Think Twice before Deducting Home Office Expenses

One of the most alluring reasons to have a home office is to qualify for deducting home office expenses as legitimate business expenses. The first time I considered the advantages of having a home office, after it was recommended to me by a tax preparer I had hired to help me do my taxes, I was elated. He said that I could, among other things, deduct a portion of my rent or mortgage.

If my home was 1,500 square feet and I had an office that took up 500 square feet, for instance – which is a third of the area – then I could deduct a third of my mortgage or rent. Plus I could deduct a third of my homeowner’s insurance, my electricity bill, my heating bill, and so forth and so on – which sounds irresistible.

Just imagine how much tax money you could save by setting up a business based inside your home. Consider, for example, what it would be like if you ran a daycare nursery inside half of your house, for 2-3 hours per day. Imagine, for example, taking about half of all your home expenses and chalking them up as business deductions. It is enough to make you downright giddy, thinking of all the different ways you can cut your taxes. But don’t get too intoxicated by the idea, because your local IRS agent also has a pretty vivid imagination and he or she sees the scenario a whole lot differently. Here’s an example. Say you deduct all those home business expenses. Then the IRS agent asks you “After business hours, do you ever go into those rooms? There is a TV in there. Do your friends or your own kids ever go in there and watch it, or do they go in there and play? Does your husband ever go into that home office and use the computer to send personal emails or play video games?”

If you answered yes to any of those questions you just admitted that when the business is not operating then that home office reverts back to being an ordinary part of your home. So that means that during those hours that you use it as part of your ordinary living space it is no longer eligible for business deductions. Suddenly it is your responsible to prove to the IRS that you never cross that legal line and use square footage in your house set aside as a “home office” for any other purpose but business.

To make a long story short, a tax attorney once told me “Look, if you buy a stapler for your office desk that’s a legitimate business expense. But if you use it to staple your child’s book report together that’s not a business activity so the stapler is no longer eligible as a business expense. A carpenter can buy a hammer for work and that’s a legitimate business expense, but according to the IRS he cannot use that hammer at home for personal projects and he cannot lend it to his wife for her to hang her pictures. It has to been used solely for business or it is no longer a deductible business expense.” Sure, it all sounds very nit-picky. But hey, we’re talking about the IRS here and they are professional nit-pickers.

Business deductions for home offices are great. In fact, they represent one of the biggest categories of deductions that taxpayers claim each year. The bad news is that because they are so hard to calculate precisely according to stringent IRS rules, and because they are also one of the most tempting ways for people to rack up sweet deductions, they are also one of the main red flags that IRS auditors look for each tax season. If you list home office expenses as deductions – especially if they add up to significant deductions – then you are asking for an audit.

So before I go that route I always ask myself this question: How much would I be willing to pay to avoid an audit? If the answer is less than my home office deductions are worth, forget it – the deduction is not worth the stress and potential trouble and penalties that could occur if I am audited. Plus don’t forget that once you have been audited the statistical chances that you will be audited again sometime in the future go up dramatically.

The bottom line is you can take a home office deduction or leave it. But if you take it and are audited, don’t say I didn’t warn you.