Home Office Tax Deductions Can Help Business Pay Off/ February 20th, 2012
Running a business from your home can help you take advantage of tax deductions to make the most of your income. Qualifying for those deductions requires research, bookkeeping, and a commitment to taking your business seriously. "If you plan to take tax deductions, [the enterprise] has to be treated as a business, not a hobby," advises Kathleen Tweeten, director of the North Dakota State University Extension Center for Community Vitality, Bismarck, N.D.
IRS rulesStart your research at the Internal Revenue Service (IRS) Small Business and Self-Employed Tax Center. IRS Publication 587, Business Use of Your Home, offers information about taxes and deductions as well as tax work sheets. Generally, the IRS requires that you use a specific section of your home "exclusively and regularly" for business purposes to qualify for a tax deduction. That may be a room or even a designated portion of a room reserved for use only by the business. In addition, the IRS requires that your home must be used:
- As your principal place of business;
- As a place to meet or deal with clients, patients, or customers in the normal course of your business; or
- In any connection with your trade or business where the business portion of your home is a separate structure not attached to your home, such as a shed or garage.
Types of expensesThe IRS uses the terms "direct" and "indirect" to describe home-based business deductions, which are separated into "business expenses" and "capital expenses." Direct business expenses are costs related solely to the operation of the business, such as a second telephone line you use only for business purposes. The full amount of these expenses is typically deductible. Capital expenses relate to the purchase of capital assets such as equipment; capital expenses are depreciated by deducting a portion of the cost each year.
If you plan to take tax deductions, the enterprise has to be treated as a business, not a hobby.Costs related to the use of your home for business purposes are "indirect" expenses. In general, the amount of indirect, home-related expenses that you can deduct is based on the percentage of your home used for business. So if the portion of the home used exclusively for business purposes is equivalent to 10% of your home's square footage, you can deduct 10% of qualifying indirect expenses. The IRS forbids deductions based on "unrelated" home expenses. For example, you can deduct a portion of garbage pick-up costs because those services indirectly serve the business. But the cost of painting a room that is not used for the business is an unrelated expense—it cannot be deducted. The IRS also allows you to take a deduction for depreciation to reflect the wear and tear on your house. The depreciation amount is figured as a percentage of the value of the house, which again is based on the portion of the home used for business purposes. It's worth noting that you cannot take more home-based deductions than what you make from the home-based business. In other words, you cannot start a home business just to reduce your taxes.
Deduct now, pay more later?Deducting indirect expenses now may require you to pay additional taxes when you sell your house. If you claim indirect expenses for your home, the IRS reduces the amount of the capital gains exemption on profits from the sale of your house by the amount of depreciation that could have been claimed on the home itself. This rule is followed even if you never claim a deduction for depreciation. The only way to avoid this potential issue is to refrain from deducting indirect expenses. In many cases, however, the benefit from annual deductions now outweighs potential taxes on the profits of home sales later.
Do your homeworkStephen Windhaus, founder of business plan consultants Windhaus Associates, Port St. Lucie, Fla., and the author of several business books, says owners of home-based businesses can avoid problems and maximize deductions by planning in advance. "So many people don't want to plan the business enterprise and then they try to fix the broken links," Windhaus says. "Whether it's paying taxes or deducting business expenses of the home, do your planning, because there may be ways that you can save money."
Expenses for your car, travel, entertainment, and gifts also may be deductible.Business owners who can afford expert help should consult an accountant for advice. If you cannot afford it, Windhaus says you must do extensive research, look for reputable online sites, and consult multiple sources to verify that you are getting accurate information. That can help you avoid scams that aim to persuade home-based business owners to buy "kits" or "systems" that claim to maximize deductions but may actually expose you to tax penalties.