THE TAX TRAPS OF WORKING AT HOME

Working from your Barcalounger may be a great deal, and it can have tax benefits. But the rules are tricky, unforgiving and potentially expensive.

Many of us dream of working from home. Of being able to pad over to the office in T-shirts and jeans and work away on our laptops, with none of the hassles of commuting, office stress and dressing for success.

Some 19 million of us like the idea so much that we work from home, myself included. About 5% of the work force telecommutes — that is, we work for someone else, but from home.

Working from your home would seem to offer some nice tax breaks, and it does. But watch out. The rules also can create some real tax terrors at the federal and state levels.

Consider the case of one New Jersey resident. We’ll call him Bob. Bob worked for a company in New York City, but he did all his work from home. New York state tax officials audited Bob and found that the company was ready, willing and able to provide office space for him in its New York office. So, New York forced the man to pay non-resident New York income taxes, which are higher than taxes in New Jersey. (His only break: a partial credit for the New York taxes on his New Jersey return.)

The reason: all of Bob’s work from home was for his convenience, the courts have ruled, not his employer’s.

Get a Letter

There was a solution to the problem. Bob could have asked his boss to write a letter stating that the man could work from home for the convenience of the company and that working from home was a condition of employment.

In fact, I recommend that anyone working from home get that letter. This issue will get hotter as telecommuting grows and states with high taxes scramble to protect their bases. Attach a copy to your tax return. If your return is kicked out by the IRS computer, it shows the human IRS auditor that you know the rules. That may actually decrease your chances of being audited.

It’s also more prudent to obtain the letter now, while you’re still working for that employer. You can normally be audited up to three years after the due date of your return. If you’ve left your former employer during that time, it may be more difficult to get that letter if you get an audit notice.

The Rules About Expenses

If you meet that standard or if you work for yourself, then we can talk about home office expenses. Again, the rules are precise. To qualify for a home office deduction, you must use an area of your home regularly and exclusively for business purposes and you must meet any of these conditions:

To claim the home office deduction, you complete and file Form 8829 and base your deductions on the square footage used for business compared to the total square footage in your house. For example, if you use a 20-by-10 room for business out of a 2,000 square-foot house, you’re allowed to claim 10% of your qualifying expenses as home-office deductions (200/2000 = 10%).

Two Potential Problems

Seems simple, right? But there’s a devil in the details. Let’s look at two common but important problems.

First: Let’s say the Internal Revenue Service questions the computer in your office. An agent may ask if you use the computer 95% for business and 5% for personal purposes, or whether you use the computer 50% for business and 50% personal.

The question is a trap! Both answers are wrong. Remember: you must use the office exclusively for business. So, any answer less than 100% for business completely disallows all your home-office deductions! (Don’t make faces at me. I only report the law — I don’t draft it.)

Second: If you’re planning to sell your home in the near future, taking a home office deduction can be a tax disaster!

Here’s why. Under current law, if you sell a home that was your principal residence for two of the last five years, you can exclude from income as much as $500,000 in gain on a joint return ($250,000 on other returns).

You don’t have to roll over the dollars, nor do you have to be age 55 or older to qualify for the exclusion (as were the alternative qualifications under prior law). All you need to qualify is to have the house as your principal residence for two of the last five years.

But if you’ve been taking home office deductions, the percentage of your home that you used as an office doesn’t qualify for “principal residence” status.

So, if you’ve been taking 10% of your home as an office deduction, then 10% of your profit doesn’t qualify for the exclusion. That means that if you actually have a $500,000 gain, $50,000 of that gain now becomes taxable!

The solution here is long-term planning. If you contemplate selling your home in the future, make sure that you don’t qualify and claim a home office for at least 2 of the 5 years prior to the year of sale in order to qualify for the gain exclusion.

Even if you do qualify for the exclusion, under current law, to the extent you’ve taken depreciation on your home office in the past, that depreciation is going to be recaptured to the extent of any gain realized on the sale and taxed at a 25% rate. But hopefully, you’ve been deducting that depreciation at a rate of 28% or better and you have both the spread and the time value of the money to your net benefit.

But even disasters may contain some good news. Current law disallows any loss deduction for selling a home for less than what it cost you. But, if you had a home office in that house, to the extent the property was used for business, you have a fully allowable business-loss deduction. You can’t accumulate wealth by taking losses, but at least the deduction helps reduce some of the pain.