Your tax client informs you that he has a room in his home that he uses only for his business or his job. If your client's purpose for this room aligns with the Internal Revenue Service definitions and requirements for a home office, he may claim a tax deduction on his individual federal income tax return for the business use of his home.

The savings from an office-in-home deduction can be significant, particularly in the case of a taxpayer who is subject to both income and self-employment taxes. However, before you include this deduction on your client's return, you should help him assess his future. In particular, you should inquire whether he'll be selling his house soon. If your client claims an office-in-home deduction in the year that he sells his house, he could incur a significant tax penalty.

Who can deduct?

To meet IRS requirements for office-in-home deductions, the following criteria must be met:

• The area must be used exclusively as a home office. For example, a computer room that your client shares with his children does not qualify.
• Your client must regularly use this space for business. If he worked on a special project at home for only a month, his office does not meet the requirement.
• If your client is an employee for a company or organization, the business use of his home must also be for the convenience of his employer. If his employer provides a working space for him on company premises and would prefer that he work there, a home office deduction would be difficult to defend if your client were audited.

What can be deducted?

Your client can deduct mortgage interest and property taxes if he owns his home.

In addition, your client can take an office-in-home deduction to deduct other household-related expenses, such as:

• Insurance (homeowner's and mortgage)
• Repairs and maintenance
• Utilities and services
• Depreciation
• Rent (if your client doesn't own his home)
• Security system

How much can be deducted?

If your client is self-employed, deducting office-in-home expenses can save him significant tax expenditures. You are aware that he is paying both income tax and self-employment tax. He may pay 40% or more of his self-employment income in taxes. Deducting office-in-home expenses can allow him to deduct expenses that would not otherwise be deductible, and to shift expenses that are otherwise deductible to itemized deductions, therefore reducing self-employment income.

However, several factors can limit the amount that your client can deduct.

Size of the office

Most of the expenses listed previously were for maintaining your client's entire house, not just his office space. To calculate the deductible portion (for the office space only), you must calculate the area of his house that his office constitutes. You can calculate this office-in-home percentage in two ways:

• Divide the square footage of his office by the total square footage of his house.
• Divide the number of rooms in his office by the number of rooms in his house.

Try both of these formulas, and use the result that has the larger percentage. This percentage is then multiplied by your client's expenses to calculate the business portion that is deductible. Remember to claim the remaining amount of mortgage interest and property taxes as itemized deductions.

Expenses that are directly related to your client's home office are not subject to the percentage that you calculated by using the formula described in this section. For example, if your client painted his home office, this expense is fully deductible.

Business income

Calculate your client's business income. Then subtract all of his business expenses other than his office-in-home expenses. If he has already incurred a loss on his business, he will not get any tax benefit from his home office this year. If he has remaining income, he can deduct his office-in-home expenses up to that amount.

If your client's office-in-home deduction cannot be used in the current year, there are two alternatives:

1. Do not claim an office-in-home deduction, but instead claim his entire mortgage interest and property taxes as itemized deductions.

   This might be the best choice if your client expects his business to continue to show losses or if this is the first time that your client is claiming this deduction. If he has claimed the office-in-home deduction in previous years, you should probably choose the second option.

2. Claim the office-in-home deduction so that it can be carried over and used against next year's business income. First remove all mortgage interest and property tax from your office-in-home claim form and instead deduct them as itemized deductions.

   If your client has claimed the office-in-home deduction in the past and intends to claim it in the future, this option maintains his claim for business use and stores current-year office expenses, such as utilities and depreciation, to use as a deduction when his business shows taxable income.

Employee's itemized deductions

An employee can also claim an office-in-home deduction. However, employee business expenses are deductible only as miscellaneous itemized deductions on that employee's income tax. If your client claims the standard deduction, instead of itemizing deductions, he will not receive the benefit of an office-in-home deduction as an employee. If he does claim these expenses as itemized deductions, they are reduced by 2% of his adjusted gross income before any amount is deducted.

Depreciation

If your client owns his home, he is allowed to deduct the depreciation for the wear and tear on the portion of his home used for business. He is not allowed to deduct depreciation for land ownership.

To determine the depreciable basis of the home office, first determine each of the following:

• [The amount your client paid for his home] + [The cost of any permanent improvements made since purchase] – [The cost of the land included in his home's purchase cost]
• The fair market value of his house, not including land, on the day he began using his home office.

Multiply the smaller of these two numbers by the business percentage calculated earlier. This is the depreciable basis of your client's home office.

Once you know the basis, you can calculate the depreciation for any tax year. On returns for tax year 2004 and later, the IRS has stated that a home office has a useful life of 39 years. The IRS provides a table that lists the percentage of the basis that a taxpayer is allowed to deduct as depreciation for each year that he uses the office.

If the current tax year is the first year that your client used his home office, you must also adjust this year's depreciation for the number of months that he used his home office.

Repairs vs. permanent improvements

Each amount that your client spends on repairs for his home must be reviewed to determine whether it is a permanent improvement — that is, whether it increases the value of the property or adds to its lifespan. For example, replacing electric wiring or plumbing is considered a permanent improvement.

Why should you care? The business percentage of a repair expense can be deducted in the year that the expense was paid. A permanent improvement, however, must be depreciated over 39 years.

Planning a sale?

Before you claim an office-in-home deduction for your client, consider whether he plans to sell his home.

The sale of a personal residence is usually not taxable. However, by claiming an office-in-home deduction, your client has now converted a portion of his home into business property equity, and the sale of business property is taxable.

To determine whether a house is a personal residence, the taxpayer must have lived in the home for at least two of the last five years. To avoid being taxed on any portion of the gain on the sale, your client generally should not claim an office-in-home deduction for two full years before he sells the house.

The best way to decide whether to claim the deduction is to compare the results of the following two formulas:

• [The deductions your client will be allowed] * [The tax rate he will pay on his self-employment income] * [The number of years he will claim the deduction] = The tax savings received with an office-in-home deduction
• [The gain on the sale of your client's house] * [The percentage used for business purposes] * [The tax rate he will pay on business sales] = The tax cost for claiming an office-in-home deduction

If the result of the first calculation is larger than the result of the second calculation, you should consider claiming an office-in-home deduction that's based on your client's individual income tax return.

Know where you can save

You might be able to add a deduction for the expenses related to the office that your client maintains in his home. If your client is self-employed, the tax savings can be significant, because this deduction reduces both his income tax and his self-employment tax. However, this deduction can be claimed only if the home office is your client's principal place of business and if it is used exclusively and regularly for his business.

Cash expenses related to your client's house that would not normally be tax deductible can be claimed. Also, you can deduct depreciation for the wear and tear on his office space. Factors that might limit the amount of office-in-home expenses that your client can deduct include the size of his office and the amount of his business income.

Before you claim an office-in-home deduction on your client's tax return, ask him to consider whether he plans to sell his home. After a portion of his home is considered business property, part of the gain on the sale becomes taxable. Make sure that this tax doesn't wipe out your client's savings from earlier years. After all, the success of your business is based on repeat business.