by SARAH J.F. BRALEY | July 01, 2003

This was my younger son’s room,” Carol Ann Gregg says of the space that serves as her office in her Grove City, Pa., home. “He used to bring his buddies in and say, ‘See what she did to my room? She really doesn’t want me to come home.’”

Gregg, who founded Gregg Consulting Services in 1991, plans one educational event a year for the Agriculture Awareness Foundation of Pennsylvania. While she thus far has chosen not to declare her home office for tax purposes, she is aware of Internal Revenue Service rules governing same (“I think if I took my clothes out of the closet and stopped playing on my computer, I’d be OK,” she says). And as she considers expanding her business, Gregg has begun to look at ways to make her home workplace more IRS-friendly.

The effort could be worth quite a bit to her bottom line. By claiming part of her home as the headquarters of her business, Gregg would be able to deduct a portion of her household expenses on her tax return. For instance, if the room she uses comprises 10 percent of the house, she’d be able to deduct 10 percent of her expenses for utilities, insurance, property depreciation, painting and repairs. And home ownership isn’t necessary to claim such deductions; the same claims can be made if your business is set up in a rented apartment or house, as long as it is your principal residence.

However, simply designating a household area as your business headquarters is not enough to qualify for a home-office tax deduction. The IRS applies two tests in this regard.

First, the room or portion of a room (a “separately identifiable space” in IRS parlance) and the equipment within it must be used exclusively for your business. As Gregg points out, her using her office for personal storage and spending time at the computer for entertainment purposes compromises the business-only nature of the room.

The second qualifying test involves the nature of the business you do in the room. It must be your principal place of business; a place where you meet or deal with customers in the normal course of conducting your business; or a separate structure you use in connection with your business.

Local ordinances also might put restraints on how you use your home office. Contrary to the IRS rules, for instance, local laws don’t allow Laurel Coote, CMP, CMM, to meet with clients in her Torrance, Calif., home. “I can’t put up a sign or have anyone in my house working for me,” says the owner of The Laureli Group Inc. “But I don’t like to have clients in my house, anyway; I don’t want them to enter my personal space.”

Old fears, new rules
In the past, one reason some home-based businesses have not taken the home-office deduction concerned their plans to sell the house in the near future.

Simply put, the old rules said that if you used 20 percent of your home for your business, you could keep only 80 percent of the profit when you sold the house (up to $250,000 for an individual and $500,000 for a married couple filing a joint return). The other 20 percent was considered a “sale of a business property” and was subject to capital gains taxes.

But now, according to Julian Block, a Larchmont, N.Y.-based tax attorney, the seller is allowed to keep the entire profit as the sale of a personal residence, up to the same $250,000/$500,000 limit.

Another misconception is that “some people believe if they claim the deduction, it increases the likelihood of an audit, which is not necessarily so,” says Nancy Mathis, a Washington, D.C.-based IRS spokesperson.

Indeed, the red flag for home-office audits is not the fact that you are using part of your house for the business, but that you are self-employed. “The IRS knows a lot of under-reported income comes from self-employed people as opposed to employees who get W-2s from their company,” says Block. “And the IRS knows the self-employed are creative when it comes to deductions.”

Keeping records
Once the office is established, the next step is to carefully document every expense related to the business, separating out such things as the paper for the office printer vs. the envelopes you got for invitations to your daughter’s birthday party.

Coote notes that independent planners who are just starting out often have trouble keeping “professional” distinct from “personal.” “Many of them don’t have the capital,” she says. “They start off with a phone and a computer that’s already in the house.”

When setting up Meeting Horizons in a spare bedroom of her Fairfax, Va., home, Elizabeth Zielinski, CMP, CMM, thoroughly researched the IRS rules. Six years later, she has a number of practices in place to keep her expenses documented.

“I get my postage off, where I can indicate which is client mail and which is administrative,” she says of the service she uses to print out bar-coded postage on a label machine. “At the end of the month, I can get a record and put the administrative costs into my tax file.” The other costs are billed to the individual clients.

“I also keep a notebook in my car to note my mileage,” says Zielinski. “I got into the habit of zeroing out the odometer every time I take a business trip.”

One deduction Zielinski eschews is the money spent on client lunches. “They’re only 50 percent deductible, anyway, and I’d rather give up the money than bring the scrutiny to my return,” she says.

Coote of the Laureli Group is less reticent on allowable deductions. “If you’re traveling on business, you can do laundry, you can have your clothes cleaned,” she says. “Any meal you have, anything you spend out of your pocket for your work counts, like buying a box of paper clips or buying flowers for a client. They might not be deductible on the same level, but they all count.”

Watch for scams
Mathis of the IRS and others warn of scam artists who offer to help home-based businesses lower their taxes. “They claim taxpayers can create any type of unprofitable business out of their home and then deduct much of their home and personal expenses,” says Mathis. “That’s a sure way to get into trouble. Nondeductible personal living expenses cannot be transformed into deductible business expenses.”

The best advice, say sources, is to find a reputable accountant or tax expert through peers who also work from home. Get this person to help you develop accounting processes that will work for you. And have an expert handle your tax returns for your first few years in business, if not longer. The money saved will be well worth the fee.