Is a portion of your home used solely for your business or job? It can be a spare bedroom that serves as your base of operations, or a remodeled basement where you meet with patients, clients, or customers regularly. If so, you may be able to reduce the income and self-employment taxes on your business income by taking an office-in-home deduction.

Before you get too excited about the potential deductions, you should know that tax laws may limit this year's deduction or even wipe out in subsequent years any tax that you save now.

Who can deduct?

To meet the Internal Revenue Service (IRS) rules for a home office, the area that you set aside must be used exclusively for work on a regular basis. If you worked on a special project at home for a month, your office doesn't meet the rule. Also, this means the computer room that you share with your kids doesn't qualify. Sorry, but that's the law.

If you're an employee, the business use of your home must also be for the convenience of your employer. If your boss prefers that you work in the company office, you'd have a hard time justifying your office-in-home deduction if you were audited.

What can you deduct?

If you own your home, you probably already know that you can deduct mortgage interest and property taxes. Taking an office-in-home deduction lets you deduct additional expenses, such as:

• Insurance (homeowners and mortgage)
• Repairs and maintenance
• Utilities and services
• Depreciation
• Security system
• Rent (if you don't own your home)

How much can you deduct?

If you're self-employed, you're in the unenviable position of paying both income tax and self-employment tax. Deducting office-in-home expenses can save you a lot. You may pay 40% or more of your self-employment income in taxes. Deducting office-in-home expenses can:

• Let you deduct expenses that wouldn't otherwise be deductible.
• Shift expenses that are already deductible to reduce self-employment income.

Several factors limit the amount that you can deduct. Here are a few items that you should consider before you plan that trip to Maui.

• Size of your office  Most of the deductible expenses pertain to your entire house, rather than to your home office. Your office takes up only a percentage of the square footage in your house. You multiply this percentage by your expenses to come up with the portion of the expenses that are deductible against your business income. Expenses that are directly related to your home office aren't limited to this percentage. For example, if you paint your home office, this expense is fully deductible.
• Business income   If you have a loss on your business before claiming a home office, you cannot get any tax benefit from your office this year. Go ahead and claim the office-in-home deduction, even if it doesn't reduce your taxes this year. You can carry over the current year's deduction to use against next year's business income.
• Employee's itemized deductions   An employee can also claim an office-in-home deduction as a miscellaneous itemized deduction. So if you claim the standard deduction rather than itemizing deductions, you cannot receive benefit of an office-in-home deduction as an employee. If you do claim these expenses as itemized deductions, they're reduced by 2% of your adjusted gross income before any amount is deductible.
• Depreciation   If you own your home, you can deduct depreciation for the wear and tear on the part of it that you use for business. The office percentage of your home cost is deducted as depreciation over 39 years.
• Repairs versus permanent improvements   A permanent improvement increases the value of your property or adds to its life. For example, replacing electric wiring or plumbing, adding a new roof or addition, or remodeling your home are considered permanent improvements. Why do you care? A repair is an expense, and your business percentage can be deducted in the year paid. A permanent improvement, however, must be depreciated over the office's 39-year life.

Planning to sell your home sooner rather than later?

Before you claim an office-in-home deduction, consider when you plan to sell your home.

The sale of your personal residence is usually not taxable. However, by claiming an office-in-home deduction, you've turned a portion of your home into business property. The sale of business property is taxable.

To determine whether a house is your personal residence, the IRS asks whether you lived in the home for two of the last five years. If so, you can use the special rules for sale of personal residence. To avoid being taxed on any portion of your gain on the sale, you generally should not claim the office-in-home deduction for two full years before you sell the house.

A great deduction in the right situation

The tax savings from claiming a home office can be large, particularly if you're self-employed. Before you claim it, however, be sure that your office meets the IRS rule that it is used exclusively and regularly in your business.

You can deduct expenses related to your house that aren't normally deductible, as well as depreciation for wear and tear. Many things can limit the amount of office-in-home expenses that you're allowed to deduct, including the size of your office and the amount of your business income. Any tax preparation software will help you with the depreciation calculations and the calculations for each of the limits.

If in doubt, consult with a tax professional before claiming the deduction for a home office.