f you’re self-employed and work at home, your newest tax break may be right down the hall.

Beginning Jan. 1, 1999, the Internal Revenue Service (IRS) expanded eligibility for the home office tax deduction. Claiming the deduction is a great way to fatten your tax refund—if you qualify.

And that’s the tricky part. Just commuting to your office in bedroom slippers doesn’t mean you qualify for the deduction. Even with the liberalized rules, employment activities in the home must meet specific criteria. If your kids play Nintendo in the same room you use to conduct business, you may not qualify.

Only 10% of the nation’s 14 million full-time self-employed taxpayers take a home office deduction, according to the American Institute of Certified Public Accountants (AICPA) in New York. In the past, many tax preparers and entrepreneurs feared that taking the deduction might trigger an IRS audit, which ranks up there with the joy of having a root canal. (Look for an article in the September issue of Home & Family Finance Online about preparing for a tax audit.) Other taxpayers didn’t meet the criteria for taking the deduction.

But the times they are a changin’ and the new tax rules reflect the reality of today’s tech-driven, small-business owning, office-liberated work force. Here’s a look at the law and its potential effect on your tax situation.
     The home office
     tax deduction
     not only reduces
     your income tax
     but your
     self-employment tax.

What are the new rules for the home office deduction?
Beginning Jan. 1, 1999, you can take the deduction if you use your home office exclusively and regularly for the administrative or management activities of your trade or business, and you have no other fixed location where you conduct those activities.

The IRS says administrative and managerial activities include billing customers, clients, or patients; bookkeeping; ordering supplies; scheduling appointments; and report writing.

What’s changed? Before, many small businesses and self-employed individuals who performed services outside their homes—but used their homes for administrative tasks—were not able to take the deduction because the IRS did not consider their homes their principal place of business. Tax experts say the new rules will help workers such as plumbers, musicians, and sales representatives who perform services on clients’ sites but do their administrative work at home.

Can you give me an example?
Joe, a self-employed plumber, spends most of his workday in other people’s homes. He runs his plumbing business from a small office in his house. In 1998, Joe’s home office did not qualify for the deduction because the administrative and management activities he did there were viewed as less important than the work he did in customers’ homes and offices. Under the new rules, Joe’s home office qualifies for the deduction.

What if I’m not self-employed, but I do a lot of work from home?
If you’re an employee, IRS rules say that the business use of your home must be for the convenience of your employer.

"If you’re someone who just prefers to work at home, and your employer doesn’t require it, you do not qualify for the deduction," says Eve Sappenfield, taxpayer education specialist with the IRS Milwaukee district office.

However, if you work for a company actively engaged in setting its employees up in home offices, you probably would meet the requirement, Sappenfield adds.

How do I calculate the home office deduction?
The home office deduction actually is several deductions, one for actual office space and others for expenses such as utilities and insurance.

To determine what percentage of your house you use for business, divide the square footage of your office space by the home’s total square footage. For example: A 150-square-foot office in a 1,500-square-foot residence totals 10% business use. This percentage establishes the portion of certain expenses you can claim. Those include mortgage interest or rent, utilities, maintenance, real estate taxes, and insurance. Homeowners also must factor in depreciation.

If your gross income is less than your total business expenses, your deduction for certain expenses for the business use of your home is limited.
     When you sell
     your house,
     the portion allocated
     to business use
     will be subject to
     capital gains tax.

Are there drawbacks to taking the deduction?
Yes. When you sell your house, the portion you’ve allocated to business use will be subject to capital gains tax. Under federal tax law, capital gains on the sale of your personal residence are exempt ($250,000 single; $500,000 for persons filing jointly). Any depreciation you have taken over the years gets taxed at that time as well.

Even if you do not take the home office deduction, but qualify for it, you must recapture the depreciation when you sell your home. For some taxpayers, that's an incentive to take the deduction.

With a little long-range planning, you may be able to avoid part of this potential tax liability by converting your home office space back to your personal residence. Consult your tax adviser to determine how the law applies to your situation.

Is it worth taking the home office deduction if I already deduct mortgage interest and real estate taxes?
That depends. For some taxpayers, the home office deduction doesn’t amount to much and may not be worth the hassle. For others, it represents a significant savings. The factors that come into play are your income level, the value of your house, expenses, and the size of your office.

Jan Zobel, a San Francisco tax preparer and author of "Minding Her Own Business: The Self-Employed Woman’s Guide to Taxes and Recordkeeping," (ISBN 0965477894) advises eligible clients to take advantage of the tax break. "It not only reduces your income tax but your self-employment tax," she says, "plus it allows you to write off a portion of your utilities, insurance, and maintenance expenses."

Another benefit: Taxpayers taking the deduction also can deduct mileage between home and customer offices.

What records should I keep?
It’s important to keep records to document the business use of your home. Keep tax returns forever. Save documentation — copies of bills and statements — for expenses you claim for five years. Make videotapes or take photos to show there are no personal items in that part of the house.

Is it true that taking a home office deduction may flag my return for an audit?
Some tax experts dismiss such concerns, others are more wary.

In 20 years of preparing tax returns for small-business owners, Zobel says only one client taking the deduction has been audited. "In my view, fearing an audit is not a good reason for not claiming it."

Gary Fleischman, CPA, Ph.D., in a recent article for the Journal of Accountancy, published by the AICPA, suggests that deducting home office expenses will increase the probability of an IRS audit, but that shouldn’t scare taxpayers qualifying for the deduction from taking it.

If you just prefer
to work at home,
but your employer
doesn’t require it,
you do not qualify
for the deduction.

Where can I get more information?
Visit the IRS Web site to review Publication 587, Business Use of Your Home. Click on the 1999 Rules for Business Use of Your Home.

Call 800-829-3676 to request a copy of the Small Business Tax Workshop Workbook, IRS Publication 1066, which provides information on the home office deduction and other topics.

Call the IRS at 800-829-1040 for answers to tax questions.

©1999 Credit Union National Association Inc.