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Steve Windhaus Ask the Small Biz Adviser

Small Biz Adviser: Rules for home office deductions

Dear Small Biz Adviser:
Are pre startup costs entered into your cash flow report? If they are entered, are they included as separate entries and totals, or should they be included in the first year account total? Another question: If your home-based business is 80 percent business and 20 percent your living area, is depreciation of the building 100 percent or 80 percent?
Thanks,
Bill

Dear Bill:
It is that time of year when we need to think about Uncle Sam, the IRS and preparing to submit our income tax returns. Yours is a good inquiry from which to begin, given the growth of home-based business and little-known facts about tax deductions. However, I was somewhat taken back by your suggestion that 80 percent of your home is dedicated to the business, and only 20 percent is for personal living accommodations. Experience suggests to me the IRS will definitely slow down when reviewing your tax returns.

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For safety's sake allow me to outline some of the basic requirements to secure deductions on a home-based business:

  • The workspace must be your principal place of business.
  • With exceptions, the home work place must be acceptable to receiving clients and customers on a regular basis.
  • The home office is used exclusively and regularly for the administrative and managerial activities of your business.
  • There is no other location where the administrative and managerial activities are conducted at a level defined as substantive.

Administrative and management activities are defined as:

  • Billing customers, clients and patients.
  • Maintaining company books and records.
  • Ordering supplies.
  • Setting up appointments.
  • Forwarding orders or writing reports.

To get the details on these and other factors regarding the qualified definitions of a home-based business, review the IRS Publication 587.

Regarding depreciable expenses directed to the home, I strongly urge that you determine the percent of the total square footage devoted to the home-based business. In other words, if 800 square feet of the building with total square footage of 1,000 are devoted to the business then that represents 80 percent. At that point you can then deduct the following home expenses at the rate of 80 percent as home-office deductions:

  • Real estate taxes
  • Mortgage interest
  • Casualty losses
  • Depreciation
  • Insurance
  • Security systems
  • Repairs
  • Utilities

However, note that these expenses cannot be deducted from business income for any period in which the home was not used for the business. Equally important, you cannot deduct certain home expenses if the gross income from that business is less than total business expenses. Furthermore, there are limits on the amount of home expenses that can be deducted.

Again, I cannot emphasize enough the need to review the IRS Publication 587.

And now let me address the matter of your pre startup expenses. Those expenses are not entered into your cash flow statement. They are expenses and flow of cash incurred prior to the startup of the company. However, it is important to note that if the expenses are common to the startup of your type of business venture, they can be categorized as Organizational Expenses listed under fixed assets on the balance sheet. Depreciation is deducted from the gross income on your income statement, and the accumulated depreciation is deducted from their original value on your balance sheet. With one recent client we depreciated approximately $70,000 using straight-line depreciation over a period of 5 years.

Finally, if you have any questions, contact the IRS. Over the years I have encountered no foundation to the fear that contacting the IRS can lead to problems. To the contrary, I have found these people to be very helpful.

I wish you a happy tax season.

-- Posted: Jan. 4, 2001

 

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