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Home-based business tax deductions
Dear Small Biz Adviser:
I have a startup business, using a room in my house for business
purposes. What can I claim on my taxes?
Oceia
Dear Oceia:
Home-based businesses are growing at a phenomenal rate, accelerated
by continued layoffs, closings, downsizing and mergers.
Very often, people forming home-based businesses are
initially focused on successfully starting the business and generating
sufficient income to pay expenses and make a profit. It's not until
that first tax season rolls around that they realize there are deductions
that can reduce gross income. Unfortunately, many entrepreneurs
are not prepared to maximize those deductions for failure to keep
some valuable receipts or other supporting documents.
The best way to begin learning what can and can't
be deducted is to examine IRS
Publication 535, Business Expenses, for a comprehensive
overview of deductible costs, and IRS
Publication 587, Business Use of Your Home.
Deducting your home office
I will leave it to you to review the details of general business
expenses. However, I would like to bring to your attention the definitions
of qualified home-based businesses (for reasons of deductions),
the types of business expenses that can be deducted and the formula
you need to apply for some of those expenses.
Typically, the following conditions should apply when
defining a home business as qualified for deduction purposes:
- The specific area defined as your office must be
used for business purposes only. Don't share it with the kids
to watch television or with your spouse to organize community
events.
- You must use the office on a regular basis to administer
and manage the business enterprise. Examples of administration
and management include bookkeeping, billing of customers, ordering
supplies and writing reports.
- You have no other permanent office location outside
the home where you conduct business activities.
- Part of the office space can be used as a day care
facility as it relates to your ability to conduct business.
- Use of any space in your business office area is
associated with the business, and used as storage on a regular
basis.
- You use the space to meet with your clients.
Now let us consider some of the most important expenses
that can be deducted:
- Interest expense on the mortgage of the residence
- Rent, if you don't pay a mortgage
- Utilities, including natural gas, electricity and
water
- Real estate taxes
- Casualty losses on the home
- House insurance
- Repair work
- Home security system
- Maintenance activities, such as waste removal
- Depreciation if you do depreciate your home
Two categories of expenses
These expenses can fall into one or two categories:
- Direct: expenses related
only to the business part of your home. This can include structural
improvements, painting or repair work in the space.
- Indirect: expenses
for running the entire home. Examples include general repair work
to the house, utilities, insurance, rent or interest expense on
the mortgage.
Direct expenses are all fully deductible. Indirect
expenses depend on the percentage of your home occupied by the office.
For example, you have a 2,000-square-foot home and the office takes
up 200 square feet of that space, or 10 percent of your home's total
space under roof. Therefore, you are allowed to deduct 10 percent
of all qualified, indirect expenses. If your utilities total $4,000
for the year, you are allowed a $400 business-related deduction;
interest expense on the home of $2,800 translates to a $280 deduction
against business income; and so on.
New rules for home sales
And there's even more good tax news for home-based business owners.
In December 2002, the IRS removed a major hurdle for homeowners
who sell a residence from which they operated a company.
Previously, if you operated your company from your
home in the three years before selling, you would owe capital gains
tax on the percentage of your net sales that equaled the percentage
square footage of the home you used for your business. That meant
that if you made a $100,000 profit on your home sale and had dedicated
20 percent of the space to business, taxes would be due on $20,000
of your gain.
That is no longer the case. As part of new
rules on taxable profit from certain home sales, the IRS now
says you no longer have to allocate gain between business and residential
use if the business was conducted within the residence. Your home
office in the guest house in your backyard, however, still would
be taxable even though that separate structure was part of your
overall home sale.
Oceia, this is a general overview of allowable home-office
expenses. I strongly urge you to access the IRS publications noted
above. They detail the many more exceptions and detailed requirements
you need to consider before taking the deduction.
-- Updated: Feb. 6, 2004
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