The good news is that legislation signed in September has relieved us of this potential nightmare. Thanks to the bill, cell phones are no longer “listed items,” meaning they don’t come under the same kind of personal-versus-business use scrutiny that cars and computers do. They still have to be used for a legitimate business purpose in order to deduct them as a business expense, but don’t require crazy levels of record keeping. Phew! A bullet has been dodged.

There are some important differences between an HSA and an IRA. First, money in an HSA can be withdrawn tax-free at any time, as long as it is used for qualified medical expenses. This is significant, because it means that the money contributed to an HSA is never taxed – not when it was contributed (because of the deduction) and not when it is withdrawn. There is no other arrangement in the tax code that is treated so favorably. Additionally, the unique set of rules which govern HSAs provide a rare “double berry” opportunity in the tax code.

Generally, medical expenses can only be deducted from your taxable income if you itemize deductions. Those who claim the standard deduction cannot receive any tax benefit from those expenses. Even if you itemize, you can only deduct those medical expenses that exceed 7.5% of your AGI (or 10% if you are subject to the alternative-minimum-tax [AMT]).

Example: James has an AGI of $80,000 and had $6,500 in medical expenses. He is only able to deduct $500 of those expenses (7.5% × $80,000 AGI = $6,000 non-deductible expense → $6,500 expenses − $6,000 non-deductible = $500 deductible). If James were subject to the AMT he would get no deduction because his expenses would not exceed the non-deductible amount (10% x $80,000 = $8,000 non-deductible).

There is a way, however, that you can deduct many of these “non-deductible” expanses. You must first have a qualifying high-deductible health insurance plan. With such an insurance policy in place, you can contribute up to $3,050 ($6,150 for families) to an HSA. In doing so, every dollar contributed is deductible. Then, you can use those funds tax-free to pay for medical expenses. In this way you can circumvent the itemization requirement and not have to get over the 7.5 or 10% of AGI hurdle.

Tip: An additional benefit to these contributions is that the AMT has no effect on your ability to claim the deduction, as it does when itemizing. In fact, the AMT is reduced when claiming this deduction.

Tip: If you are over the age of 55 you can contribute an additional $1,000 over those limits as a “catch-up” contribution. 

While the money is in the HSA it can be invested and grow tax-free. When the money is needed it can be withdrawn tax-free, as long as it is used for medical expenses. If the money in the savings account is not used for medical expenses, it can be used for any expenses once you reach retirement age, which for this purpose is considered 59½. If used in for non-medical expenses after age 59½, income taxes will be due for the amount withdrawn in the same way that all retirement accounts are taxed.

Tip: Contributions to an IRA or 401k do not limit your ability to contribute to an HSA. If you have made the maximum contribution to an IRA, this could be a great way to significantly increase the contribution that you can make into an IRA-like account. Additionally, there is no high-income cap on HSA contributions. High income earners who may not be allowed to make contributions to IRA are able to contribute to HSAs.

In order to take advantage of this strategy, you must first ensure that you have a qualifying high-deductible health insurance plan. The best way to find that out is to contact your insurance company or your HR department. Once you have the right plan, then you must set up an HSA account with a provider. Many large banks offer HSA accounts. They will usually give you a special debit card for the account, which makes it very easy to access the funds when you need to pay a bill. Once you have the right plan and the account, contribute all that you can to the account, up to the maximum allowed.

Tip: If you need to switch insurance plans in order to qualify for an HSA, there is a very good chance that the money you save in premiums will add up to a large portion of the maximum HSA contribution. Put at least the amount that you save in premiums each month into the HSA.

If your budget is really tight, then at least contribute to the HSA as you have medical expenses. If a doctor bills you for $150, send the $150 to your HSA first, and then pay the doctor from that account. Doing so will usually bring a greater tax benefit than by paying the doctor from funds outside of the HSA account.

Tip: In the scenario above, you are ensuring that each dollar you pay in medical expenses becomes a deduction. If paid out of pocket, not through the HSA account, the expenses will be limited by the itemization thresholds.

There is a way to have your cake and eat it too, when it comes to HSA accounts and itemized medical deductions. Here is what to do:

• Contribute the full amount allowable to your HSA in order to have maximum deduction.
• Do not take any money out of the HSA for medical expenses that you incur – just leave all of the funds in the HSA.
• Allow the contributions to grow tax free for the future.
• Pay all of your current medical expenses out of pocket. Included in those expenses is the cost of your health insurance premiums (which cannot be paid from the HSA).

By following these steps you will get a deduction for the HSA contribution, another deduction for expenses over 7.5% of AGI (including premiums), and tax free growth on your HSA account. Is that not beautiful?

Here are the things to know in order to get the full benefit of this strategy and avoid the pitfalls:

• Like an IRA, you can make HSA contributions up to April 15th of the following year.
• Do not contribute more than the maximum allowable to an HSA—there are fairly steep penalties if you do.
• Do not use the HSA funds for anything that is not a qualified medical expense. If you do you will pay taxes on the amounts used, as well as a 10% penalty if you are younger than 59½. Beginning in 2011 the penalty will increase to 20%.
• Beginning in 2011 you cannot use funds from an HSA to purchase over-the-counter medications, unless they are prescribed by a doctor. You can use them, however, for un-prescribed medical equipment that qualifies under the tax code.
• Keep records of your medical expenses that you pay for using funds from your HSA.
• It is possible that you (and your spouse) may not be eligible for an HSA because of an employer-sponsored health plan, unless it is an HSA plan.
• Ensure that your insurance plan meets all of the necessary qualifications.

In order to illustrate how this planning strategy works, I will use the example of a married couple in their 40′s who own a home.  Each year they pay $1,500 in property taxes, $6,000 in mortgage interest and give $4,500 to their favorite charities.  This adds up to $12,000 in itemized deductions.  Their standard deduction would be $11,400.  In this scenario it is better for them to itemize, but it would only give them $600 more in deductions than by claiming the standard deduction.

What this couple could do instead is strategicly plan their itemized expenses each year in order to maximize their deductions.  They could delay writing a check for this year’s charitable giving until January 1st of the next year. Then, in the next year they could be sure to make the donations for that year before December 31st.  Finally, at the end of December in the second year they could make their mortgage payment for January a little early.

By delaying the charitable giving in the first year their itemized deductions would be $7,500 – far below the $11,400 available in the standard deduction, so they would claim the standard deduction.  In the second year they would have two years worth of charitable deductions and an extra mortgage payment.  This would give them a total of $17,000 in itemized deductions in the second year.

If the couple did not plan, they would have $12,000 of itemezed deductions each year, or $24,000 over a two year period.  With the planning in place they would claim a standard deduction of $11,400 the first year and an itemized deduction of $17,000 the second year, for a total of $28,400 in deductions over the same two year period.  While their total expenses did not change at all, proper planning allowed them to take an additional $4,400 in deductions! If they were in a 25% marginal tax bracket this would have saved them $1,100 in taxes.

There are a couple potential pitfalls in this strategy, however.  First, you must be sure to monitor your income and the changing tax laws.  If the tax rates or your income are going to change significantly in a coming year, you must be sure to take those changes into account when implementing this strategy. Second, if you are subject to the Alternative Minimum Tax there are several itemized deductions that will not help you if you accelerate their payments because they are removed in the calculation of the AMT.

The rules of the tax code only allow you to claim $3,000 more in capital losses than you had in capital gains.  So in any given year, no more than $3,000 in capital losses can be subtracted from other, ordinary income when calculating your taxable income.  For those who have more losses than $3,000, the remaining amount gets carried over to future years when there is a gain, or if there is no gain, to be used $3,000 per year until the loss carry over is gone.

The good news is that most investors who had significant losses in 2008 and 2009 have also experienced significant gains this year.  If that is the case for you, you can realize some or all of those gains tax free this year.  Any net gains that you have, up to the amount of loss carryover that you have, will not be taxed at all.

Now is a great time to analyze your portfolio for those investments that appear to be topping out and sell them for a tax free gain. Even if you don’t want to sell the investments that you are holding, because you believe they will keep going up, you could sell them and immediately turn around and buy them back.  This will capture the gain tax free now, and increase your basis in the stock going forward.

One other great reason to consider capturing gains now – even those in excess of your loss carryovers – is that many taxpayers are in the 0% tax bracket on long-term capital gains, which ends this year.  Once you exceed the 0% bracket, the long-term gains are still only taxed at 15%.  It is not likely that the 0% bracket will be extended in future years, especially those years beyond 2011.  This could be another way in which to capture tax free capital gains in 2010.

Of course, you should consider the transaction costs and other factors of this strategy before moving forward.  And it should go without saying that taxes are only one of many considerations that should be made when deciding to sell an investment.

In previous years self-employed health insurance was taken as an above-the-line deduction.  This served to reduce your adjusted gross income and your income tax, but it did not reduce your self-employment income, so you still paid the self-empolyment tax on that portion of your income.  This year it is deductible for both.  Hooray!

There is a special tax credit available for homeowners who upgrade the energy efficiency of their residence.  The credit is the equivalent of 30% of the cost of the improvement, up to a maximum credit of $1,500.  That means that the credit is available on the first $5,000 of improvements ($5,000 x 30% = $1,500 max credit).  The maximum credit applies to 2009 and 2010 combined.  So if you claimed $1,000 in 2009, for example, you would only have $500 of credit still available for you to claim in 2010. The credit is non- refundable, does not carry forward into subsequent years, and cannot be used against the alternative-minimum tax.

There are many ways in which to improve your home’s energy efficiency that qualify for the credit.  You can install a high efficiency furnace, air conditioner or water heater.  You can also install skylights, new outside doors or windows.  Installing insulation qualifies. Even certain roofing materials will qualify for the credit.  Be sure that the specific improvement that you are making will qualify before buying it.

So, if any of these improvements are on your near-term list, get them taken care of right away so that you can claim the credit as well.   Make your holiday season nicer, as well as you local contractors, and then have the added bonus of fewer taxes next spring.

The Benefits

There are some really great benefits that can come from taking the Business Use of the Home deduction.  First, not only does the deduction allow you to write-off expenses that are normally non-deductible, but it allows self-employed individuals to reduce their income taxes and their self-employment taxes.  Most personal deductions can only be taken against income tax, whereas these count against the self-employment tax as well.  This results in an extra 15% tax savings on top of whatever marginal income tax rate you are in.

Second, there are certain itemized deductions on Schedule A that are limited, and the home office deduction can reduce the effects of those limitations.  For example, if a person’s AGI is too high the amount of real estate taxes that they are able to deduct from their Schedule A is reduced.  If a portion of those taxes are claimed as business expenses the limitation becomes smaller or is eliminated, allowing more to be deducted and some to even be deducted for the purposes of the self-employment tax.  Another example of this is found in the $1 million limitation on mortgages (interest on mortgages of greater amounts cannot be deducted).  With the Business Use of the Home deduction the excess interest that could not be claimed on Schedule A can be used for the business-use deduction, as long as it can be shown that the excess is as a result of the business.

Finally, for those whose home office is their principal place of business, a mileage deduction can be claimed for anywhere the individual goes for business purposes.  Under normal circumstances, the distance of the commute between the home and the office is considered a personal expense and cannot be deducted.  Only those trips that are conducted after the arrival at the office can be claimed.  However, when the home is the office, any business travel can be claimed.  It is not uncommon for this mileage deduction to add up to much more than the Business Use of the Home deduction.

The Potential Drawbacks

While it is exciting to realize that you can deduct some of your “personal” expenses from your business income, it is important to know that there are potentially significant downsides to doing so.  I have included in this section some of the things to consider before taking deductions for the business use of your home, as well as precautions to take if you choose to claim the deduction.

When you sell your home there may be tax consequences.

Thoughtful consideration should be given to the future tax consequences of claiming a deduction for the business use of your home.  By declaring that a part of your home is, in essence, business property, you can lose some of the tax benefits of home ownership when you sell the home.

In most cases, when you sell your principal residence you are able to realize up to $250,000 in gains ($500,000 for couples who file jointly) on the home without paying any taxes on those gains.  There are specific rules governing this exclusion of gains that I won’t cover here – but for the purposes of this discussion I will just assume that you would otherwise qualify for this tax exclusion.

Example:  Mike and Susan purchased their home in 1995 for $200,000 and made an additional $40,000 in improvements.  They sold their home in 2010 for $600,000 – a gain of $360,000.  If they had realized a gain from the sale of any other asset, they would be required to pay taxes on that gain.  In this case the taxes for Mike and Susan would add up to $54,000 ($360,000 gain x 15% capital gains tax bracket = $54,000).

However, because this asset was their main home, the tax code offers an exclusion from tax on the first $500,000 of capital gains if all of the rules are met.  Under normal circumstances this would mean that Mike and Susan would not be required to pay the $54,000 in taxes.

When part of the home has been treated as business property, instead of personal property, the rules that govern the exclusion change.  The primary difference is that any depreciation that has been taken on the home must be “recaptured.”  

The idea behind depreciation is that over time an asset becomes less valuable.  For this reason, the tax code allows you to expense, or deduct this loss in value.  However, if you have sold the home for a higher price than you bought it for, then the home has not really depreciated in value.  For this reason you are required to “recapture” the depreciation you have claimed and then pay taxes on that amount, since you paid fewer taxes in the past by claiming it.

When this depreciation is recaptured it is taxed at rates determined by special tables.  The maximum rate for this recapture is 25%, as opposed to the maximum 15% capital gains rate.  This is because you have, in the past, taken the depreciation against ordinary income (and sometimes against self-employment taxes as well).  So, instead of a gain on your house that would not result in any taxes, you would pay taxes on any amount of depreciation that you have taken.

Example:  Mike used his shed for about 6 ½ years before they sold the house. During that time he claimed $3,096 in depreciation.  While the gain that he realized from the sale of his personal residence would normally be excluded from taxes, he will have to pay up to $774 in tax on the recaptured depreciation ($3,096 recaptured x 25% maximum rate = $774).

For those whose business use of the home is within the main walls of their residence, this is the only adjustment that will need to be made.  For those who claimed a business-use of a structure that is appurtenant to the home, such as Mike’s workshop, there is an additional adjustment to be made.  When the portion of the home that was depreciated is separate from the “dwelling unit” the gain on the home must be proportionately divided up and taxes paid on the business portion of that gain.

Example:  Mike claimed on his tax return that 8% of his home was used for business purposes.  Because his workshop is a separate structure from his home he will have to claim 8% of the gain on the sale of his home as taxable, which would otherwise be excluded under the personal residence rules.  This will cost him an additional $4,320 in taxes ($360,000 gain on the sale of the home x 8% of the home used for business x 15% capital gains tax rate = $4,320).

As you can see, there are some potentially significant tax consequences when selling a home that has been claimed for business use.  These consequences are compounded by the fact that when the home is sold, the full tax impact happens in one year, whereas the tax benefits of the deduction have been split up over multiple years.  The impact of the sale could even change your marginal tax bracket, or cause you to become ineligible for certain tax deductions in that year because your income becomes too high. 

In addition, you cannot fully anticipate what the future tax rates will be.  You could end up saving a little each year from the deductions in a lower tax bracket, then have the rates change (or your income change) in the future when you sell the home and end up paying a much higher marginal tax.  All of these factors should be taken into consideration before claiming a business use of the home.

Tip:  There are special ways that the gain on the sale, the excluded portion of the gain, and the recapture of the depreciation need to be reported.  I recommend working with a tax professional or studying the IRS publications before finalizing a tax return that contains this scenario.

The amount that you can claim as a deduction may be limited.

While you are allowed to deduct expenses related to the business use of your home against business income, you are not allowed to claim a loss because of those deductions.  In fact, there is a specific order in which each expense must be deducted in order to determine which will be allowed and which will not.

First, you must subtract all business expenses that are not related to your home from your gross business income.  For example, expenses for things such as office supplies, wages, meals and depreciation of business assets (not including the home) would be subtracted from income first.

The next group of items to be deducted would be those expenses related to your home that you would be able to deduct regardless of business or personal use.  These expenses would include mortgage interest and real estate taxes.

If, after these expenses are taken, there remains a positive net income you would then be allowed to subtract other expenses related to the home that would not be allowed as deductions if they were personal expenses.  Some examples of these expenses would be utilities, insurance, repairs and maintenance.  None of these deductions can lead to a negative net income.  Once the net income reaches $0, these deductions must stop.

The final expense that you are allowed to deduct, as long as there is sufficient net income remaining, is depreciation on the business-use portion of the home.  As with the previous set of deductions, the deduction for depreciation cannot exceed the net income that remains after all previous deductions.

At no time will the deductions claimed in the third and fourth group be allowed to produce a loss.  However, any unused deductions will be carried forward to a future year when there is sufficient income to deduct them.

Example:  In 2008 Mike had a hard time selling his woodwork because of the difficult economy.  While he made a profit, it wasn’t as much as he was accustomed to.  In fact, his income wasn’t even enough to be able to claim all of his Business Use of the Home deduction.

            Gross Income                                                      $25,000

            Ordinary Business Expenses                               - $21,000

            Net Income Remaining                                         $  4,000

            Business % of Mortgage Interest & Taxes           - $  2,300

            Net Income Remaining                                        $  1,700

            Other Business-use Expenses                           - $  1,500

            Net Income Remaining                                       $     200

            Depreciation on Home                                      - $     492

            Net Income                                                    – $     292

Depreciation on the home is not allowed to result a negative net income.  For this reason Mike had to carry over $292 of Business Use of the Home deductions to a future year when he had sufficient net income to deduct it from and still leave a positive balance.

As you can see from this example, even if you meet all of the qualifications for the deduction, you may still not be able to use it all in the current year.  This lessens the benefit of claiming the deduction at all – unless in most years your income is more than sufficient to be able to claim the full deduction.

Tip:  If your net income after non-home expenses is low enough that you cannot even claim all of the business-use portions of your mortgage interest and property taxes, you will want to consider the possibility of not claiming a business-use of your home at all.  This is because you may have a greater benefit in being able to claim all of your mortgage interest and real estate taxes on Schedule A (itemized deductions), rather than carry forward the business deductions to a future year.  You will only know which is best by playing with the numbers and finding the result of both scenarios in the current year.

Multiple places of business

The above scenario of deductions being limited by the amount of income becomes even more complicated when you have multiple places of business.  This is because the deduction is actually limited by the amount of income derived from the business-use of the home.  So if you run most of your business elsewhere, and only perform administrative duties at home, for example, it may be difficult to claim sufficient income derived in the home to cover the expenses claimed.

Example:  Earlier I used the example of Russ, Mike’s neighbor who is an optometrist.  Russ sees 25% of his patients in his home.  In this case Russ would only use the income from those in-home visits against the expenses that he claims for the business use of the home, since that is the only business activity that he performs in his home.

Tip:  When allocating income to the home, take into account the amount of time spent at each business location, the amount of money spent on capital assets at each location, and an income that is easily attributed to each location.

Audit Risk

As I mentioned in the beginning, the Business Use of the Home deduction is one of the most commonly audited deductions on a tax return.  The IRS has not officially admitted that this is the case, or that the deduction increases your chances of an audit.  However, there have been a couple instances where high officials in the Service have stated that it is the case in public forums.  I have personally been told by an IRS auditor that the computer system ranks that deduction higher on the list of reasons to audit.  In addition, IRS statistics show that self-employed individuals are twice as likely to be audited as other individuals.  Claiming the Business Use deduction only adds to that risk.

This fact alone is an additional reason to consider whether or not to claim the deduction, even if you are entitled to it.  The cost of defending yourself in an audit, both in time and in money, plus the potential for the IRS to find other deficiencies while examining your return, can add up to a lot.  If the tax benefit that you are getting from the deduction is small, it may not be worth claiming it.

If you choose to claim the deduction, though, there are several things that you can do to be more prepared for an audit and have a more successful outcome.  Why go to all of the work that it takes to calculate and claim this deduction, only to have the IRS disallow some or all of it, and add penalties and interest to boot? 

Tip:  Some of the things that you can do include to protect yourself are:

• The old mantra for the three most important things in real estate – location, location, and location – can be re-coined for taxes and IRS audits as documentation, documentation and documentation.  I can’t stress enough how important good records are in an IRS audit.  They can literally make all the difference.  For every expense that you claim, be sure to have the documentation (bills, bank statements, etc.) to back it up.
• Have a floor plan of your home that shows the dimensions of each room, drawn to scale.  Most of the time the IRS agent will never see your home.  This will help the agent to see that your allocation between business and personal use has been made correctly.
• Take a picture of the space that you use for business, from different angles.  Take these pictures each year with the date printed on the picture.  The audit of your return will usually happen 2-3 years after the actual year of the tax return.  In that time you may have moved, changed the layout of the room, or gone out of business and started using the area for personal use.  If you have a picture of the way it looked during the tax year it will help a lot when your return is examined.
• It has been found that those who claim to use more than 20-25% of their home for their business are far more likely to be questioned.  If you are going to claim more than that, be extra certain that you can back it up.
• If you are renting, send a 1099 to the landlord for the business portion of the rent to help substantiate the expense.
• If you conduct business anywhere besides the home, keep a log book that shows the amount of time you have spent in the home office during the year.
• Be careful not to double-deduct expenses.  I have seen people take a deduction for the business portion of their mortgage interest and real estate taxes, and then deduct the full amount of those expenses on their Schedule A as well.  This is a simple error, but the IRS computers will quickly pick up the fact that you have claimed more mortgage interest than the bank reported and you have created an automatic flag on your tax return.
• Avoid having multiple years of “losses” on your business, and then having other years of $0 income because of the home business deductions and carry-overs.   In my opinion it would be better to show income for your business and pay some taxes than to have losses and $0 income.  If you do that for long enough the IRS may say that you have a “hobby,” not a business – and that can mean a lot of taxes, penalties and interest.
• In most cases you can deny the IRS entry into your home if the request a visual examination of your business-use space.  Doing so, however, will likely result in the disallowance of all business-use deductions.  If the IRS actually wants to see your home, I would strongly recommend getting help from an experienced tax professional who has Power of Attorney to represent you before the IRS.

A look to the Future

Congress has considered a “standard deduction” for the business use of the home.  If this change were to come to pass it would greatly simplify the deduction for most people who claim it.  The number being bantered around for the standard deduction is $1,500.  In order to claim the standard deduction the taxpayer would only have to meet the criteria of business use, but would not have to do all of the record keeping and dividing up of expenses.  Let’s all keep our fingers crossed for this change to happen.

Once you have determined that you are eligible to claim expenses related to the business use of your home, the next step is to determine which expenses are deductible, and to what extent.  In making this determination, there are three potential categories into which each expense will fall:

• Directly related expenses
• Indirectly related expenses
• Unrelated expense

Directly related expenses are those expenses that only benefit the business-use portion of the home.  Examples of this type of expense would be improvements or repairs to the specific room that is used for the business, or additional insurance on the business property in that room.

Example:   The improvements that Mike made to the shed in his backyard, when he converted it to a workshop, would be directly related to the business because they did not benefit any other part of the house.  For this reason they would be fully deductible business expenses.

Tip: Whenever possible, separate out receipts and bills into business and non-business portions.  For example, if you will be having the inside of your entire home painted, ask the contractor to specifically separate on the bill, or on separate bills, the cost for painting the home office.  In this way you will have a clear way to distinguish the business-use expense, and will be able to count it as a fully-deductible business expense.

Indirectly related expenses are those that benefit both the business and non-business portions of the home.  Some examples of this would be the cost of utilities, repairs to the roof, mortgage interest, insurance or real estate taxes.  These are things that can’t easily be divided between the personal and business portions of the home.

Generally, these types of expenses will be deducted proportionately to the amount of space used in the home.  So, if the home office is 250 square feet, and the home is 2,500 square feet, 10% of indirect expenses will be deductible (250 / 2,500 = 10%).  However, there are certain expenses that may be treated differently than by this general rule.

One indirect expense that may receive special treatment is utilities.  If the nature of the business lends itself to using a disproportionately high or low percentage of the utilities, the amount deducted should be adjusted to reflect the actual usage.

Example:  The tools that Mike has in his workshop use a lot of electricity.  In fact, based on the difference in his electric bill between months when he is spending a lot of time making crafts, and those when he is not, he estimates that 35% of his annual electric usage is related to the workshop.  While the shop only makes up about 8% of his home’s total square footage (by combining the sq. ft. of the shed and home together), he will deduct 35% of the electricity bill for tax purposes.

On the other hand, he really doesn’t use any water for his business.  Practically all of the water used at his home is for personal reasons.  Because of this he would not deduct any portion of the water bills as business-use.

Tip:  If you are going to claim a disproportionate amount of utilities as deductible business-use, especially if you are claiming a higher amount, be sure that you can substantiate that claim with good records and evidence.  In the example above, Mike keeps records of all of the electricity bills and marks months where he did not use the shop as much so that the difference in usage can be substantiated.

Another indirect expense that has special treatment is homeowner’s insurance.  The IRS only allows the portion of insurance premium that applies to the current year to be deducted in that year.  So, if you make an annual payment for your insurance on October 1^st, then you may deduct ¼ of that premium (3 out of 12 months worth of insurance), multiplied by the business-use percentage, this year and the remainder would be deducted in the following year.  Of course, you could also claim this year the 9 months worth of premium that you were not able to claim the previous year.

Also be aware that the IRS does not allow a deduction for the first phone line into the home.  The cost of basic local service, plus taxes, for the first phone line is considered 100% personal, even if you could prove that it was used 100% for business.  However, the cost of additional services on that phone line, such as long-distance service or voice-mail, can be used as business deductions to the extent that they can be shown to be for business use.

Unrelated expenses are those that have a benefit to the home, but no benefit to the business portion of the home.  If, for example, you run an internet based search-engine optimization business, and you replace your kitchen stove, you would not be able to claim any portion of that expense as a business deduction.

One important item to note is that you usually cannot claim landscape installation or maintenance as a business related expense.  The only exception to this rule is if you see clients, customers or patients in your home.

How much of a particular expense can I deduct?  If it is a directly-related expense, you can deduct all of it.  However, even for direct expenses, if the expense was for an item that falls under the rules of depreciation (ex: furniture or equipment) you must follow the depreciation rules and the deduction will be taken on a different portion of the tax return – not the business use of the home deduction.

If the expense is indirectly related, you will deduct the amount that is proportionate to the amount of space your business uses in the home (see the explanation and example given in the “indirectly related expenses” section above.)

If your business is a daycare, there is one additional rule that you must follow for indirect expenses.  As with all businesses you must multiply the percentage of space used by the expense (i.e. 10% of all utilities.)  Then you must also multiply that number by the percentage of hours used for the business.   

Example:  Mike’s mother, Nancy, runs a daycare in her home ten hours per day, five days per week, fifty weeks per year.  This makes a total of 2,500 hours per year.  There are 8,760 hours in a non-leap year, so the daycare is run 28.54% of the available hours in a year.  If Nancy makes 50% of her house available to the children in the daycare, and her annual electric bill is $1,800, she would be able to deduct $257 of her electric bill as business-use (50% of home used  x  28.54% of the time  x  $1,800  =  $257.)

Tip:  If you run a daycare there are several other special deductions of which you should be aware. Be sure to consult a tax advisor.

Can I claim depreciation on the home?  

Beginning with the first month that you can establish a business-use of the home you may begin to depreciate that portion of the home.  In order to do so, you must first establish a “basis” in the home, or in other words, the value of the home that you can base the depreciation on.

For the purpose of the Business Use deduction, the basis of the home is the lesser of:

• The original cost of the home, plus the cost of improvements, minus any depreciation previously taken,  – OR –
• The fair market value of the home when you started using it for business.

Given the conditions of the housing market, your current home value may be less than what you paid for it.  If this is the case, you must use that smaller value in your depreciation formula.

Tip:   I would recommend getting some third-party valuation of your home at the time that you begin to take this deduction.  An appraisal would obviously be the best, but I think that even a realtor’s evaluation or a website like Zillow.com would be better than nothing.  I don’t know how these later sources would hold up in an audit, but you could at least show that you had reasonable cause for the basis that you showed.

Once you have established the total cost of the home, or its current value (if less), then you must subtract from that number the value of the land that the house is on.  This is because land cannot be depreciated.  The best source for the land value is your real estate tax bill.  It will usually show the value that the county assessor has given the land versus the buildings.  After you have subtracted this amount you have arrived at the “basis” of the home.

The next step is to multiply the basis of the home by the percentage of the home used for business purposes. This will give you the net depreciable basis of the home for business purposes.

Example:  Mike’s home is 2,300 square feet, and the workshop is 200 square feet, making a total of 2,500 square feet for business-use calculations. This means that 8% of his home (200 / 2,500 = 8%) is qualified for business-use deductions.

Mike purchased his home for $200,000 and has made $40,000 in improvements, for a total cost of $240,000.  His home was recently appraised at $300,000 when he refinanced.  The cost of $240,000 is lower than the appraisal, so the cost will be used as the basis.

The depreciable basis for Mike’s home is $19,200 (8% x $240,000 = $19,200.) This is the number that all depreciation for the business use of his home will be based on.

As long as you began using your home for business after 1993, your home office will be depreciated over 39 years. (If you began using your home for business purposes during or before 1993 there are other rules for you to consider that I will not cover here.  See a tax advisor for assistance.)  That would translate into being able to depreciate 2.564% of the depreciable basis each year.

The exception to this standard annual depreciation rate would be in the first year that depreciation is claimed (or in any year that the business-use is not for a full year.)  In that year a deduction can only be claimed for the portion of the year that the property was used for business.  See the table below to know what percentage should be used for depreciation in the first year of business use.

Example:  The first year that Mike used his workshop for business he began using it in September. In that year he would be able to claim $144 in depreciation expense ($19,200 depreciable basis x 0.749% from the table = $144.)  In all other years he would claim $492 ($19,200 x 2.564% = $492) until the basis is fully depreciated.

First-year Allowable Depreciation of the Home

How do I claim the deduction on my tax return?

For business owners, the principal form used to calculate and report expenses related to the business use of the home is Form 8829. This is the form where most of the number crunching happens, and which shows the IRS how you arrived at the dollar amount of the deduction you are claiming. Once the total amount is determined, this number then flows to the Schedule where the other business income and expenses are reported. For the self-employed that would be Schedule C, and it would be Schedule E for the Partner, S-Corp owner, or rental owner.

For employees, the expenses are reported on Form 2106, which then flow through to Schedule A and are subject to the 2%-of-AGI minimum of miscellaneous deductions as unreimbursed employee expenses. The employee (and farmer) is not required to use Form 8829 to compute the deductible expenses. The IRS provides a worksheet to help calculate the deductible amounts, which should be retained by the taxpayer with other tax records.

Tip:   Employees who claim a business use of the home should not put any mortgage interest or real estate tax as part of that deduction. Rather, those expenses should be reported completely as person expenses on Schedule A. This will bring a greater benefit because they are not subject to the 2% floor.

A Warning:

If you have determined that you are eligible to claim a deduction for the business use of your home, don’t assume blindly that because you can, you should. There are some significant potential downsides to taking that deduction. Be sure to read Part 4  before making your decision to deduct those expenses.

The first thing to understand about this deduction is that it is contained in a part of the tax code known as the disallowance section – because in most circumstances the expenses related to your residence are specifically not allowed as deductions. Then, within that section of the code there are narrowly defined exceptions to the rule. With this in mind, there are several questions which must be asked in order to figure out whether or not the use of the home is for “business,” and whether it qualifies for the deduction.

Is the activity a “business” in the eyes of the IRS? The mere fact that a certain activity brings a profit does not necessarily mean that it is a business.

Example:   Mike’s wife, Susan, is a retired chemist. She now devotes a significant portion of her time to managing her stock portfolio. She has an office in her home that she uses several hours per day for this purpose.  She cannot claim this as a business use of her home, however, because for tax purposes personal investment management is not considered a business. Even though she makes a profit, it is not a business, so this use of the home is not eligible for the deduction.

Is the space that you are using part of a “home?”

You must determine whether or not the space you are using is part of a home, or “dwelling unit” as the code refers to it. There are several factors to consider. First, the term “dwelling unit” includes any property that provides basic living accommodations, such as a toilet, a place to sleep, and a place to cook. From this description you can see that even some RVs and boats would fall into this category. Additionally, the space must be used as a residence.

Where the tricky part comes in is in regard to structures that are not connected to the “dwelling unit.” If a structure, such as a shed, is “appurtenant” to a dwelling unit, then it is considered a part of it. “Appurtenant” means that the structure is related to, or belongs to, another piece of property.

If the space being used for business purposes is a dwelling unit, or is appurtenant to one, then the special rules for Business Use of the Home must be applied before taking any deductions for that space.

Example:   Mike’s workshop shed is not considered a dwelling unit, in and of itself, because it does not have a bathroom, a kitchen or a place to sleep, and because he does not use it as a residence. However, the shed is on the same lot as his home.  It does not have a separate address, and does not have any separation from the home in its expenses, such as property taxes, utilities, and insurance. For these reasons the shed would be considered to be appurtenant to the home (belonging to / related to) and as such, would be subject to the rules of the Business Use of the Home deduction.

If, on the other hand, the shed were on a separate piece of land that Mike owned, which had its own real estate taxes and utility bills, the expenses of the shed could be deducted directly, without being subject to the Business Use of the Home deduction guidelines.

Is the space used exclusively and regularly for the business?

Exclusively means that the space is used for no other reason during the year. If a computer and desk, for example, are used for the business during the day and for video games at night, the use of the space for business purposes would not be deductible. If you use the space for personal reasons at all during the year, it is not deductible.

Example:   If Mike uses his workshop all year for his business, but in the fall he also uses it to make gifts for his grandchildren and for the students in his class, he cannot claim any of the expenses for the space under the Business Use of the Home deduction. No personal use of the space is allowed during a year in which the deduction is claimed.

Regular use requires that the area be used more than occasionally or incidentally. In our example, Mike satisfies this requirement because he uses the workshop several times per week.

Did you answer ‘yes’ to the first three questions? If so, then you are close to being able to claim the Business Use of the Home deduction. All that remains is for you to be able to satisfy one of the following three requirements.

Is it the principal place of business?

This requirement is satisfied if:

1. The area is used to conduct administrative or management activities for the business, and
2. There is no other fixed location where you conduct substantial administrative or management activities for the business.

There are certain circumstances in which it may appear, by the letter of the law, that you do not meet these two requirements. However, you will still meet the requirements above in the following situations:

• Administrative and management activities are handled by other people at separate locations (such as bookkeeping, payroll or billing.)
• You perform these activities at other locations that are not fixed locations of the business, in addition to doing them at home (such as in a hotel or car.)
• On a minimal and occasional basis you perform these activities at another fixed location of the business.
• You perform a significant amount of non-administrative and non-managerial activities at another fixed business location.

Example:   Mike’s neighbor, Drew, is a traveling vacuum cleaner salesman. In order to spend as much time selling as possible, Drew outsources his bookkeeping work. After filling out invoices at customers’ homes he sends all of the paperwork, along with expense receipts, to his bookkeeper downtown. However, there are still a few administrative items that he must do, such as ordering new supplies. Drew handles all such administrative tasks when he gets home, using a spare bedroom that he has set aside exclusively for the use of his business. In this scenario, Drew can claim the spare bedroom as his principal place of business.

Do you use the area to meet or deal with customers?

Even if your “home office” is not your principal place of business, as defined above, you may still be able to claim the deduction if you use it to meet with customers, clients or patients there on a regular basis. To meet this requirement you must meet with customers in the home office during the regular course of business, and these meetings must constitute a substantial and integral part of your business. Keep in mind, also, that the meetings must be in person – phone calls and emails don’t count.

Example:   Mike’s other neighbor, Russ, is an optometrist. He has an office near the hospital where he meets with most of his clients. However, about 25% of his patients are friends and family who he meets with in his home office on Fridays. Even though the home office is not his principal place of business, nor is it the location of his administrative duties, he can claim the business use because he meets with patients their on a regular basis and it constitutes a substantial part of his business – about 25%.

Is the area that you use in a separate structure from the home, but still part of the home under the “appurtenant” rules?

If the answer is “yes,” then the building only need be used “in connection” with the business – it doesn’t have to be the principal place of business or a place where you meet with customers. Remember, though, that the area must still be used exclusively and regularly for the business.

Example:   Mike’s woodworking business began to really take off and he decided to quit his teaching and open up a storefront downtown where he could sell things on a daily basis – not just at craft fairs. This storefront would likely be considered his principal place of business. However, he would still be able to claim a deduction for the shed where he creates all of his woodwork because it is used in connection with his business.

So, can you claim the deduction?

If you answered yes to all of the first three questions, and yes to at least one of the last three questions, then you may claim a business use of your home and deduct the related expenses. Of course, with taxes there are always exceptions to the rules. Before making a final determination on your eligibility, there are three more questions to consider that may change whether or not you qualify, if you fit into one of these more unique situations.

Are you claiming the business use as a business owner, or as an employee?

If you are claiming business use of your home as an employee, not a business owner, there is one more rule that you must satisfy. The use of your home must be for the convenience of the employer. There must be a reason that it helps the employer, and that reason cannot solely be that it is more convenient to the employee.

Example:   While Mike was still teaching he used a spare bedroom in his home, regularly and exclusively, for the grading of homework and tests. The school provided a place for Mike to do this work, but he preferred to do it at home. Because it was Mike’s choice to use his home in this way, for his own convenience, and not for the convenience of the employer, he could not claim this as a business use of the home.

If, however, he had been employed as a teacher for an internet based home-school program, and the school required all of its teachers to work from home because it did not maintain a campus, then Mike would have been able to claim the deduction for the use of his home.

If you are in the situation where your employer requires you to work from home, for the convenience of the employer, I would highly recommend getting a letter from the employer stating that this is the case. While the possession of such a letter is not a guarantee, it will likely be a great support to your case if you were to be audited by the IRS in regard to this deduction.

Is the business use that you are claiming related to storage space?

The rules regarding storage space can actually be a little easier to satisfy than those that are related to other business uses of the home. However, in order to qualify for the deduction you must satisfy all of the following requirements:

• The storage space must be used for inventory or product samples that you sell through your business, be it retail or wholesale.
• The storage space must be separately identifiable from other areas, and suitable for storage.
• The home must be the only fixed location of the business and the storage spaced must be used on a regular basis.

Some of the key determinants for “business use” do not apply to storage space. For example, the home does not need to be the principal place of business, nor do you need to meet with customers there. Also, the space does not need to be used exclusively for business, just regularly.

Keep in mind that the items you are storing must be inventory of something that you sell in your business.

Example:   As an accountant, if I used space in my home to store client files I could not claim the space used for storage because I am not in the business of selling client information (thank goodness.) However, if I always keep 5,000 copies of my book, Tax Insight, on hand (in order to meet high demand) I could claim the space because the book is an item that I sell.

Is your business a Day Care Service?

I didn’t ask if it “feels” like a day care service, or if it feels like you are babysitting all day. But if you do run an actual day care service in your home there are special rules that apply to your type of business in regard to claiming the business use deduction.

First, in order to claim the deduction you must be licensed or otherwise approved by your state for the type of care you are providing. Second, your primary service must be the custodial care of children, adults over 65, or those who are physically or mentally unable to care for themselves. Finally, the care must be limited to certain hours of the day – it cannot be 24-hour care.

If your business falls into this category of service, the main difference in eligibility to claim the deduction is that there is no exclusivity rule. So, if you use your kitchen and living room for the day care, but also use it for personal reasons at other times of the day, you can still claim the deduction (under a specific formula discussed later.)

You qualify for the deduction – so now what do you do?

If you have made it through the entirety of this post I congratulate you. If you have determined that you qualify for the deduction, even better. Part 3 of this series will teach you which expenses you can claim, and how to do it correctly. Part 4 will help you determine if you should claim the deduction.

You may have heard of this deduction as the Home Office deduction.  A more accurate name, however, is the Business Use of the Home deduction.  As the name indicates, there are many more opportunities to use this deduction than by simply having an office in your home.  You may also qualify for this deduction if you store inventory, have a greenhouse or workshop on your property, have a lab or studio, or run a daycare.  Don’t limit your possibilities for this deduction by thinking you have to have a home office.  Any use of your home or property for your business may qualify for the deduction.

Example:   Mike is an elementary school teacher.  He also has a side business making wooden toys that he sells at craft fairs.  Mike converted an old shed on his property into a workshop that he uses exclusively for his business several nights a week.  Mike is able to deduct a portion of his rent and utilities, and the cost of the improvements on the shed (through depreciation), which saves him about $1,500 per year in income and self-employment taxes.       

While this deduction presents a great opportunity to save money on your taxes, it is important to know from the beginning that determining the Business Use of the Home deduction is a fairly complicated, multi-layered process.  So if you think this deduction may apply to you, be sure to read Part 2,  Part 3 and Part 4 of this series  in order to understand the deduction and take advantage of its tax savings.