Working from Home: Ten Tax and Legal Tips

Vol. 28 No. 7

By

Kelly Phillips Erb practices tax law in Philadelphia, Pennsylvania, and blogs at taxgirl.

 

My husband and I have a pretty good commute these days to our office: It’s just about a mile and a half away from our home. That’s nothing, though, compared to the commute to our first office: It was a mere flight of stairs away. Like many lawyers who hang their own shingle, when we first started our law firm, we opted for a home office. We turned one floor of our house into an office, complete with desks, computers, a full-sized copy machine, a small conference table, and chairs. We installed two additional phone lines, one for phone and another for fax. Just like that, we were in business.

The very next year, we signed a lease for office space and hired two employees. We had outgrown our space and faced a whole other set of challenges. I was, however, grateful for our stint at home. The experience taught us a lot about the legal aspects of running a small business and helped me sort out the practical implications—especially from the tax side—of having a home office. It’s one thing to read Internal Revenue Service (IRS) regulations that explain how a home-office deduction is figured; it’s quite another to pull out your ruler and calculator to determine it yourself on your own tax return.

Below are ten tips for running a home office, tips that I learned both from counseling my tax law clients and from my own experiences practicing law at home.

1. You may need additional insurance. Our homeowner’s insurance did not include liability for our home office. As a lawyer, I was careful to arrange my business to limit my liability (we’re a professional corporation under state law). It didn’t make sense, then, to open ourselves up to additional liability (and potential losses) by skipping out on insurance. After checking with our insurer, we opted for a rider that would include coverage for our equipment as well as liability protection in the event that someone was injured on our premises.

2. Zoning laws may affect your practice. Many professionals believe that opening a home office has nothing to do with the neighbors or the local authorities. This isn’t true. Depending on the kind of business you have, your ability to work from home (including seeing clients or customers) may be restricted by local zoning laws. Even where home offices may be permitted, there may be restrictions on signage, parking, number of outside employees, and hours of operation. Check with your local zoning code or zoning board for confirmation.

3. Not everyone qualifies for the home-office deduction. I know, a home-office deduction feels like a no-brainer if you work from home. But, as with any other deduction, you have to meet the criteria. The home-office deduction is allowable under Section 162 of the Internal Revenue Code as a business expense. To qualify as a “deductible expense” according to the official IRS definition, “a business expense must be both ordinary and necessary.” An ordinary expense is defined as one that is “common and accepted in your trade or business.” A necessary expense is defined as one that is “helpful and appropriate for your trade or business.”

To qualify for the home-office deduction, you must use the part of your home attributable to business “exclusively and regularly for your trade or business,” and that part of your home must be your principal place of business; a place where you meet or deal with clients in the normal course of your trade or business; or a separate structure used in connection with your trade or business. In other words, to be deductible, your home office must be your actual office and not just a spot where you occasionally work.

If you use part of your home as a work space, it must be exclusively work space. This is key. Although it’s not necessary to have a door that locks (a popular misconception based on old rules), the space must be clearly delineated from your personal space. You can’t write off your living room simply because you tend to camp out on the sofa reading briefs and banging out petitions on your laptop. The space must be exclusively business space.

4. Calculating your home-office deduction requires precision. Generally, the amount you can deduct depends on the percentage of your home that you use for business. If you can easily separate the expenses related to your home office (if, for example, it’s a separate structure such as a garage), you can deduct those actual expenses.

However, if the expenses for your home office are difficult to separate from your home expenses, you can calculate your home-office deduction by prorating the use. Figure the amount of space attributable to your business compared with the total. For example, if your home office space is 200 square feet and your home is 2,000 square feet, you would claim 10 percent of your home-related expenses as a home-office deduction.

Home-related expenses include homeowner’s insurance, taxes, mortgage interest, utilities, security systems, and other maintenance expenses. Also keep in mind that if you rent your home, this is one time that you can take advantage of a rental payment as a deduction; your rent is considered an expense that you can prorate for the home-office deduction.

Alternatively, if the rooms in your house are roughly the same size, you can calculate the percentage of business use by adding up the number of rooms and dividing by the number of rooms used for business. So, for example, if you have ten rooms and use one room for business, you would claim 10 percent of your home-related expenses as a home-office deduction.

No matter which option you use, be precise. Try to avoid round numbers, as these can raise a few eyebrows at the IRS. Other than rent, when is the last time you paid a bill that was exactly $500? Use real figures.

5. Prorate expenses that can be used for personal and business use. At your home you probably don’t have Internet service that you use solely for your law firm. You probably browse the web for fun occasionally or send a friendly e-mail “off the clock.” If you’re mixing business and personal use, you must divide the total cost between the two based on your usage. You can only deduct as a business expense the piece attributable to business, so if you use your Internet service 75 percent for business, then you can deduct 75 percent of the cost. This rule also applies to the use of your other expenses and utilities—but not your actual home telephone line, which the IRS considers routinely personal and never deductible (even prorated), although you can deduct the cost of a dedicated second line or cell phone.

6. If you plan to sell your home, reconsider claiming the home-office deduction. If you claim a home-office deduction, you may not be able to claim the full capital gains exemption on the sale of your home. This is an exemption that you don’t want to miss if you can help it: Taxpayers can exclude up to $250,000 in gain from the sale of a principal home (or $500,000 for married couples) so long as they have owned the home and lived in the home for a minimum of two to five years prior to the sale of the house. The home-office deduction may not make up for a loss in exemption; check with your tax professional to see if the numbers work out for you.

7. Keep good tax records. You claim the home-office deduction on federal form 8829 (Expenses for Business Use of Your Home), generally filed along with your Schedule C (Profit or Loss from Your Business) on your personal 1040. Although you don’t have to provide documentation along with the form, you want to retain records to support your deductions for a period of at least three years (tax professionals are increasingly recommending six years because of aggressive IRS stances on statute of limitations claims). Records would include bank statements, credit card and other receipts, and copies of bills. You may also want to keep a journal of long-distance calls or other extraordinary expenses. Be sure to keep those journals or annotated records contemporaneously; it’s nearly impossible to try to reconstruct records after the fact. To help you out, you may scan your records to keep clutter low, but make sure that scanned records are easily accessible and legible.

8. Don’t be tempted to cheat. The IRS estimates that as many as 70 percent of taxpayers who report net losses on a Schedule C have artificially inflated expenses to create losses. One area where you might be tempted to bump numbers is the home-office deduction because, well, who would know? You should be aware that, statistically, taxpayers who file a Schedule C are two to four times more likely to face an audit than other taxpayers. Those aren’t terrific odds. Inflating deductions cannot only subject you to risk of audit but penalties as well. Keeping excellent, contemporaneous records (see #7 above) helps you report correctly—no guesswork needed.

9. You may need to obtain additional licenses for your business. Your law license may not be the only license you need in order to hang your shingle. In some localities, you need permission to open up shop. In Philadelphia, for example, new businesses have to register with the city in order to operate.

10. You may have to pay additional taxes. In some localities, claiming the home-office deduction may subject you to additional local taxes because, for tax purposes, an office is an office, even if it’s located inside your home. Check with your tax professional if you’re not sure.

If you do decide to work from home, remember to be reasonable when it comes to claiming expenses. Before you list an expense on your tax return, ask yourself: Does the expense make sense? Can you prove it? It’s okay to be aggressive when it comes to deductions, but also be smart. Expenses should always be appropriate and sensible.

There’s a lot to consider when deciding whether to work from home—beyond the issues of finding the space and keeping the kids quiet when the phone rings. Working from home isn’t always cheaper and better. Run the numbers and see if a home office makes sense given your individual circumstances, including the tax implications. I suggest that you consult with your tax professional about your options before you print your business cards. As an added bonus, both the advice and the business cards are deductible.

 

 

 

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