How to Defend Your Home Office Deduction

Claiming the deduction isn't a red flag, but the IRS does tend to audit the self-employed more often.
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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.

Let's say you bought a house for $500,000 and held it for five years. You claimed a home office deduction and depreciation on 10% of the square footage each year, then sold it for $750,000. Your total deduction for depreciation over that time, based on the IRS's 39-year depreciation schedule (see

Publication 946), would be about $1,200 a year, or $6,000 for the period.

If you're self-employed in the 28% tax bracket, you'll typically pay 5% or 6% in state taxes, plus about 15% in self-employment tax. Each dollar you deduct would save you 48 cents, so that $6,000 deduction would save you about $2,900 over five years.

In the year you sold the house, you'd pay taxes on that deduction, likely at a 25% rate (plus self-employment and applicable state taxes). The bill would be about $2,500, Levine says. So in the long run, the deduction would have saved you $400 or so. That seems like a lot of work for $400, but remember: That's likely just

part

of the savings you can reap when you factor in the deductions you can claim for utilities, improvements and repairs.

There is one exception: If your office is in a separate building, such as a shed or garage, it's considered a separate commercial structure. That means it gets treated as offices did

before

2002, and it does not fall under the $250,000 exemption. If you claim the home office deduction in a detached building in three of the five years before you sell, you'll have to pay capital gains taxes on the value of the structure.

Bottom line? Consult a tax professional to see what works best for you. And if you're planning a move in the next few years, don't take the home office deduction.

Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.