Summary:
Will IRS allow you to deduct home-office expenses and what effect do the deductions have when you sell your home?

If you use part of your home for your business or your employer's convenience, you may qualify to deduct part of your home expenses. Here are major considerations in general terms:

Use regularly: You must use the space regularly to operate your business: It's your principal place of business, or you meet patients or customers there, or you do most of your administrative work there. Managing your personal portfolio of stocks and bonds probably wouldn't qualify as a business.

Employer's convenience: If not used for your business, you must use the space for your employer's convenience. This is difficult to support if you also have an office in your employer's building.

Use space exclusively: The space could include an office, showroom, lab or storage area. It need not be a whole room or even marked off by a permanent partition. It only needs to be an identifiable, dedicated space. Your dining room table isn't a work-dedicated space if you serve meals on it.

Deduction: If your home office qualifies, deduct part of your home expenses. Example: if you use 20% of the square footage in your home, deduct 20% of expenses like utilities, home insurance, repairs and rent or depreciation. Deducting depreciation yearly is how you recover part of the cost of the home (excluding land). To compute the deductible portion of your home expenses, compare the business area with the area of the whole house or apartment. Do this based either on square footage or number of rooms.

Home sale: Generally, you can sell your home and exclude tax on the gain. Recently issued regulations show how prior depreciation affects this exclusion. If you sold your home at a gain, depreciation is taxable as a gain; the balance generally is tax-free. Gain is recognized up to depreciation after May 6, 1997. Example: Assume Mary sold her home in 2002 at a gain of $16,000. She had used half the house for office space and deducted depreciation of $4,000 after May 6, 1997. She reports the depreciation of $4,000 as taxable; the balance is probably tax-exempt.

Under the old method, Mary would report half the gain or $8,000 as taxable. If you sold your house in a recent prior year and over reported taxes using the method allowed then, consider amending your return for a refund. Typically, a refund is timely if requested within three years from the time you filed the return.

(more at Planning, Other)