The general rule for individual taxpayers is that no deduction is allowed for the use of a dwelling unit which is used by you as a residence. However, there are several exceptions to this rule.
This rule does not apply to any deduction to the extent that it is allocable to a portion of the dwelling unit which is exclusively used on a regular basis in one of the following ways:
• as the principal place of business for your trade or business;
• as a place of business that you use for meeting patients, clients, or customers; or
• in connection with your trade or business (for a structure that is separate from the main dwelling unit).
The term “principal place of business” includes a place of business used for administration or management activities of any trade or business, if there is no other fixed location from which substantial administration or management activities are conducted.
The application of the “principal place of business” exception can be complex in cases where the business is conducted at more than one location. In such a case, the one location that is the “most important, consequential, or influential” will be the principal place of business. The most important factors used to answer this question are:
• the relative importance of the activities performed at each location, and
• the time spent at each location.
The “relative importance” test is applied first. This test compares the activities performed at each business location. If this test provides no definitive answer, then the “time” test is applied. The “time” test looks at the amount of time spent on business at home with the time spent on business at other locations.
Most likely like the “time” comes under the second exception. Under this exception, expenses are deductible if they are allocable to a portion of a dwelling unit used exclusively and on a regular basis as a place of business in which you regularly meet or deal with customers in the normal course of your business. The meetings must be substantial and integral to the conduct of your business. The customers must be physically on the premises; phone calls are not enough.
There are limitations on the amount you can deduct each year. Your deduction cannot be more than the gross income derived from the business use of the dwelling, less deductions allocable to the business portion of the unit whether or not it was used in a business (real estate taxes and mortgage interest) and deductions allocable to the business but not allocable to the qualifying business use of the unit itself (such as expenses for supplies and compensation).
Also, the business deductions are allowable in the following order:
• deductions allocable to the business use without regard to whether the unit is used for business (mortgage interest and real estate taxes),
• deductions allocable to the business but not allocable to the business use of the unit, and
• deductions allocable to the business in which the qualifying business use occurs which are allocable to the use of the unit (depreciation, utilities, etc.).
For example, assume that you earned $45,000 from the qualifying business use of your home and you had the following expenses:
•$10,000 (business percentage of mortgage interest and real estate taxes),
•$20,000 (salary expenses), and
•$20,000 (depreciation and utilities expenses).
In this scenario, even though your total expenses were $50,000, only $45,000 is deductible this year. The remaining $5,000 (the depreciation and utilities expenses – deductions allocable to the use of the home itself) is carried over to the next year (subject to next year’s income limitation).
The expenses allocable to the portion of the unit used for business purposes may be determined by any reasonable method under the circumstances, such as the number of rooms or square footage.