To qualify for deductible business expenses for the use of your home, you must use your home or part of your home exclusively for business, on a regular basis, and it must be used for your own trade or business. In addition, the business part of your home must be:

• Your principal place of business or;
• A place where you meet or deal with patients, clients or customers or;
• The area is a separate structure, not attached to your home, that you use for business.

In order for your home to qualify as your principal place of business you must use it exclusively and regularly for administrative or management activities and you have no other fixed location where you conduct substantial administrative or management activities.

If you are an employee, then you must meet two additional criteria. The business use of your home must be for the convenience of the employer, and you are prohibited from renting your home to your employer while performing services as an employee. Once you have determined that you qualify to claim a home office deduction you must determine what to include in the deduction.

Business expenses attributable to your business use of your home have two limitations. The first limitation is based on the area of your home that is used for business. You must obtain a percentage of business usage of your home and apply the percentage to certain deductible expenses. One common method is to determine the square footage of the area used for business and divide that by the entire square footage of your home. Another method is to divide the number of rooms used for business by the total number of rooms in your home. Regardless of how the percentage is calculated, it is then applied to indirect deductible business expenses to limit the deduction.

The second limitation is based on the gross income earned from the business activity at your home. Total business expenses not otherwise deductible are limited to the gross income from the business use of your home. First, expenses that would otherwise be deductible (mortgage interest and real estate taxes) are deducted against income. Next, expenses not otherwise deductible (insurance, utilities, depreciation, etc.) are deducted from income with depreciation being the last expense used. If your expenses exceed income then the expenses may be carried forward to be used in future years.

The home expenses you incur can be broken down into three categories: direct, indirect, and unrelated. Direct expenses can be solely attributed to the business portion of your home and can be deducted against income without applying the percentage limitations. Indirect expenses are related to the entire household (i.e. homeowners insurance, utilities) and can be deducted against income after being limited by the percentage limitation. Unrelated expenses cannot be attributed to any portion of the business area of the home and are not deductible. Examples of this would be repairs to a room separate from the business area or lawn maintenance.

Some examples of deductible expenses would be:

• Depreciation 
• Mortgage Interest
• Real Estate Taxes
• Utilities
• Insurance
• Security System
• Rent
• Repairs

One item that needs further explanation is the expense related to the telephone. Your first home phone line is a non-deductible expense. Any additional phone lines used for business and any business long distance charges are allowable deductible expenses.

One final calculation that needs to be made is the current year's depreciation expense. If you own your home and qualify for a home office deduction, you may claim a depreciation expense.  You must first determine the depreciable value of your home using two calculations and using the lesser of two. This is something you probably will want to get professional assistance to calculate. Once you have determined the lesser value, you apply the percentage limitation to the value. For example, if you determine that you use 20% of your home exclusively for business and the adjusted basis of your home is $100,000 (excluding land) then your depreciation base would be 20,000. Depreciation for nonresidential real property is taken over a 39-year period. In this example, if you were using your home for business for the entire year then you would divide 20,000 by 39 to calculate the current year of depreciation of $512.83. Depreciation would be adjusted for years when the home was used for business for less than the entire year.

In addition to these expenses connected to your home office, you can also deduct any equipment expenses used exclusively in your home office. A desk, chair, computer, calculator, etc. used exclusively for business in the home office are deductible in the year of purchase up to $20,000 for the year ending December 31, 2000. Total purchases over $20,000 will need to be depreciated over the life of the asset purchased.

In closing, the home office deduction has been a "red flag" in recent years for an IRS audit. If you have legitimate home office deductions, do not hesitate to take them, but if you have any questions, you should seek professional advice from a CPA before you file your tax return to avoid problems with the IRS.

Originally published March 19, 2001