Claiming the Home Office Deduction Without Getting into Trouble

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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For many small business owners, there's a sense that claiming the home office deduction on your taxes is asking for trouble. Maybe it's a red flag to the IRS or maybe it's just a complicated procedure, but most small business owners simply worry about taking the deduction even when they're entitled to it. But the truth of the matter is that claiming the home office deduction has become a relatively simple matter, and it doesn't trigger an automatic audit. Rather, it's simply an opportunity for small business owners who work out of their homes to legitimately claim the expenses used to maintain that home office. Assuming you do the paperwork correctly, claiming the home office deduction shouldn't cause trouble — just as writing off a new printer or a company vehicle doesn't create problems.

Pass the Exclusivity Test

The biggest problem that small business owners tend to face is making sure that a home office passes the exclusivity test. In order to be claimed as a home office, the space you work in must be used exclusively for your business — other family members can't use the area for anything else and neither can you. There are several potential pitfalls, like having your children in your office while you work. Jan Zobel, the author of Minding Her Own Business: the Self-Employed Woman's Guide to Taxes and Recordkeeping, points out a crucial problem. "The biggest issue these days is computer use. If a computer is in the home office and either the kids or the partner use it also, that effectively makes the home office ineligible because requirements state that the space must be used exclusively for the business."

Jamie Ciocco runs his business, Trendy.com, from one of the bedrooms in his two-bedroom condo: "My office is already a separate room, so I didn't need to put up any partitions to separate it from the rest of the house. It even has a separate entrance door I can use, which is great for when a client stops by, since I can let them in to my office directly and don't need to clean up the rest of my house...I use my home office only for business. I also work from my sofa sometimes, but I can't deduct my living room as a home office since it's not used exclusively for business."

Decide If the Home Office Deduction Worth the Effort

Although claiming the home office deduction can save you a significant amount of money on your taxes, claiming it is not always worthwhile. If, for instance, setting up an area that is exclusively used for your business would require you to rent a larger home, all the expenses that go along with such a move would likely outweigh what you would be able to deduct on your taxes. It's worth your while to run the numbers before you start changing your home office set-up in order to claim the deduction. You may be surprised at what you'll be able to claim; a variety of expenses at your home can be deducted. "Homeowners are already able to claim the mortgage interest and real estate tax they pay, but when a portion of these expenses are deducted for an office-in-home, not only is income tax reduced, but there is a reduction of self-employment (social security) tax as well. Additionally, claiming a home office means that a portion of such expenses as rent, utilities, insurance, and depreciation, which could not otherwise be deducted, can now be claimed as business expenses," says Zobel.

With an eligible home office, you can also claim more transportation expenses and other business expenses as deductions. Zobel continues, "Another benefit of claiming a home office is that a greater percentage of car expenses become deductible. Without an office-in-home, most taxpayers cannot claim the miles driven from home to the first business stop of the day and from the last stop of the day back home as this is considered non-deductible commuting mileage. With a deductible home office, every trip from home to another place of business is considered a trip between two business locations and is fully deductible. For those reasons even, for example, a 3' x 5' desk exclusively used for business may be worthwhile to claim as an office-in-home."

Track the Numbers Carefully

There are more than a few numbers that go along with claiming the home office deduction, from the actual size of your office to the expenses you can associate with maintaining it. You do need to keep careful track of those numbers — they aren't something that you want to be scrambling to recreate as tax season rolls around. Ciocco describes his process: "I track expenses related to the home as a whole separately from expenses exclusively related to the home office. At tax time, I deduct the full amount of expenses that are just for my home office, such as office furniture. I also deduct a fraction of my expenses for my whole home (overall maintenance, electricity, etc.) based on my home office's square footage as a fraction of the home's total square footage...At one point when my office was actually clean, I took photos of the space and saved them with my tax information so that I could easily document my home office to the IRS if needed. I don't fudge the numbers. Being scrupulous about calculating the exact costs and square footage of my home office puts me on solid ground if I ever do have an audit."

Don't Let the Process Scare You

It's easy to get thrown by any tax situation, including the home office deduction. There's a lot to consider, but that doesn't mean that you're going to face trouble for claiming it on your tax return. Zobel notes, "Many people incorrectly believe that claiming the home office deduction on a tax return means an automatic audit or, at the least, a red flag. I have about 350 tax clients, about half of whom claim an office-in-home on their tax return. I've been in business for more than 30 years and have had about 25 clients audited during that time. Only about three of those audits were of people who had claimed a home office and none of those audits were focused on that deduction."