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Steve Windhaus Ask the Small Biz Adviser

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.

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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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See Also
Kicking the corporate mindset
Finding clients for a home-based business

Good recordkeeping can maximize business deductions

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