Consumers who set up home offices should not fear taking the home office tax deduction if they qualify. Many believe that the deduction is a red flag that will trigger an IRS audit. If you keep good records and follow the rules then there is no need to worry. You are eligible to deduct your home office if you meet with clients there regularly in the course of business or if the home office is your principal place of business. Some general rules that might help you avoid the suspicion of the IRS are:

• Use your home office only for business and make that clear to your family. This might include not using the office as a guestroom or not having computer games installed in your personal computer for the kids to play.
  
• Put your home office in a separate part of the home. Don't forget that storage of business records is also considered a part of the home office.
  
• Keep a log of what percentage of the time you use your computer for business and what hours you keep in the home office. Also, take pictures of your office. These tools will be helpful in case of an audit and may prevent a personal visit from the IRS.
  
• If you have a home office and you work for someone else, your home office must be required by the employer and it must be for the convenience of the employer and not you.
  

You are probably aware that home office use is on the rise and that telecommuting is the wave of the future. Many employers may not realize that they can save up to $10,000 a year by allowing employees to telecommute. As more employers learn that productivity increases for telecommuters, and costs do lower as well as turnover; they will be encouraged to allow workers to stay home if the position supports working from home. This means that the IRS will be refining and defining the home office structure to accommodate the increased numbers.

The key difference this year is that the space for the business activity must be obviously used exclusively for that purpose. The amount of time spent there is not necessarily a deciding factor anymore. Remember that you have a right to maximize your tax deductions and deduct any expenses that directly relate to you earning business income. However, the IRS could disallow the deduction if you so much as balance your personal checkbook in the home office.

Contractors, independent sales reps, doctors and consultants are the types of people most likely to benefit from the new tax laws concerning home offices. All of these professions may now also benefit from the ease on travel costs since the travel from your home office to your first appointment and vice-versa at the end of the day are now deductible. The rules also say that the home office can now be used for management and administrative activities. This is providing that there is no other fixed location to do these chores. The office no longer needs to be a separate room either, just a defined space that you use for business. Those with sole proprietorships at home can fare pretty well on home office deductions while employees of other firms have a little less reason to celebrate.

SOLE PROPRIETORS

You can deduct 100% of expenses that are directly related to the home office space. This includes painting, cleaning, the home-office rider on your insurance policy, office telephone lines and utilities (if you have separate hookups). In addition, you can deduct a percentage of indirect expenses that relate to your entire residence, such as, mortgage interest, property taxes, association fees, depreciation (over 39 years), utilities, security monitoring, garbage pickup and general maintenance and repairs. If you rent your home you may deduct a portion of the rent.

Once you know what to deduct it is important to find the method that will yield the best deduction for you. IRS forms lead you to believe that the only method you can use is the square footage method. They do say, however, that you may use any other "reasonable" method to compute the business use for indirect expenses. The easiest way is to count the rooms and divide or to measure the square footage and figure a percentage of your entire household. The key word is "reasonable" so be sure to back up your claims so as not to arouse suspicions.

EMPLOYEES

If you are an employee of another company, to meet the standards for a home office deduction, you must meet the requirements of a sole proprietor plus your work-at-home arrangement must be for the convenience of your employer.

Since you are not self-employed, your home-office deductions are counted as miscellaneous itemized deductions on Schedule A, rather than on Schedule C, where self-employed people calculate their profits and losses. (Mortgage interest and property taxes go on Schedule A just as they always have.) The bad news is that you can only write off your miscellaneous itemized deductions to the extent that they exceed 2% of your adjusted gross income. So unless you have other itemized deductions you will probably not get the windfall you had hoped for.

TAXES WHEN SELLING YOUR HOME

If you sell your home you must meet the two-out-of-five-year test to exclude capital gains on the home office portion of your home. If the office space is used residentially for periods totaling at least two years in the five years prior to the sale, the gain on the office is eligible for the home-sale exclusion of up to $500,000. Even if you do satisfy the two-out-of-five-year test, depreciation after May 6, 1997 is recaptured and taxed at a 25% rate.



See your accountant or financial professional to get all of the details concerning your home-office deductions.