For many of us, being able to work out of our home is a dream come true. And for the most part, it is a great thing. But many considerations come into play, especially when you consider taking deductions for your home office expenses. Here are the basics:

Home office expenses are considered either direct or indirect. Direct home office expenses are those that are 100% dedicated to your business. Indirect home office expenses are those that must be allocated between personal and business use.

Direct home office expenses (100% business use) include things like phone costs, office supplies, equipment and furniture.

Indirect home office expenses (not used entirely for business) include things like mortgage interest, real estate taxes, utilities, repairs and maintenance, etc.

The most common allocation method accepted by the IRS for indirect home office expenses is this:

1) calculate the square footage of the office in your home;

2) divide that number by the total square footage of the home;

3) multiply that number by the total amount of the bill you’re allocating;

4) the number you arrive at equals the deductible business portion for

the office in your home

Home office deductions are only allowed for the portion of your home that is used exclusively as your principal place of business.

To satisfy the IRS principal place of business criteria, you need to satisfy one of two different tests, the Statutory Administrative/Management Activities Test or the Supreme Court’s Comparative Analysis Test.

Under the Statutory Administrative/Management Activities Test, a portion of your home must be used for the administrative or management activities of your business, but this only works if there is no other fixed location where you conduct a substantial amount of these activities. Examples of these functions include paying bills, billing clients, writing reports, setting up appointments, maintaining the books, etc. If you are performing these functions at another business location, you may still meet this test, but only if you are not performing a "substantial" portion of the functions at another location.

Let’s look at an example: A building contractor builds houses during the day in a subdivision. At times he needs to be at home to pay bills, order supplies, create ‘in progress’ billings, phone subcontractors, etc. The contractor meets the home office principal place of business test.

Under the Supreme Court’s Comparative Analysis Test, the qualification is more difficult. You have to look at the relative importance of the activities performed at each business location and the amount of time spent at each location where your business activities occur.

Here’s an example: A doctor who works primarily at a hospital is usually denied a home office deduction because comparatively, the functions she performs at the hospital involve her ‘principal business’ and her home office duties pale in comparison to her hospital work.

To satisfy the exclusivity requirement, you have to prove that a portion of your home is used exclusively, and on a regular basis, for business. For example, if you use part of your kitchen for business, the deduction will be denied because the kitchen is not used exclusively for business. Rooms do not always have to be divided by a wall to allow for exclusivity, but the room must be distinctly separated in other ways to pass the exclusivity test.

Because the law relating to home office deductions is complicated, most taxpayers are afraid to take these deductions - they’re concerned they’ll be audited by the IRS. But if you are running a business out of your home, take the deductions! Use IRS form 8829, Expenses for Business Use of Your Home, and be very careful in the preparation. And take good care of your records; keep them on hand for at least 3 years after you file your tax return. If things really get too complicated, talk to your tax professional!

Ó TaxInsurance.com