Tax Deductions Pay Off for Home-Based Businesses

by Darla Dernovsek

Achieving the full tax benefits of working from home typically requires you to take your tax deductions as seriously as you take your work.

The tax breaks available to home-based businesses can considerably increase your earnings. But your ability to justify those tax deductions will depend on decisions that you make involving business use of your home, other expenses, and record keeping.

Business use defined

Substantial tax advantages are linked to what the Internal Revenue Service (IRS) defines as "business use of the home," described in IRS Publication 587.

The IRS uses the term "home" to include houses, apartments, mobile homes, garages, greenhouses, or even boats. Most people choose to use a specific space to run a home-based business, which can range from a spare bedroom to the basement to half the garage.

While the IRS is flexible about the type of space you use, you must meet certain rules. You must use the space on a continual basis, either as the principal location where business occurs, or the place where you meet patients, clients, or customers. The space qualifies as your "principal location" if you use it regularly and exclusively for administrative or management activities, such as keeping books, writing reports, or billing customers. It also qualifies as your "principal location" if it is the only fixed location available to perform these tasks. Separate structures like greenhouses, garages, and workshops that you use for production, storage, or other ongoing business needs also can satisfy business use requirements.

Equally important, you must reserve the area of your home claimed for business use exclusively for use by the business. This area must be identifiable as a separate space or room, although a permanent partition is unnecessary. Any personal use of this area disqualifies it for tax purposes. Rules are more flexible for in-home day care facilities, but you still must meet certain guidelines.

Home deductions

Once you set aside an area for work, determine the percentage of your home that is allocated solely to business use. The most common way to arrive at this percentage is to determine the square footage of the area used for business, and then divide it by the total square footage of your home. IRS Form 8829, Expenses for Business Use of Your Home, will guide you through this process.

You can deduct the full cost of direct expenses for the business section of your home. These direct expenses may include the cost of painting, carpeting, or repairs done only in space used for business.

In addition, you can deduct the business percentage of the cost of certain indirect expenses. For example, if business space makes up 10% of your home's total area, you generally can deduct 10% of any indirect expenses like mortgage interest, rent, utilities, insurance, repairs, property taxes, and other services.

The amount of expenses you can claim generally is limited only by your income. Expenses cannot exceed your gross business income in a single tax year, although expenses may be carried forward and claimed in later years when your earnings are higher or your deductions are smaller.

While business deductions for using your home are valuable, there is a catch. When you sell your house, some of your profits will be taxed based on the deductions you took for the home office. If you sell your business first, keep those records available for when you sell your house.

Recording expenses

If you intend to deduct the costs of using your home for business purposes, keep careful records. These records should show the area of your home that was used for business, including how that space met the requirements for regular and exclusive use. You also should record any depreciation claimed. Finally, you should file cancelled checks, receipts, and invoices to verify your expenses.

Regardless of whether you decide to deduct costs for business use of the home, you probably can benefit from a wide range of other deductions for expenses, fees, and services.

• Start-up expenses include facility renovations.
• Operations expenses include office supplies, equipment repairs, postage, utilities, subscriptions, and similar costs.
• Required equipment costs include computers, office furniture, and specialized items.
• Legal and professional fees include fees paid to attorneys, accountants, and consultants.
• Purchased services include hiring family members or service firms to help complete special projects. Payments to family members are deductible as long as you document the services rendered and the cost and issue W-2's.

• Automobile costs may be deductible if you keep a mileage log and claim the standard IRS deduction, set at 37.5 cents a mile in 2004, or you can deduct the business share of actual expenses. If you purchase a vehicle for business use, you may be able to deduct the full cost or depreciate it over several years, depending on the type of vehicle you buy and its cost. A special rule allows small businesses to deduct the full cost--up to $100,000 annually--of any vehicle that weighs more than 6,000 pounds.
  Keep careful records that separate business use from personal use.

For all expenses, keep careful records that separate business use from personal use. Allowable deductions can vary by the nature of the expense. For example, the IRS will assume that your first telephone line into the house is for personal use, although you can deduct the cost of a second telephone line installed for business purposes, as well as all business long-distance calls. The IRS may allow you to split some expenses between home and business, such as a vehicle purchase, as long as you can document the business use.

Generally, you should log every expense in an account book, a computer accounting program, or a diary. In addition, keep receipts or bills to document expenses whenever possible.

Consult the experts

The IRS offers additional details about home-based business deductions in the small-business section of its Web site.

Many small-business owners report that accountants specializing in small-business taxes can provide invaluable advice and assistance. Consider buying a half hour of an accountant's time to identify acceptable deductions for your business. Remember, tax laws for small businesses can change frequently. Many deductions also carry special restrictions or requirements, so always check the fine print before filing.

Published March 15, 2004

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