Starting a business from home can be extremely advantageous. In addition to controlling expenses, the allowed IRS deductions can go a long way to reducing your tax liabilities. The eligibility rules are pretty clear and easy to follow, but it is important to understand the limitations on writing off the business use of your home. And, in order to receive the maximum benefit of the tax laws, it is critical to establish a system for managing the paperwork to keep track of deductible expenses.
The IRS considers the term home to mean your house, apartment, condo, trailer home, or boat, as well as any structure also on the property, such as a garage (attached or unattached), shed, greenhouse, studio, and the like. Any space you use in any structure on your property counts, as long as the way you use it meets the IRS qualifications.
The rules state that “business use” of an area of your home must be exclusive, regular, and for your business. Your business space must be your principle place of business, a place where you meet with clients in the normal course of business, or a separate, unattached structure used in connection with your business to qualify.
The exclusive use test requires that you use the space only for your business. That is, if you do most of your work in the living room, but also use that room as personal space, it does not pass the exclusivity test. While the space does not have to be divided by a wall or other permanent partition, it must be used only for business purposes. Set up a dedicated space for your office, even if you don’t have a completely separate room available.
There are some scammer “tax programs” that encourage you to write off the business use of your kitchen (you have to eat at work, right?) and bathroom (you can’t hold it all day). Don’t do it. These areas do not meet the exclusive use test, and claiming a high percentage of your home’s space as business use will raise red flags with the IRS. The exceptions to the exclusive use test are if you use space for inventory storage or your business is a day-care center.
The regular use test requires that you use the qualifying area of your home for business on a continuing basis. If you only use your home office occasionally, it can’t be deducted, even if the space passes the exclusive use test. Pretty basic. Just having an office space at home doesn’t mean you can deduct it – it must be used on a regular basis for your business.
To qualify as your principle place of business, your home office does not have to be your only place of business. As long as the space is used exclusively and regularly for management (or administrative) activities and you do not conduct these activities at the other location, your space is deductible. If you have a bookkeeper that works somewhere else, that is OK. As long as your home office is your primary location for completing specific work tasks, you should qualify. Any separate structure (garage, shed) that you use for business purposes does not have to be your principle place of business to qualify, but does have to pass the exclusive and regular use tests.
Once you have clarified which work spaces qualify, you need to determine the percentage of your home that is can be deducted. That is, divide the area used for your business by the total area of your home. If your office is in a 10×12 room, the total office space is 120 sq ft. In a 1200 sq ft house, the business use percentage would be 10%. Thus, 10% of all relevant expenses can be deducted from your personal taxes. IRS Form 8829 provides the formula for calculating the business percentage of your home. This percentage is then used to determine the eligible deduction amount allowed for certain business use of the home expenses.
The expenses you may deduct fall into three categories: direct, indirect, and unrelated expenses. Direct expenses, for the most part, are not subject to deduction limits. These are expenses such as repairs or renovations related only to the business areas of your home. Also, any dedicated phone line or internet access that is only for the business can be deducted in full.
Indirect expenses are those that cover running the entire home and are generally deductible up to the business use percentage you calculated previously. Utilities, insurance, general repairs, and the like are all subject to the percentage limit. Thus, if you calculated that 10% of your home qualifies for business use, then 10% of all indirect expenses can be deducted on your taxes. Most of these expenses are not deductible at all unless you use your home for business, so being able to deduct even a percentage can provide real tax advantages. Unnecessary expenses are those related only to parts of your home not used for business. They cannot be deducted. Unnecessary expenses are things like lawn care, repairs to another part of the home, and the like.
The deductions you can take for the business use of your home are also limited by the gross income of your business. You first reduce your gross income by regular business expenses and certain other expenses, then can claim business use deductions up to the amount of the remainder. Basically, you cannot use business use of the home deductions to create an overall loss to the business, only to the point of breaking even.
Be careful not to double-dip on allowable deductions such as mortgage interest and real estate taxes. These expenses must be divided on your personal taxes according to the percentage for business and the percentage for personal. The IRS publications for deducting the business use of your home are very straightforward. As long as you have good records for all the allowable expenses, filling out your 1040 is not particularly complicated.
Before you launch your business from home, be sure you have established an efficient system for tracking expenses for tax purposes. An effective filing system is a good start – you should be able to find and retrieve any filed document within a few minutes. Be sure you keep all relevant utility statements, repair bills, and real estate tax statements for the year. Staying organized throughout the year will save you untold hours come tax time.
Kehr Law is a first class “one stop shop” for all your business, contract, intellectual property & tax planning needs. Contact Kehr Law today at (619) 400-4942 or dan@kehrlaw.com for a free consultation!
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About the Author
K. MacKillop, a serial entrepreneur with a J.D. from Duke University, is co-founder of LaunchX and authors a small business startup blog. The LaunchX System for Business Startup is designed to give you everything you need to start a business, whether you start from a home office or not. Visit LaunchX.com for a free Business Readiness Assessment and get on the road to owning your own business today.
