Some Taxpayers Fear
Home-Office Deduction

Even as more Americans work from home, many of them appear to be missing out on valuable home-office tax deductions, an Internal Revenue Service official says.

"It is questionable whether most taxpayers who are eligible to take the deduction actually do so," IRS National Taxpayer Advocate Nina Olson said in a report to Congress last week. She urged lawmakers to offer taxpayers a simpler, optional method of calculating the home-office deduction.

Among the reasons people don't take such deductions, she says, are the law's complexity and its record-keeping requirements.

Another reason: fear of being audited. "Some clients of this firm who are eligible don't take it," even after being told about the tax savings, says David A. Lifson, a certified public accountant and partner at Hays & Co. in New York City and president of the New York State Society of Certified Public Accountants. "Many people believe the home-office deduction is a red flag" for IRS agents.

That has long been a familiar refrain: Claim the home-office deduction, and you have an above-average chance of an unpleasant date with an IRS auditor. IRS officials won't disclose details of how they pick which returns to audit or what percentage of those who claim the home-office deduction are audited. But the subject does appear to be a matter of concern. Eric Smith, an IRS spokesman, says that "underreporting of income" by small businesses is one of the highest areas of noncompliance and that "improper" home-office deductions contribute to underreporting by small businesses. To help taxpayers sort through the rules, the IRS has issued a "fact sheet" on the subject.

Even so, several lawyers and other advisers say taxpayer fears of getting audited are exaggerated. They say more people with legitimate home offices should consider claiming the home-office deduction, which would enable them to deduct the business portion of real-estate taxes, mortgage interest, rent, utilities, insurance and other items. They also say it's clear from IRS data that most people who claim the home-office deduction don't get audited.

Nearly 3.2 million returns claimed the home-office deduction for the 2005 tax year, the latest year for which statistics are available, says Mr. Smith of the IRS. That's up from nearly three million returns for 2004.

Among taxpayers who do claim the deduction is Barbara Weltman, an attorney and author of several books on small-business tax matters. Ms. Weltman works in a 12-by-25-foot office built specifically as an office in her home in Millwood, N.Y., a suburb of New York City. She says she has taken home-office deductions since the early 1980s and has never been audited over the issue.

Ms. Weltman says she makes sure to follow the rules - such as using her home office only for business and making sure it clearly is her "principal" place of business. She also takes photographs of her office each year and has them time-stamped, just in case she is challenged. "Suppose you're using your home office now. But three or four years from now, you may be audited and, by that time, you may have gone back to work and are no longer using the space for work," she says.

Among those who have run into trouble over the home-office deduction is Bernard Kerik, the former New York City police commissioner. In a wide-ranging indictment late last year, Mr. Kerik was accused of tax fraud, including deducting as a business expense a home office he claimed to have maintained in New Jersey when he wasn't living in that home, according to U.S. Attorney Michael Garcia. Mr. Kerik has pleaded not guilty.

If you're going to claim the home-office deduction, make sure you've mastered the fine print. "People shouldn't refrain from claiming it out of fear of an audit if they're entitled to it," says Mark Luscombe, principal analyst at CCH, a Wolters Kluwer business that provides tax and other business information and software.

Small-business owners increasingly are using their home as a primary place for business, Ms. Olson's report says. It cites government data showing the number of home offices jumped about 20 percent between 1999 and 2005. The report also estimates that slightly over half of small business are home-based but says "many" business owners don't take the home-office deduction. For example, the IRS report says that of the nearly 20 million filers who sent in Schedule C (for sole proprietors) for 2003, only about 2.7 million claimed the deduction.

As Ms. Olson points out, the rules are tricky. To qualify for the deduction, you typically have to use your home office regularly and exclusively as a principal place of business or as a place to meet or deal with patients, clients or customers in the normal course of work. (However, this isn't always true. For example, you don't have to pass the exclusive-use test if you use part of your home as a day-care facility, or if you use it to store inventory or product samples.) If the office is in a separate structure not attached to your home, you have to use it in connection with your trade or business.

If you're an employee, you can claim the deduction only if the regular and exclusive business use of the home is for the convenience of your employer and the portion of the home isn't rented by the employer, the IRS says.

"Exclusively" doesn't mean "occasionally" or even "most of the time." Suppose you're a lawyer and use a den in your house to write briefs and prepare clients' tax returns. Your family also uses the den for recreation. If so, the IRS says, you can't take a deduction for business use of the den.

Defining "principal place of business" can be especially tricky. The IRS says a single business can have more than one business location. As for whether your home qualifies as your principal place of business, the IRS says the answer depends on "the relative importance" of the activities performed at each place where you conduct business and the amount of time spent at each place.

Several years ago, Congress made changes that allowed more taxpayers to qualify for the home-office deduction. Under that law, your home office will qualify as your principal place of business if you use it exclusively and regularly for substantial administrative activities or management of your trade or business - and you have no other fixed place for your trade or business. Examples of these activities would be billing customers, clients or patients - or keeping books and records.

For more details, including how to calculate the deduction, see IRS Publication 587 at irs.gov.

A survey in 2006 for the National Federation of Independent Business Research Foundation found that about 75 percent of those polled said the home-office deduction would apply to their business - but only about 15 percent said they had a good understanding of the rules, says Bill Rys, tax counsel at the National Federation of Independent Business. Mr. Rys says the federation strongly supports the idea of creating a simpler, optional way of figuring the home-office deduction.

APPEALING: A taxpayer asks the Supreme Court to review a closely watched case.

At issue is whether Marrita Murphy owes taxes on a $70,000 award from her former employer for emotional distress and loss of reputation.

Last summer, a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit said Ms. Murphy does owe taxes on the award. That decision reversed the panel's own ruling in 2006.

The case has stirred widespread interest among lawyers and tax-law scholars.