that Dr. Soliman could have rented an office space near the hospital and that would have been deductible all day long. In light of this, the ruling was crazy, but it stuck. Until about 1999, that is.

The impact was disastrous for entrepreneurs. Unless you performed all of your duties from your home office, you could not deduct it. That meant that pretty much everyone was excluded from the deduction. Imagine that! Building contractors, landscapers, handymen, appraisers, realtors and so many others were no longer entitled to the deduction. And if they attempted to take it, the deduction was rejected, possibly along with other deductions that fell to an auditor's scrutiny.

In 1999, the IRS came to its senses and decided to retract their illogical thinking on this matter. The home office was back! By 2010 there are many more people who have become self-employed using home offices, and the IRS no longer automatically looks askance at the deduction.

So What Are the Rules?
First of all, the space must be used exclusively as a home office. If the room you use is multi-purpose--it's a guest room as well as a home office--then you can only count the area of the room that is 100 percent devoted to business use. The area must also be used on a regular basis, be your principal place of business or be a place to meet or deal with patients, clients or customers in the normal course of your business. This means that you do not have a second location where most of your business activity takes place. In other words, you don't have a retail store or a second office downtown and you just bring home bits of paperwork now and again. If that's the case, you do not have a bona fide home office. You can, however, deduct a portion of your home for storage of inventory, equipment, etc., even if you have another main business location. Please note that there are special rules for child care providers.

IRS Publication 587 contains all the rules and regulations you need to know to properly deduct your home office. Stay tuned, I will discuss these rules in my next column.