Deducting the Home Office: For Itemizers and Non-Itemizers

By: Anthony Cataldo
Submitted: 2007-01-17 16:17:40
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Introduction
The IRS provides numerous examples on a variety of topics, usually focused on what the taxpayer cannot do. This article covers some of the planning opportunities, focusing on what you can do to legitimately deduct your home office expenses and to maximize your home office expense deductions. The home office deduction is one of the least understood deductions. Many taxpayers avoid the deduction, frequently on the advice of their tax accountant or attorney, for fear of an IRS audit. This is nonsense!

The IRS provides detailed instructions on Business Use of Your Home in its Publication 587. This publication is updated every year and is provided to the public, for free, by calling the IRS tax forms 1-800 telephone number or by downloading the publication from the Internet at www.irsgov.com . Home office deductions are reported on Form 8829, Expenses for Business Use of Your Home.

Folklore - The "red flag" to the IRS
Folklore suggests that use of the home office deduction will send up a "red flag" and result in an IRS audit. However, it does not make sense to fail to take a deduction that you are legitimately entitled to! Consider the following:

 For the 1997 tax year fewer than 1.5% of all individual income tax returns included claims for the home-office deduction.
 In recent years, about 15% to 16% of all tax returns have included self-employment income/losses and a Schedule C or F.
 Therefore, if the IRS devoted 100 percent of its audit resources to the tax returns for self-employed taxpayers, they would only be able to audit 1/10th of the individual federal income tax returns with self-employment income or losses.

Of course, the IRS does not audit the tax returns for all self-employed taxpayers. Self-employed taxpayers establish a home office for several reasons. First, they already own or rent a home, so operating out of their personal residence reduces the duplication of overhead and/or the maintenance of a separate office or place of business. The reduction of overhead, and related monthly cash outlays for the additional expense associated with rent, utilities, etc., reduces business risk and business failure rates. Establishment of the home office as the principal place of the self-employed taxpayer's trade or business also minimizes non-deductible commuting expenses and increases the business use percentage of the business use automobile and, of course, reducing fuel consumption. In summary, one could legitimately argue that the home office is good for the U.S. economy!

IRS Audit Statistics
The IRS publishes audit statistics. For the 1996 tax year, 1,519,243 individual federal income tax returns were audited (1.28%), down from 1.67% of the returns filed for the 1995 tax year. The "no change" rate averaged 14% for office audits, 10% for field audits and 13% for correspondence audits. Additional percentage audited measures for 1996 individual federal income tax returns follows:

TABLE 1

Individuals - Non-business and based on Total Positive Income (TPI)
< $25,000 1.39%
$50,000 to $50,000 0.70%
>$100,000 2.27%
Individuals - Schedule C with Gross Receipts as indicated
< $25,000 3.19%
$50,000 to $50,000 2.57%
>$100,000 4.13%

Generally, the percentage of returns examined will depend on IRS staffing available for a particular geographical region. The returns least likely to be selected for audit are those on which the majority of the income was subject to withholding (e.g., salaries and wages) and where the taxpayer does not itemize deductions on their Schedule A.

The IRS selects returns for examination based on discrepancies identified against informational returns (e.g., W-3 and 1098 transmittals), history of deficiencies, statistically selected random sampling from an updated variation of the Taxpayer Compliance Measurement Program (TCMP), questionable refunds and their computerized discriminant income function (i.e., DIF scores).

Why pursue the home office deduction? There are several reasons why the taxpayer should deduct a home office:

 The depreciation of the business use portion of the taxpayer's home is otherwise not deductible. This expense is taken on the taxpayer's Schedule C and results in a reduction of the 15.3% SE tax. Even if the taxpayer later sells the house and has to recapture the depreciation, the SE tax savings are permanent.
 The business use portion of otherwise deductible real estate taxes and home mortgage interest are shifted from the taxpayer's Schedule A (itemized personal deductions) to the Schedule C (deductible business expenses). The legitimate shifting of the business use percentage of the taxpayer's home from Schedule A (reducing FIT and SIT) to Schedule C (reducing FIT, SIT, and SE tax) results in the additional reduction of the 15.3% SE tax. Again, the SE tax savings are permanent.
 For taxpayers otherwise unable to itemize, the business use portion of otherwise deductible real estate taxes and home mortgage interested are added to the taxpayer's Schedule C. In this case, the taxpayer benefits from combined FIT, SIT, and SE tax savings.
 The business use portion of otherwise non-deductible expenses such as: utilities, repairs, homeowner's association dues, basic cable, etc., are legitimately converted to deductible business expenses. Not only are the related SE tax savings permanent, but FIT and SIT reductions are also achieved and are permanent.

How to qualify for the home office deduction To qualify for the home office deduction, you must use the business portion of your home…

 Exclusively (except for inventory storage or day-care facilities)
AND
 Regularly for your trade or business
AND
The business use percentage must be:
(1) Your principal place of business
OR
(2) A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business
OR
(3) A separate structure (detached from your home) used in connection with the trade or business.

FIGURE 1: Non-itemizers

FIGURE 2: Itemizers

The above sections and flowcharts illustrate the tax savings, associated with the home office deduction, available to both non-itemizer and itemizer taxpayers.

The home office deduction for the non-itemizer

The non-itemizer taxpayer does not file a Schedule A with the federal income tax return. This taxpayer uses the standard deduction, because it is larger than the itemized deductions available. This does not, however, prevent the non-itemizer from deducting the business use portion of their home office expenses on their Schedule C.

As FIGURE 11-1 illustrates, the otherwise non-deductible business use portion of utilities, insurance, depreciation, repairs, real estate taxes and home mortgage interest results in FIT, SIT, and SE tax savings. Establishment of the legitimately deductible home office may also result in a reduction of otherwise non-deductible commuting and increased deductible business use mileage, which also results in increase FIT, SIT, and SE tax savings.

The home office deduction for the itemizer

The itemizer taxpayer files a Schedule A with the federal income tax return. This taxpayer is able to legitimately shift the otherwise deductible business use portion of real estate taxes and home mortgage interest from the Schedule A to the Schedule C. The business use portion of otherwise deductible, personal expenses, are reclassified as deductible business expenses, resulting in additional and permanent 15.3% SE tax savings.

As FIGURE 11-3 illustrates, the otherwise non-deductible business use portion of utilities, insurance, depreciation, and repairs results in FIT, SIT, and SE tax savings. As was the case for the non-itemizer, establishment of the legitimately deductible home office may also result in a reduction of otherwise non-deductible commuting and increased deductible business use mileage, which also results in increased FIT, SIT, and SE tax savings.

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