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The first images that spring to mind for many of us when we think about working from home are the benefits. There's no commute to or from work, saving time and making dealing with rush hour traffic a headache buried somewhere in our past life. That leaves more time to spend with the family or being productive. It quite literally provides all the comforts of home. In fact if someone wanted to adopt the dress code of a certain well-known publisher, they could spend the entire day in their pajamas. However, there are other things to consider as well. Most work requires an area to dedicate to the purpose, either as a workshop or office, even if it is only to remove the worker from the distractions of home. Unfortunately, this can cause some moderately complex tax results from using a personal residence for split business and personal use.
The first question that arises is weather or not the home worker qualifies as having a home office. By home office, any dedicated business portion of the taxpayer's residence will qualify. It need not specifically be an office, but may be a workshop, greenhouse, or other dedicated business use portion of the residence. An office is merely the most common use. Several years ago the requirements were modified to include any dedicated portion of the home, no longer requiring a dedicated and separate structure, but it must be a dedicated portion of the residence. What this means is the portion of the property used for business needs to be specifically set aside and used exclusively for the business endeavor. Incidental personal use of the business portion of the home is still allowed. For example, an attorney who uses a spare bedroom as a home office, sees clients there, and uses it almost exclusively as a legal office wouldn't loose their home office status by allowing their teenage son to study for finals in their office during the evening the last few weeks of their son's high school year. However, an accountant who keeps a laptop in their kitchen to do taxes in the evening on the kitchen table doesn't qualify as having a home office.
Once the taxpayer knows they can qualify for having a home office, they need to make a decision as to weather or not it's worth having one. While there is technically no choice whether or not the taxpayer is using a portion of their residence for business if they actually are using it as such, the taxpayer can simply chose to fail this test by also using that portion of the home for personal purposes during the period, thereby failing the test for dedicated business use. There are several reasons both to, and not to use a portion of one's residence as a home office. Most of them are related to the interplay between the income tax, social security and Medicare taxes (hereafter referred to as self employment, or SE taxes), the depreciation recapture rules, and the home sale gain exemption under section 121. Fortunately, the bulk of this complication is related to homeowners. Tenants who are entitled to take a deduction for having a home office have little reason not to. They must simply prorate their rent and utilities in the same manner a homeowner prorates all the expenses relating to their home to take the deduction. As they have no gain on the sale of their property or depreciation to recapture they skirt the more complicated areas of this option. Homeowners, however, have much more to coordinate.
The first level a homeowner must consider is the effect of the deduction on their income and SE taxes (we'll assume a self employed individual here, addressing the differences for an employee using a home office deduction as an un-reimbursed employee expense later on). In most cases, it is beneficial for the homeowner to claim a home office at this level if their business indicates a profit. To arrive at the amount of the deduction, the taxpayer prorates (usually based on the square footage of the home office to the square footage of the entire residence) all the expenses of maintaining and operating their residence. This includes property taxes and mortgage interest (which, in turn, only leaves the remaining amounts to be used as itemized deductions), homeowner's insurance, utilities, depreciation, and any amounts paid for repairs and maintenance of the entire home. Also, any amount directly related to the home office itself need not be prorated, but may be taken in whole, such as the cost of a second insurance policy to protect the homeowner against liability if their base homeowner policy bars collection under commercial use. The total deduction is then recorded as a business deduction directly against business income. This serves to directly reduce the taxpayer's business income, and, so doing, directly reduce their gross income.
To illustrate the effects of this we'll employ two examples, both will be taxpayers with the same amount of home office deductions. Each will have a home with a structure value of $390K, $10K in property tax, $10K in mortgage interest, and $10K in utilities, insurance and maintenance, and each will have a home office consisting of 300 square feet of a 3,000 square foot home. This will give each example a home office consisting of 10% of their home, entitled to $1K of depreciation (390K/39 years X 10%), $1K of property tax, $1K of home mortgage interest, and $1K of utility, maintenance and insurance expenses, for a total of $4K of deductions. The taxpayer in the first example will have a business profit of only $20K and a taxable income of $10K placing them in the 10% income tax bracket before taking a home office deduction, while the taxpayer in the second example will have a business profit of $400K and a taxable income of $500K placing them in the 35% income tax bracket before taking a home office deduction. The taxpayer in the first example would save $169 in income tax ($2,000 of the deduction would be taken as itemized deductions regardless of business use, and they would lose the income tax deduction for half the amount saved in SE tax) and $612 in SE tax, for a total savings of $781. The taxpayer in the second example would save $749 in income tax (the same 2,000 would not be subject to the 20% reduction in itemized deduction for high income) and $116 in SE tax (being well over the social security threshold), for a total savings of $865. Additionally, neither example takes into account the potential benefit of reducing either taxpayer's AGI by the net effect of the $4K and the reduced half SE deduction to lower the 7.5% AGI threshold for medical expenses or the 2% threshold for miscellaneous expenses, nor the potential affects on a taxpayer's Alternative Minimum Tax liability.
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