How to Defend Your Home Office Deduction

Editor's note: This is the second of two stories on the home office deduction. Part one covered who's eligible for the tax break and what qualifies as a legitimate home office. Part two looks at the documentation you'll need if you do take the deduction and then face an audit, as well as the tax implications of taking the deduction if you eventually sell your home.

Some taxpayers balk at taking the home office deduction because they worry that it's seen as a red flag for IRS auditors.

Others fear the costs associated with the deduction when you sell a house. You're allowed to claim depreciation on your office space every year. As a result, when you sell, the IRS will collect taxes on a portion of the profit derived from the office space.

Making the right decision depends on several factors.

Is the home office deduction a red flag for an audit?

"The truth is, we don't know," says Mark Luscombe, principal federal tax analyst for CCH, the Riverwoods, Ill.-based provider of tax and audit information to accountants, attorneys and compliance professionals. If -- like many who claim the home-office deduction -- you're an independent contractor or the sole owner of an unincorporated business, you probably have a higher-than-average chance of being audited, but not because of the deduction itself.

Such taxpayers (freelance writers and solo plumbers, for example) must file a Schedule C, which covers business income or loss. And Schedule C does appear to be an audit flag: Last year, IRS commissioner Mark Everson said there would be increased focus on those who file Schedule C, as auditors crack down on under-reported incomes.

Indeed, the IRS' latest statistics show that, depending on income, the audit rate for Schedule C filers is two to four times higher than normal.

Not everyone who claims the home-office deduction will file Schedule C, though many will. The point is that if you're already filing a Schedule C, claiming the home-office deduction may not make any difference in your chances of being audited. "I haven't seen any concrete evidence that the home office deduction itself raises the odds against you," says Luscombe.

Besides, Luscombe and others say that if you're entitled to a deduction, you should take it, even if you're worried about an audit. The reason? There's nothing to worry about with the proper documentation, and -- as we saw in part one of this series -- the savings can be significant.

What will you need to back up the deduction?

Keep meticulous records, hold on to your receipts and make sure the office really looks like an office. Since the deduction includes the relevant portions of mortgage or rent payments, utilities and improvements or repairs, you'll want to carefully document all of those costs.

You'll also want to keep your office space set up for business, and keep personal activities out of it as much as possible. Make a floor plan of the house that clearly distinguishes the office from the rest of the house, including square footage totals for each part.

"If the IRS comes to your house during an audit, they'll want to see evidence of the activity you claim goes on there," says Jeff Levine, a CPA with Alkon & Levine in Newton, Mass. "File cabinets that show you store things, a computer with records, computer programs that you use -- they all help you prove your case. If they make you come to them, bring pictures."

Will it cost me when I sell my home?

Probably. When you sell your primary residence, you're allowed to exempt $250,000 ($500,000 if married, filing jointly) of your profit from capital gains taxes. Prior to 2002, home office space was treated as separate from the rest of the house, and you'd pay capital gains tax on the profit from that portion of the house. That has changed, though home-office owners do still have to pay a "recapture tax" based on depreciation.