Beware the tax pitfalls of making an office close to home

It's a rule of taxation, both local and national, that if you take whatever you think you're entitled to by way of tax allowances, you probably need to tone your expectations down a little before you get to the true picture.

Even bearing this in mind, however, freelance journalist and PR consultant Juliet Shaw had a shock when her local authority called her to say she was due an inspection because she used her home as her business premises.

'I received a letter from the valuation office saying they were aware that I was using my home as an office and that they wanted to come and assess it for business rates,' she explains. 'So I called them because I was worried about it, and they said that as I'd stated on my tax return that I worked from home I'd be liable for business rates.'

In fact, once the inspection took place it became quite apparent that Shaw used her conservatory/office for personal purposes as well as for business because of the number of children's toys in it and the senior inspector confirmed that this put her well beyond the remit of the business rates. Nevertheless, the incident suggests that local authorities are waking up to the fact that a lot of people are working from home, and anyone considering working in this way needs to understand the tax implications.

If you are employed (as distinct from self-employed) but working from home, matters are not much better. Tony Medcalf, head of tax with Lancashire accountancy firm Moore and Smalley, says that the allowances for someone working in this way have come down in recent years.

'The situation used to be that people who were employed and working from home could claim tax relief for expenses incurred wholly, exclusively and necessarily in the performance of their duties. There were a number of people who'd set up an office in the back bedroom and then claim a number of overhead costs like gas, electricity and so on. The Inland Revenue has been resisting this for a number of years and said there is something called duality of purpose.'

In other words, if the Inland Revenue is persuaded that you are spending money on heating the house whether you were working in it or not, they won't give you the tax relief if you're on someone's staff. 'In the last budget they announced that they would allow an employer to pay an employee an allowance of up to £2 per week untaxed to cover any expenses associated with the home. Which isn't particularly brilliant.

'In terms of tax, there's not a lot to working from home [as someone else's employee],' he adds. 'There's the work/life balance stuff, but tax-wise it's really limited to that £2 per week.'

Added to this, he says, there can be tax downside to working from home. 'If anyone owns their home and sells it, they get principle private residence relief, which means you don't pay any tax on selling your own home. But if you have a room that's solely your office, the Revenue can and has argued that the proportion [of your sale price] that room represents isn't tax free.'

So if you have an eight-room house, close one room off as your office, sell the place and make an £80,000 gain, £10,000 of that will become subject to capital gains tax. The way around this, in the same way as Shaw found out for business rating, is to put something in the room that demonstrates it's not solely a business office. 'If you've got an upstairs room it's not much of a problem; it's when people convert a garage, maybe, and have separate access to the office, and can't get from the office into the house, that's when problems arise.'

Mark Magrath, accountant with Bournemouth firm Harrison's, points to the phrase 'wholly, exclu sively and necessarily' in the rules about what counts for an employed person's tax breaks. 'You could argue that a computer makes it easier for you to do your job, but is it necessary? Could you do the job with a calculator and paper, or even a slide rule?'

Getting relief under that regime was always problematic for home-based staffers, whereas the self-employed have to demonstrate only that costs have to be 'wholly and exclusively' and not 'necessarily' for business use. In other words, if a computer makes life simpler, there are no queries, it doesn't have to be crucial to the task.

'The principle is that you're paying costs and it's tax deductable. You used to be able to pluck a figure from the air and say your costs were £5 a week or something, you'd put that on your self-assessment and you were fine, but the Inland Revenue is apparently showing a greater interest in this than it used to - you have to think exactly what does come within this definition.'

So phone calls are an obvious one, line rental if you have a separate phone, and broadband costs. If something is shared between home and business use, such as a broadband connection, you should tell the Revenue and apportion costs accordingly.

It's important to bear in mind other financial considerations when setting up a home office. By all means the self-employed home worker will get tax allowances on all of their equipment and bills, but the mortgage company and insurers need to know this is happening. Everyone who signs mortgage and contents insurance application forms confirms that they will use their home purely as a residence, and if this changes then the insurers and mortgage providers need to know. This needn't be onerous, as usually they're looking for increased risk to the property such as expensive stock being held, or large amounts of busi ness visitors to the premises.

Guy Hayward, co-owner of GroovyFoods (www.groovyfood.co.uk) with his wife Rosie Hayward, says the red tape hasn't been a problem. 'On the mortgage side if it's just a small home office they aren't worried about it,' he says. 'For insurance we took out a small business insurance policy that covered our premises as a business. As far as having employees in our house went [when the business first geared up and people were needed for packaging], we used an agency and all the employees' insurance was taken care of by that agency.'

As Medcalf says, there are a lot of beneficial lifestyle issues for people who can work from home. Not everyone can do it, since the domestic distractions and isolation from colleagues will put some people off, and even the lifestyle implications can be overstated - research from printer company Lexmark in November suggested that only 44 per cent of home workers were satisfied with their office space, 37 per cent of home workers had no natural light, and 75 per cent worked in cramped or cluttered space. But the financial considerations also need careful weighing up; contrary to popular belief the tax man doesn't pay for everything.