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Eyeing risks, rewards of home-office deduction

One of the most tempting but also terrifying small business tax deductions is for a home office — deducting the cost of operating out of your home can help you save on taxes, but complying with IRS regulations can be a little daunting.
/ Source: The Associated Press

One of the most tempting but also terrifying small business tax deductions is for a home office — deducting the cost of operating out of your home can help you save on taxes, but complying with IRS regulations can be a little daunting.

Accountants say the good news is that the deduction, which used to be considered a fast way to an audit by the IRS, doesn't raise red flags with the government as it did in the past. Still, business owners often make mistakes trying to claim the deduction that can grab the attention of the tax authorities — something every taxpayer wants to avoid.

Stephen Fishman, an attorney and author of "Home Business Tax Deductions" said a common error company owners make is to try to deduct space in their homes that has both business and personal uses. That won't fly with the IRS.

"You have to use the space in your home exclusively for business," Fishman said.

An office with PCs and a fax machine isn't the only way to take advantage of the deduction for using your home for business. If you manufacture goods or store inventory in your home, the space you use for that can also be deducted. The same applies if you run a business like a day care center or nail salon in your home.

You don't necessarily have to have a separate room for your office or business space, but taking the deduction is less complicated if a room is indeed set aside for business purposes. For example, it might be hard to convince the IRS that the home office in part of your family room is never used by your children to do their school work or play computer games.

Whatever the space is, it must be regularly used for your business. It doesn't have to be your only place of business, however.

An owner with a home business can deduct the expenses used to maintain the business space — the portion of utilities, mortgage interest or rent, insurance, repairs and maintenance and other expenditures that can be attributed to that space. One of the big pluses of a home business deduction is that you can also depreciate the portion of a residence used for business; normally, a residence cannot be depreciated.

To determine how much of their expenses they can deduct, most owners divide the total square footage of the home by the square footage allotted to the business. For example, if 5 percent of a house was used for a business, and the owner had $5,000 in expenses for the entire house, then $250 could be deducted.

But square footage is another way owners can run into trouble with the government — for example, if it appears to the IRS employees examining your return that your home business space is too big for the kind of business you operate, they may question the size of your deduction.

If you're thinking of claiming the deduction, you need to get yourself educated about the IRS' requirements. The first thing you should probably do is download and carefully read IRS Publication 857, Business Use of Your Home, from the IRS Web site. There are also several small business and home business tax guides available in bookstores that can give you a grounding about the deduction.

Also take a look at the IRS form you'll need to file, 8829, Expenses for Business Use of Your Home, and its accompanying instructions. They can also be downloaded from the IRS Web site.

It's probably a good idea not to try to claim the deduction without consulting a tax professional. Jeffrey Chazen, a tax partner at the accounting and consulting firm Richard A. Eisner & Co. LLP in New York, noted, "there are little quirks you have to look out for" with a home business deduction.

For example, he noted, if you've been depreciating the space for your home office but now sell your home, you'll have to "recapture" the depreciation, or adjust the profit you made on your house to account for the tax break you already received.

Another, important quirk: Your deduction cannot be larger than the net profit you make. But you can use the excess to offset profits in succeeding years.

Chazen suggests that now, as you're preparing your 2006 tax return, isn't the time to be thinking about the home business deduction for last year. If your business space didn't already meet the requirements for the deduction, you can't shoehorn it in after the fact.

You can, however, start working now so you can claim the deduction for the 2007 tax year.