While it is a common practice for sole proprietors to run their business out of a personal residence, that does not necessarily mean that you can take a tax deduction and almost certainly not for the entire property. A tax deduction can be claimed for home expenses pro-rated by the square footage percentage of the home that is “exclusively used for business.” Types of home expenses that can be claimed on Form 8829, “Expenses for Business Use of Your Home” include mortgage interest, property taxes, utility bills, repairs, association dues, cleaning, and monthly rent. However the recent tax court case ruling in Jeffrey L. and Simone I. Rayden vs. Commissioner of Internal Revenue shows that when you calculate the business percentage of your house, only specific rooms or areas of your personal residence that were used “exclusively for business” during the entire calendar year; no other purpose can be factored in.
Jeff Rayden was the sole owner of his computer software business InfoGen. Rayden ran the company exclusively out of the home his family had been renting. Rayden’s 7,272 square foot home was two-stories tall and consisted of 12 rooms. When Rayden filed his 2004 Individual Income Tax Return, Rayden prepared a Schedule C “Profit or Loss From Business” for InfoGen. Rayden claimed on Schedule C that 70% of his home was deemed “exclusive for business” and deducted 70% of his home expenses including his rent. After Rayden filed his tax return, the Internal Revenue Service (IRS) issued a notice of deficiency citing that the percentage of home “exclusively used for business” was too high and his deductible home expenditures were overstated.
The court ruled that only 43% of Rayden’s residence was used “exclusively for business” and 27% of Rayden’s home expenses claims as business deductions on Schedule C would be disallowed. The business percentage was determined by reviewing all the activity that took place in each part of the house during 2004. Here was the court’s determination of several of the rooms Rayden had originally claimed as “exclusively for business”:
- Garage used for business storage and as a shop: Exclusively for Business
- Kitchen where the subcontractors ate but the family used the room on rare occasions: Not Exclusively for Business
- Two bedrooms in which one room contained a graphic video studio while the other was used as programming and survey office: Exclusively for Business
- Den, vestibule, and adjoining bar used for business purposes but was used one or twice to entertain family visitors: Not Exclusively for Business
- Living room used for business purposes but family members walked through on occasion: Exclusively for Business
The kitchen and the den were disqualified by the court because according to Internal Revenue Code section 280A, “the taxpayer must use a specific part of a dwelling unit solely for the purpose of carrying on his trade or business.” Even if the rooms were used only once or twice for personal use; they are no longer deemed “exclusively for business.”
Despite family members walking through the living room on occasion, this room was allowed because passage from one room to the next can be classified as “de minimis” personal use of the room and will not disqualify the space as “exclusively for business.” Using a room once or twice for personal use during the year is not “de minimis” personal use, according to the court. The court also stated that they found it implausible that the taxpayer and his family had no social or personal life in any portion of the residence other than a few bedrooms.
“Rayden vs. Commissioner” clearly demonstrates that the area claimed as home office must be exclusively used for business, and that personal usage you may thing is immaterial is in fact very material, to the point of disqualifying that space completely. If you plan on claiming a portion of home expenses on your tax return this year, it is imperative that you only include the rooms or areas that had zero personal use when determining the business percentage of your personal residence that was used “exclusively for business.” Equally as important is evaluating as objectively as you can whether the non-business portion of your home is sufficient space to carry on your daily living activities.