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You may deduct your home office expenses if you meet any of the following three tests:
1. the separate structure test;
2. the place for meeting patients, clients, or customers test; or
3. the principal place of business test.
You may also deduct the expenses of certain storage space if you qualify under the rules described further below.
If you do qualify, you compute your home office deductions on Form 8829, and report them above-the-line on Schedule C.
Separate structure: The easiest test to meet allows a deduction for the costs of a separate unattached structure on the same property as your home: for example, an unattached garage, artist's studio, workshop, or office building that is used as a home office. To qualify for the deduction, the separate structure must be used exclusively and on a regular basis in connection with your business.
Home office used for meeting patients, clients, or customers: Alternatively, you may deduct your home office expenses if you use the home office exclusively and on a regular basis to meet with patients, clients, or customers in the normal course of your business. The patients, clients, or customers must be physically present in the home office. Telephone calls to them from your home office won't do the trick.
Principal place of business: In addition, you may deduct your home office expenses if you use your home office, exclusively and on a regular basis, as your principal place of business.
The meaning of "principal place of business" has been the source of many disputes between the IRS and taxpayers. The current rules for determining a taxpayer's principal place of business were laid down by the Supreme Court in its January 1993 decision in Soliman, which was widely reported in the media. But the Taxpayer Relief Act of 1997 has altered some aspects of the ''principal place of business" test in favor of taxpayers starting in 1999.
According to the Soliman decision, there are two primary considerations in determining a taxpayer's principal place of business: (1) the relative importance of the activities performed at each location where the taxpayer's business was conducted, and (2) the amount of time spent at each place. The IRS says that it will first apply the "relative importance" test by comparing the activities performed at home with those carried on elsewhere. If this comparison clearly shows where the principal place of business is, there's no need to look further. When the "relative importance" test doesn't give a clear answer, says IRS, the "time" test comes into play. However, these tests may not clearly reveal that any location is the taxpayer's principal place of business. In that case, the taxpayer will be treated as not having a principal place of business.
New principal place of business rules for home offices used, in 1999 or later, for management or administrative activities: Under a provision in the Taxpayer Relief Act of 1997 -- which will go into effect in 1999 -- a home office will qualify as the taxpayer's principal place of business if the taxpayer uses the home office to conduct administrative or management activities of the business, so long as the taxpayer doesn't have another fixed location where substantial administrative or management activities of the business are conducted. However, according to IRS, the office must be used exclusively, and on a regular basis, for the administrative or management activities.
Space for storing inventory or product samples: If you're in the business of selling products at retail or wholesale, and if your home is your sole fixed business location, you can deduct home expenses allocable to space that you use regularly to store inventory or product samples. The space doesn't have to be used exclusively for business purposes, and you can do business at the fixed locations of your customers (e.g., retail stores, if you're a wholesaler) and non-fixed locations, such as flea markets or craft shows.
Exclusive and regular use requirements: As noted above, when you claim to be using your home office under any of the tests outlined above (except the "storage space" test for retailers and wholesalers), the home office must be used exclusively and on a regular basis in connection with your business. (For storage space used by retailers or wholesalers, the space must be used regularly for business purposes, but doesn't have to be used exclusively for those purposes.)
The exclusive use requirement means that you must use your home office solely for the purpose of carrying on your business. Any other use of the home office will result in loss of all deductions for your home office expenses.
For example, a professional musician's home studio that's used only for rehearsal, recording demo tapes, etc., passes the exclusive use test. But a caterer's living room that's used to meet with clients and potential clients, but is also used for family entertainment and gatherings, won't pass the test. Neither will a spare bedroom that's used to work in and store business records, but that's also used to sleep occasional overnight guests.
The regular basis requirement means that you must use the home office in carrying on your business on a continuous, ongoing or recurring basis. Generally, this means a few hours a week, every week. A few days a month, every month, may do the trick. But occasional, "once-in-a-while" business use won't do.
Well, that's enough for this week. Next week we'll look closer at the deductions you may be able to generate and how some of the computations work for the office in home deduction. In the meantime, if you want to read more about the office-in-home deduction, read IRS Publication 587 at the IRS website.