THE HOME OFFICE DEDUCTION
by Royce E. Chaffin and George S. Busby
Both Royce E. Chaffin, CPA and George (Steve) Busby, CPA are Associate Professors of Accounting at the State University of West Georgia.
The home office deduction is becoming increasingly an issue with the tax paying public. Today, in addition to traditional at-home workers, thanks to the availability of relatively inexpensive computers, modems, and fax machines, many others also work at home. The on-going adverse economic conditions and corporate down-sizings have forced many individuals to develop new sources of income through businesses operated out of their homes.
Currently, nearly 25 million Americans run a home business, while another 6 million telecommute.(1) Estimates are that, by the year 2000, at least 11 million employees will spend at least part of their work week telecommuting from home offices.(2)
To be tax deductible, an office in the home, unless it is in a separate structure, must be used as either the principle place of business or as a place of business used to meet customers, clients, or patients in the normal course of business. In all cases, the office in the home must be used exclusively for business and on a regular basis for these purposes. An employee can only qualify if the business use is for the convenience of the employer.(3)
The home office does not have to occupy a separate room. Taxpayers have prevailed in court cases involving "exclusive use" where only a portion of a room was set aside for business use(4) and where more than one business was conducted in the space. The latter requires that each business using the office meet the deductibility tests.(5) Taxpayers have generally been unsuccessful where other office facilities were available(6) or where the home office was merely helpful in conducting business.(7)
In recent years, the courts had been moving away from the "focal point" test in favor of a "facts and circumstances" test, as shown by their decisions in Soliman, Drucker, and Weissman(8). Some observers felt the courts were, in fact, moving back to the old "appropriate and helpful" standard used before enactment of IRC Section 280A.(9)
However, the Supreme Court overturned both the Tax Court and the Court of Appeals in the Soliman(10) ruling. The final ruling holds that facts and circumstances control, but the factors that must be considered are: (1) the relative importance of the functions performed at each business location; and (2) the time spent in the office compared to the time spent in each of the other places where the business is conducted.
A comparison of the relative importance of the activities performed at each business location depends on the nature of the business. If the business requires meetings or conferences with clients or patients, or delivering goods and services to a customer, the place where the contact takes place must be given great weight. Performance of necessary or essential activities in the home office, such as planning for services or the delivery of goods, or the accounting or billing for these activities is not controlling.(11)
The comparison of time spent at the home office must be compared to the total time spent in the business. This test is particularly important when a comparison of the importance of each activity yields no clear answer to the location of the principal place of business. These tests appear to fix the legal definition of "principal place of business" as being where the taxpayer meets the customer - at least for those taxpayers who have no other office available.(12)
The last two Congresses have proposed changes to the law to relieve many home-based business owners from the onerous home office rules following the Supreme Court's decision in Soliman. The last Congress considered legislation, incorporated as part of the "Contract with America", that would have amended section 280A to provide that a home office qualifies as the "principal place of business" if:: (1) the office is used by the taxpayer to conduct administrative or management activities of a trade or business; and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities.(13) There was bipartisan support for the legislation, so it may be introduced in the next Congress.
What Can Be Deducted
The home office deduction includes only those expenses that are, directly or indirectly, incurred in the business use of the area. Other business expenses not allocable to the business use of the home, such as salaries, supplies, and business telephone expenses, are deductible elsewhere on the business schedule.
Expenses that would be deductible as an itemized deduction (mortgage interest, property taxes, and casualty losses) are prorated between business and personal, with the business portion compared to income from the business. If there is a surplus of income over these items, then other expenses such as rent (or depreciation), utilities - other than basic telephone service, insurance, and repair and maintenance costs, are deductible - but not to the extent they will create a loss from operations. Designation of a portion of a residence as a business office causes that portion to become subject to depreciation under the "allowed or allowable" clause of Section 167. The portion deemed business will be depreciated using a 39-year life.
Although allocation of business and personal expenses will generally be based on a comparison of square feet of space used for business purposes compared to the total square footage of the residence, other reasonable methods are acceptable,(14) including the rooms used compared to total rooms.(15) Deductions are based on prorated actual cost, and not on current rental values.(16)
It would appear that if some space is generally unused by the family--for instance, an extra bedroom--then the square footage used for office space could be compared to the total square footage actually used, rather than the total available. This approach would probably only be applicable to certain expenses (e.g., repairs or utilities), but not for depreciation, as the cost basis includes the unused spaces.
Having a deductible home office may affect other areas. For instance, depreciation of the home office results in a reduced basis of the property in the event of sale. Further, that portion currently being used for business will be ineligible for rollover of gain under Section 1034 in the event of a "trade-up" of residences and will not qualify for the "over age 55" exclusion of gain under Section 121. (President Clinton, in his successful reelection campaign, discussed allowing homeowners to exempt the entire gain on the sale of their personal residence, but, even if enacted, this would not exempt the business portion of the home office.)
Also at issue are tax deductions for daily transportation expenses incurred in travel to and from a residence and another work location. Deductions for these costs may depend on whether or not the taxpayer qualifies for the home office deduction.
The IRS believes that the requirements for determining if a taxpayer's residence is the "principal place of business" for purposes of local transportation deductions should be the same as the standards for home office deductions under IRC Section 280A. However, in the Walker case(17) the Tax Court held that RevRul 90-23(18) allowed a taxpayer who has one or more "regular places of business" and "who pays or incurs daily transportation expenses for trips between the taxpayer's residence and temporary work locations within a metropolitan area" to deduct such expenses regardless of the distance.
In RevRul 94-47(19), the IRS indicated that it will not follow the Walker decision. Its position is that RevRul 90-23 provides a deduction for daily transportation expenses incurred in traveling between a taxpayer's residence and a temporary place of business only when the taxpayer also has a regular place of business that is not located at the taxpayer's residence.
If the residence doesn't meet the "principal place of business" requirements, RevRul 94-47 holds that the business activity at the residence is not sufficient to overcome the inherently personal nature of the residence. In such a case, transportation expenses incurred in going between the taxpayer's residence and another work location are nondeductible commuting expenses.
Other factors besides the tax deductions come into play with offices in the home. For instance, homeowner's insurance policies usually do not fully cover business property or injuries incurred by business clients; local governments may have zoning restrictions; neighbors may object, particularly if there are clients coming to the office; or family members may interrupt or otherwise limit client privacy.
In addition, the property tax assessment may change for that portion of the home, since business property may be taxed at a different rate than residential. Home-owners exemptions may also be affected. If clients come to the office, the house may have to be altered to meet fire safety standards or to provide access to those with disabilities, such as the need to install sprinklers, elevators or ramps, and make restrooms available to those with wheelchairs.
Family considerations should also be weighed. Many have found that family members have a belief that "at-home" means "off-duty." Additionally, those who work at home may develop a feeling of isolation resulting from the lack of companionship. Also lacking will be the support and/or advice of co-workers. Regulating work time is important, otherwise the worker may overwork (any time becomes potential work time) or underwork (any time becomes potential free time).
Taking the Deductions
Most taxpayers will use Form 8829 (Expenses for Business Use of Your Home) to determine the allowable deduction. While the probable purpose of this form is to force taxpayers to limit the home-office deduction to the amount of income from the business, it may also serve to "flag" the return for potential audit. Those taxpayers filing Schedule F will use the worksheet in IRS Publication 587 instead of Form 8829 to determine the amount of the deduction.
With varying success, since Section 280A enactment, taxpayers have proposed a series of differing justifications for taking the home office deductions. Listed below are specific discussions for day care providers, employees working at home, educators - including college and university professors, outside salespersons, specialist physicians, and securities investors and traders. (Click on those of interest to you or scroll down to them. References follow them.)
DAY CARE PROVIDERS
The exceptions carved out for day care operators who use their home in their business make it difficult to understand why other business people and investors cannot have the same standards.
Although day care providers operating businesses in their homes come under rules of IRC Section 280A, they are allowed to deduct costs associated with any area of their home that is used regularly (but not exclusively) for day care, even if the area is not so used every hour of the business day and is used for personal use after day care hours.(20)
To take advantage of this rule, the day care providers must use two computations to arrive at the amount deductible: (1) The total expenses are first multiplied by a fraction derived by taking the total square footage of the house that is available and used for day care use throughout each business day divided by the total square footage of the home. (2) This number is then multiplied by a second fraction derived by dividing the total hours in the year that the day care business is operated (including substantiated preparation and clean-up times) by the 8,760 total number of hours in a year.
Note that the day care operator is not required to keep records of the specific hours of usage of designated day-care facilities, but he or she would be required to substantiate such use upon an IRS challenge. Also, the occasional business use of non day-care rooms does not make that area fall under the exception.
The statute allows an employee to take a home office deduction only if the office is exclusively used on a regular basis "for the convenience of his employer".(21) While the term is not defined in the Code, an employee should get an appropriate statement or memo from the employer that he/she has an office at home for the employer's convenience. Court cases won by employees seem to be for those who are on call at virtually all times in order to perform their assigned duties.(22)
Employees who can't otherwise qualify for the home office may try to rent all or part of their house to their employer. Where such a lease arrangement exists, the only deductions allowable are those deductible at any rate (e.g., mortgage interest, real estate taxes, and casualty losses).(23)
The courts have consistently held that the focal point of the business activities of a teacher is the classroom, rather than the home office. This is true even if the taxpayer spends more time in the home office than the classroom and even though the school/employer provides inadequate or even no office space for the teacher's use.(24)
Educators have tried to argue that their homes were used exclusively and regularly as a place where they graded papers and communicated with parents. The Tax Court has generally ruled that the educator used the space, not the students or parents. Since the educator had access to a classroom, papers could have been graded there. In addition, telephoning parents did not mean that those parents actually visited the home office for purposes of meeting or dealing with the teacher.(25)
Many college and university professors are required to do research to remain in their positions. While most are provided an office at their institution, some consider it to be a poor place to conduct research because of frequent interruptions by co-workers or students, and small or inadequate facilities and equipment. As a result, many do significant school-related work at their homes and have, therefore, often tried, with varying success, to deduct associated expenses.
Where a professor teaches appears to be a factor since one appeals court, in ruling on Professor Cadwallder's(26) claim, stated, "Research and writing are the principal work of most university (as distinct from college) professors..."
The court in Cadwallder felt that if the university fails to provide adequate office facilities, this would imply that the university expected the professor to equip his home with a suitable office. If he did so, and used the home office exclusively and on a regular basis for his scholarly research and writing, then he would be entitled to the home office deduction.
While this decision would appear to make the case easier for university faculty than would be the case for college professors, the Court of Appeals appears to have ignored the current push for regional state schools whose primary mission remains teaching, rather than research, be reclassified as universities..
Any professor attempting to deduct home office expenses should be prepared to show that research and writing of scholarly papers are critical to maintaining or preserving income. The time factor also comes into play, as, perhaps, those who teach only six or eight hours a week may have a better chance of success than those who spend a majority of their work time in the classroom.
Whether these individuals will be able to deduct office-in-the home expenses will depend on the facts and circumstances used to prove that the home office is the "principal place of business". If the essence of the business requires work primarily at the customer's place of business, the home office activities are not as important as the sales activities performed when visiting customers. Thus, the home office isn't the "principal place of business". If most of the sales are made by phone or mail from the home office and the time spent on these activities is more than that spent visiting customers, this would then bolster the conclusion that the home office is the "principal place of business".(27)
Specialist physicians who do not maintain an office for their patients, such as anesthesiologists, have special problems. According to the Supreme Court in Soliman(28), actual treatment of patients is the most significant event in the professional activities. The home office activities are less important to the business of the specialist physician than the tasks performed in a medical facility.
If the nature of the profession requires the taxpayer to meet or confer with clients or patients, the place where that contact occurs is often an important indicator of the principal place of business. Unless members of the medical profession can show that the home office is the primary place where services are delivered to clients, it is unlikely that the home office deduction will be allowed.
SECURITIES INVESTORS AND TRADERS
Individuals who manage their securities portfolio at home will not be entitled to deduct the home office expense unless they are active "traders". This requires that they are interested primarily in the short-term profits derived from active trading of securities, rather than the long term gains realized from holding for dividends or long-term capital appreciation.
Investors are denied home office deductions because their investment activities are not a trade or business.(29) No deduction is allowed, for example, if a taxpayer, who is not in the trade or business of making investments, uses a portion of his residence (even though exclusively and on a regular basis) to read financial periodicals and reports, clip bond coupons and perform similar activities. That activity is not a trade or business.(30)
1. New York research firm IDC/Link Resources Corp. cited in Money, March 1996, Vol 25, No. 3, p 74
2. Nations Business, Nov. 1995, Vol 83, No. 11, p 41.
3. IRC Section 280A
4. Weightman, George, TCM 1981-301
5. Curphey, Edwin, (1980) 73 TC 766
6. Weissman, David, (1984 CA-2) 751 F2d 116
7. Honan, Lars, TCM 1984-253, Cadwallader, Thomas, (1980 CA-7), 67 AFTR 2d 91-301, and many others
8. Soliman, Nader, (1993 S Ct) 71 AFTR 2d 93-463, 93-1 USTC 50014 revg (1991 CA-4) 67 AFTR 2d 91-1112, 91-1 USTC 50291; Drucker, Earnest, (1983 CA-2) 83-2 USTC 9550; Weissman, (See note 6)
9. See Newi, George, (CA-2) aff'd TC, 70-2 USTC 9669 for discussion of "appropriate and helpful" standard.
10. Soliman (See note 8)
11. Notice 93-12, 1993-1 CB 298
12. Soliman (See note 8)
13. Committee Report, H.rept 104-84, 95ARD 058-1, H.R. 1215
14. Revenue Ruling 62-180, 1962-2 CB 52
15. Moretti, Gene, TC Memo 1982-552
16. Carves, TC Memo 1985-352
17. Walker, Charles, (1993) 101 TC 36; 101 TC 537
18. Revenue Ruling 90-23, 1990-1 CB 28
19. Revenue Ruling 94-47, IRB 1994-29
20. Revenue Ruling 92-3, 1992-1 CB 141
21. IRC section 280A(c)(1)(A)
22. Frankel, Max, (1984) 82 TC 318; Green, John, (1982) 78 TC 428, 83-1 USTC 9387
23. IRC Sec 280A(c)(6); Senate Report No. 99-313 (PL 99-514) p. 84
24. Renner, Rolf H., TC Memo 1984-303
25. Cousino, Paula, 41 TCM 722 (1981) aff'd 679 F2d 604 (CA-6, 1982)
26. Cadwallder (See note 7)
27. Notice 93-12, example 2, 1993-1 CB 298: IRS pub 587 Page 2
28. Soliman (See note 8)
29. Moller, Joseph v. Com., (1983, CA Fed Cir) 52 AFTR 2d 83-6333, 721 F2d 810, 83-2 USTC 9698, cert den(1984, S Ct) 467 US 1251, 82 L Ed 2d 839, revg(1982, Cl Ct) 51 AFTR 2d 83-369, 1 Cl Ct 25, 553 F Supp 1071, 82-2 USTC 9694.
30. S Rept No. 94-938 (PL 94-455) p. 149; IRS Pub No. 587, pp. 2.