With a computer, high speed internet service, fax machine and telephone, many people can and do run quite substantial businesses right from their homes. If that includes you, you've probably heard you can take a deduction for a home office, but you may also have heard that this is an automatic "red flag" for the IRS to audit your return. You may be wondering if the deduction worth the risk.

My advice: If you qualify, take the deduction.

Qualifying

To qualify for the home office deduction, you must have a part of the home which is used exclusively and regularly for doing business. This could be seeing clients or storing inventory. It even includes performing administrative or management functions, provided there's no other place of business where you do those things. So, for example, if you do most of your work in an office in the back of your retail store, but also do some administrative functions at home, no home office deduction is allowed.

The point that trips up most people is the "exclusive use" test. A desk with a computer that you use for business during the day, and your kids use to play video games at night, does not count. It's best to have a complete room set aside just for business, or at least an easily definable section of a room. If you store inventory in your basement or garage, make sure that section is used only for storing inventory, and not the kids' bicycles and toys, or your old exercise equipment.

What You Can Deduct

You can deduct all of your direct business expenses, which includes things like extra phone lines or features on your phone that you get for business use, along with long distance charges for business calls. Your main home phone line is generally not deductible.

You can also deduct part of all of your utilities, including electricity, gas, water, sewer, etc. A portion of your mortgage interest, insurance and real estate taxes are also deductible. And, you can take a depreciation deduction, which means you are actually writing off part of the cost of your home.

You'll notice I said you can deduct part or a portion of these expenses. You are allowed to deduct that portion of your expenses that relates to business, which is most often determined by square footage. You take the square footage of the portion of your home used for business, and divide by the total square footage of the house. So if you have a 2,000 square foot home and your home office is 200 square feet, you can deduct 10% of the household expenses as business. While 10% may not seem like much, you might be surprised just how much you save in taxes when you add up all the different expenses you can deduct.

One limitation to keep in mind is that you must have a profit from the business in order to take the home office deduction. The deduction can't cause you to have a taxable loss. Also, when you sell your home, you may have to pay tax on part of the sales price, even though home sales are usually tax free. Check with your tax advisor for more details.

Red Flag?

Many people, even many tax professionals, assumed for many years that taking the home office deduction would automatically draw attention from the IRS. In reality, there doesn't seem to be any extra scrutiny at all. This is especially true since the law was changed in 1997 to make the deduction available for people who just use their office for administrative purposes. Previously, you had to see clients or store inventory at your office, and many people took the deduction who did not qualify.

Like any tax deduction, you should not take the home office deduction unless you are entitled to it. And to make sure you meet all the requirements and are following all the rules, consult a professional tax advisor. But if you are entitled to it, don't be bashful. You have the right to the deduction, and you are giving away money if you fail to take it.