The following is a post by MPFJ staff writer, Kevin Mercadante, who is a freelance professional personal finance blogger for hire, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
There is a common perception that taking a home office deduction is a red flag that will trigger an IRS audit. But is it even true? Possibly, if it doesn’t comply with IRS regulations, and it seems excessive for your business or income. But if it’s handled properly, the risk of an audit from taking the deduction is actually quite low.
IRS Home Office Deduction Rules
The IRS rules required for a home office deduction include:
Regular and exclusive use. You must use part of your home exclusively for conducting business. It needs to be a dedicated space – preferably a room, that you run your business out of. It can’t be a family room that doubles as an office.
Principal place of your business. Your home office must be your principal place of business, though you may qualify if you also conduct business outside of your home office, but use the home office substantially and regularly for business purposes. This includes meeting with clients on a regular basis at your home office, even though you also conduct business at another location. You can also deduct a structure, such as a garage, if it is used to store business materials there, or used as a studio. But again, it must be used substantially and exclusively for business, and not shared with some non-business purpose.
There are also special rules for employees who use a home office:
- Your business use must be for the convenience of your employer, and
- You must not rent any part of your home to your employer and use the rented portion to perform services as an employee for that employer.
As long as you are deducting your home office within the scope of these IRS rules, you should be OK to take the deduction.
So why do so many sources say that the home office deduction is an IRS red flag for audits?
Taking an Excessive Deduction
Any tax deductions that you claim that look excessive will automatically generate IRS concern. The IRS has all kinds of metrics to determine whether or not an expense is reasonable based on the taxpayer’s income and business type.
For example, if your business earns $12,000 in gross revenue, but you expense $7,000 as a home-office deduction, that will be a flag. This will be particularly true if the home office deduction is the largest in a list of expenses that ultimately results in your business showing a loss.
An outsized deduction can be an indication that a business may not be legitimate, an excessive allocation of the home for the business, or even an attempt by the taxpayer to gain a tax break for the cost of maintaining a home that cannot be deducted on Schedule A as a legitimate personal deduction.
As an example, let’s say that you live in a 3,000 square foot house, but you claim 1,200 square feet as a home office. This would be an indication that 40% of your house (and housing expenses) is used substantially and exclusively for business. As that is unlikely arrangement, it could trigger an audit.
The key with all business expense deductions is that they must be reasonable and necessary. Any deductions that look excessive or superfluous can trigger an audit.
Taking an Inconsistent Deduction
The home office deduction should be relatively consistent from one year to the next. That’s because the expenses that comprise the deduction – home mortgage/rent, real estate taxes, insurance, homeowner’s association dues, and utilities – are fairly stable expenses. Your home office deduction should represent a fixed percentage of those expenses, based on the ratio of home office space to gross household space.
Since they form the basis of your deduction, that deduction should not change substantially from year to year. But if you show a deduction of $5,000 one year, then $10,000 the next, you could be inviting an IRS audit.
The IRS may suspect that you are padding the deduction in order to offset a higher income from one year to the next. Make sure that if you take the deduction, that you keep the consistency factor in mind each year that you use it.
An Audit Might be Triggered by Something Other than Your Home Office
It’s likely that any time a person who takes the home office deduction gets audited that it’s assumed that the home office is the reason. In reality however, a tax return can be audited for just about any reason. First, a person who is self-employed already has a higher risk, due to the ability of deducting expenses from income.
But an audit could be triggered by virtually any other expense on your return, or simply by the fact that you are taking too many expenses in general. One example is contract labor. The IRS is on the lookout for businesses classifying people as contractors who are actually employees. If you have a large line item for contract labor, this could be the reason for the audit.
The point is, a home-office deduction is hardly an automatic audit. As long as the deduction complies with IRS regulations, and is reasonable, consistent and based on actual home expenses, you should be safe taking the deduction.
How about you all? Have you avoided taking a home-office deduction for fear of being audited?
Share your experiences by commenting below!
***Photo courtesy https://www.flickr.com/photos/dierken/448629059/sizes/q/
