Home Businesses The IRS Rules
By Sharon Walker

Many of us have dreamed about the possibility of having a business in our homes.  The transformation of these dreams to reality will undoubtedly increase as the Internet, and technology in general, provide new opportunities.   In addition to cost savings, a home-based business can result in some nice tax deductions.    

Per IRS Publication 587, to obtain a business use deduction of your home you must either have a separate structure that is used solely for your trade or business, or use part of your home in at least one of the following ways:

• Exclusively and regularly as your principal place of business; 

• Exclusively and regularly as a place where you meet with patients, clients or customers;

• Regularly for storage of inventories or samples; or

• For rental and/or as a daycare facilities (which have special rules).

If you itemize on your tax return, certain household expenses (e.g. mortgage interest and property taxes) are deductible regardless of whether your home is used in a business.   In addition, and even if you do not itemize, a portion of these and other household costs can become deductible expenses of a home-based business.   But before you have visions of “IRS Refunds Dancing in Your Head”, there are a few other things you should know.  First, the costs must be both ordinary and necessary to be deductible. Ordinary and necessary expenses are common and accepted by your trade, profession or business, and appropriate and helpful to such business.  While as always you should exercise good judgment, a few examples of costs that can qualify for deductions are home and flood insurance, rent and/or depreciation, repairs and maintenance and utilities.

The first step in calculating your deduction is to determine the business percentage of your home. This can be done by any reasonable method; however such method must result in an answer that approximates the percentage of home square footage used for business.

Secondly, you have to allocate these expenses between personal and business use, and determine if the expense is considered direct or indirect.  Direct expenses relate only to the business portion of your home (e.g. if you paint the business area of your home, the expense would be fully deductible, whereas painting the entire house only results in an indirect expense).  Other examples of indirect expenses, which are deductible to the extent of the business percentage of your home, include insurance, utilities, and maintenance.  Personal expenses (i.e. those that relate to the parts of your home not used for business) are not deductible.

If you own your home and qualify for business use, you can also deduct depreciation.  To determine your depreciation deduction, you must know the following:

• The month and year you started operating your business from your home,

• The adjusted basis and fair market value of your home,

• The value of improvements to your home, and

• The business percentage for the home. 

To arrive at your depreciable basis, multiply the lower of your home’s adjusted basis or fair market value by the business percentage of the home.  This amount should (don’t try to be a good American and forego this deduction as the IRS generally assumes you took the deduction when you sell your home) be depreciated over a thirty-nine year life using the straight line method.   That’s right, the gain on the sale of your home will be based on the adjusted basis of your home meaning that it will be increased by the depreciation deductions you enjoyed previously.  In addition, furniture or equipment that you use in your home business qualifies for depreciation deductions, regardless if you qualify for business use of your home.

As with most aspects of the tax law, there are limits to the deductions of home business use. If gross income exceeds your total business expenses, you can deduct all of the business related expenses of your home. If gross income is less than your business expenses, your deduction for home business use is limited. In the event your deductions are greater than the current year’s limit, you can carry over the disallowed expenses to the following year.

Sole proprietors and single member LLCs report their business expenses on Schedule C and attach Form 8829 to the return. If you file Schedule F for farm activity, you add in an expense for “Business Use of Home.”  Partners can deduct these expenses as unreimbursed partner expenses on Schedule E of their personal tax returns.  And finally, these expenses are simply reflected as expenses on the corporate tax return for stockholders.  And remember, for those itemizing their tax returns, interest and other itemized deductions over the business percentage portion can still be deducted.

As with all deductions, good record keeping will help you keep track of and provide support for your deductions.  You should keep canceled checks, receipts, allocation calculations and any other written evidence that supports your home business activity. These types of documents should be retained for at least three years after the tax return due date or the date filed, or two years after the tax was paid, whichever date is later.

As always, be sure to consult with your tax advisor to ensure compliance with the current tax code.

Kingery & Crouse, P.A.

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