Taxes and the Home Office
- Jan 1, 1996
Angela Sanderson (not her real name) has been breeding and selling Paso Finos for five years. Her ranch and breeding operations are small--three mares on five acres. Although Sanderson considers herself a savvy business woman, the California breeder lost money two out of the last three years. In her effort to improve her bottom line, Sanderson is making changes on how she manages her business. One change she is considering is claiming a home-office deduction against her taxes.
According to J. K. Lasser's Your Income Tax 1995, Your Guide to New Tax Changes, Macmillian, USA, 1995, claiming a home-office deduction might allow Sanderson to deduct expenses related to the office. Depending on her income, Sanderson's home-office deductions could include a portion of her mortgage interest, real estate taxes, insurance, utilities, repairs, and depreciation proportional to the area of the house used for business. Thus, if Sanderson's office takes up 10% of her home, she may deduct 10% of the cost of maintenance fees, i.e., painting the outside of the house or repairing a roof. However, household repairs and expenses that do not benefit the office space are not deductible, i.e., costs of lawn care and landscaping. She can also deduct 10% for depreciation, however, there will be consequences (tax ramifications) when she sells her home which will need to be calculated by an accountant or tax specialist.
"Deductions for the business portion of utilities, maintenance, insurance cost, etc., may not exceed net income derived from the office's use," Lasser's book states. "If you do not realize income during the year, no deduction is allowed."
Thus, if Sanderson does not sell any of her mares or foals in a particular year, and her breeding expenses exceed her income, she may not claim a home-office deduction for that year. The breeder can, however, carry the disallowed expenses over to another tax year, subject to the income limitations of that year.
Another home-office benefit is that it is easier to deduct business use of a vehicle.
"Every time Angela leaves her home for business purposes to go to the post office, a professional meeting, the veterinarian, the feed store, etc., the mileage is considered business use," said Mary Ann Chaffin, an Enrolled Agent and Public Accountant. "If you don't have an office, then getting to your first business appointment of the day, and from the last business stop back home, is considered a commute. Commute mileage is not deductible, but the mileage between business stops is deductible.
Sanderson also might be able to deduct her home-office furnishings and office equipment.
"All of the office equipment Angela uses in her home office would be considered to be located at a business location," said Chaffin, who specializes in taxation and is based in Aurora, Colo. "This takes her computer out of the category of listed property--property used in a non-business environment and subject to substantial personal use. If Angela plans on using her equipment for personal use, she may need to keep a time and usage log for the computer."
The home-office deduction appears to be a sensible way to reduce Sanderson's tax liability. However, this type of deduction can "red flag" her tax return for an Internal Revenue Service (IRS) audit.
"When the IRS pulls a return for potential audit, one of the first things they look for is if the tax payer is claiming a deduction for a home office," said Wynona Brooks, a Certified Public Accountant based in Oklahoma City. "The IRS red flags home-office deductions because it (the home-office deduction) is so abused."
Brooks has plenty of personal and professional experience from which to support her claim. Wynona's husband, Jack, is one of the nation's leading trainers of running Quarter Horses. Her brother-in-law Monty Brooks is also a successful trainer, and her son Tim saddled his share of winners before becoming a dentist. In addition, her CPA clientele includes a variety of horse owners, breeders, trainers, and veterinarians.
Depending on the individual, Brooks said the gain acquired by claiming the home-office deduction is generally minimal. Any savings gained might not be worth triggering an IRS audit.
Brooks was quick to add that not everyone who claims a home-office deduction is subject to an audit. However, claim a home-office deduction for a horse-related business, she said, and your chance of an audit jumps substantially.
"The IRS loves to audit people with horses because of the hobby-loss rule," she explained. "The IRS is notorious for questioning whether horse-related activities are a hobby or sideline business. Horsemen often have to prove to the IRS that they are engaged in the activity to make a profit."
To support a claim that an individual is in business to make a profit, and to claim a home-office deduction, Brooks said the self-employed taxpayer must use the home-office space exclusively and regularly:
- as a principal place of business;
- as a place to meet or deal with clients and customers in the normal course of business;
- in connection with the business if the space is a separate structure from the residence, i.e., a barn or detached garage.
Lasser's book supports Brooks' statement, stating, "A home office will qualify as a principal place of business if you spend most of your working time there and most of your business income is attributable to your activities there."
In the landmark case of Commissioner vs. Soliman, the Supreme Court identified two primary factors to use in determining whether a home office qualifies as the taxpayer's principal place of business: (1) the relative importance of the activities performed at each business location, and (2) the time spent at each place.
At first glance it may appear Sanderson can use her den for a home-office deduction because she uses the den/office regularly for:
- maintaining and storing all her breeding and business records;
- contacting stallion owners and potential buyers via an office phone, computer, and typewriter;
- meeting and negotiating with potential foal buyers.
However, based on IRS home-office criteria, Sanderson's den/office would not qualify for the home-office deduction because the office space is not used exclusively for her breeding business. In addition to managing her breeding business from the office, Sanderson also maintains and stores household and family records in the den/office and on her computer. In addition, her son regularly plays on her office computer, and her husband's piano graces one corner of the room.
"Using a home office for anything other than business disqualifies it for a home-office tax deduction," said Brooks. "For the IRS to allow a home office deduction, a person must be very business-like."
To deduct the entire den as a home office, Sanderson must move her household records and piano to another part of the house. Her son will have to play somewhere else. To further support her claim for a home-office deduction, Sanderson should furnish the room as an office with a desk, files, and a phone used only for business calls. She should also keep a running record of time spent and work done in the office, and note any business visitors.
Chaffin advises individuals who claim a home-office deduction to take pictures of their home office to substantiate that it qualifies as a home office.
"The IRS generally has three years, from the time you file your tax return to audit that return," she said. "That could be three years after you moved your office to another location and re-established the room as a guest room, den, or sewing room. Having pictures does help to show that it was, in fact, used as an office."
Assuming Sanderson has no place else to store her household records or her husband's piano, she can divide the den and use only part of the den as office space. The room, however, must be divided into distinct areas and the area designated as her home office must be used for breeding business operations only. Once divided, the home-office square footage can qualify for a deduction as long as the office area meets the IRS' criteria of regular use and principal place of business.
Also, if a home office is used for more than one business, both businesses must meet the IRS' criteria for a home office in order to claim a home-office deduction.
For example: Sanderson is an office manager for a group of pediatric physicians. She occasionally brings work home for her own convenience. She also buys, sells, and breeds Paso Fino horses and reports the income on a schedule C as a sole proprietor. By itself, Sanderson's sole proprietorship might meet the requirements of regular and exclusive use of the office space. But because she also uses the home office to do office work for her employer, the deduction is disallowed. She does not use the office space exclusively for her breeding business.
"If one business use qualifies and another does not, the IRS will disallow the deduction, even for the qualifying use," Lasser's book states.
If a home office is in a separate structure such as a barn or detached garage, the expenses related to the office space are generally deductible. But like an in-home office, a detached home office must satisfy the exclusive use and regular basis test noted above.
For those individuals contemplating the use of a home office, or claiming the home-office deduction for the first time, the IRS offers several free publications that might be helpful. The following publications all offer information pertinent to claiming a home-office deduction: Publication 587, Business Use of Your Home; 523, Selling Your Home; 534, Depreciation; 551, Basis of Assets; 583, Taxpayers Starting a Business; and 946, How To Begin Depreciating Your Property. The index to all publications is contained in Publication 910, Guide to Free Tax Services, also free at your local IRS office or by requesting it on a form that is included in the back of the federal tax package mailed to each taxpayer in early January.
Because the IRS criteria for claiming a home-office deduction are so specific, and because the pros and cons of a home-office deduction vary by each individual situation, Lasser, Brooks, and Chaffin all recommend that business owners consult a certified public accountant or enrolled agent before deciding to claim, or not claim, a home-office deduction.
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