Taxes for Home Based Business

Yay!  It’s tax time again (or near enough).  I can’t wait.  Just love this stuff.  Not!  OK, I know it’s boring, I know your eyes glaze over at the mere thought of all those forms and paperwork but it has to be done so let’s just bite the bullet and get on with it.

Now let’s start with the fact that there’s no substitute for a qualified professional when it comes to this sort of stuff so I’m not going to attempt a comprehensive survey of everything you need to think about when it comes to tax and your home business.  What we’re going to look at in this article is *one aspect* of home business taxation in the U.S.: the home office deduction.  By having a  working knowledge of this deduction BEFORE you hand everything over to your accountant will not only save both of you a lot of time (and therefore expense), you will be able to make sure you’re keeping good records for everything you need to. 

WHAT IS A HOME?

For the purposes of the home business deduction, a “home” means a house, apartment, condo, mobile home or boat as well as other structures on the property such as a garage, shed or barn.  It does not include property used exclusively as a hotel or an inn.

IS PART OF YOUR HOME USED IN CONNECTION WITH A TRADE OR BUSINESS?

If not, you can’t deduct business use of home expenses.  Duh. Stop reading now.

In order to satisfy the trade or business use test, you must use part of your home in connection with a trade or business.  So far so good.  But if you use your home for a profit-seeking activity that is not trade or business, you cannot claim a deduction for the business use of home expenses.  A good example given by the IRS is research you undertake for your own private stockmarket investments.  Although this is a profit-seeking activity, you are not involved in the trade or business of stockbroking or dealing and so you cannot claim the home business deduction.

IS THE USE REGULAR AND EXCLUSIVE?

OK, this is where things get a little trickier.

=> The Exclusive Use Test

To qualify under the exclusive use test, a specific area of your home must be used solely for your trade or business.  It can be a separate room or part of a room but it need not be marked off by any form of permanent partition.

So, if you have an “L” shape living room/dining room area and the dining room area is hived off as your “office” and is used for no other purpose, then this satisfies the exclusive use test. 

If, however, you clear the dining table of your papers every night so the family can use it for dinner, you don’t meet the exclusive use test.  So confine family meals to the kitchen!  Easy.

=> Exceptions to the Exclusive Use Test

The only exceptions to the exclusive use test are if you use part of your home for the storage of inventory or product samples or as a day-care facility.

If you use part of your home for storage of inventory or product samples, although you don’t have to satisfy the exclusive use test, you must meet all of the following tests instead:

* you keep the inventory or product samples for use in trade or business;
* your trade or business is the wholesale or retail selling of products;
* your home is the only fixed location of your trade or business;
* you use the storage space on a regular basis; and
* the space you use is an “identifiably separate space” suitable for storage.

Therefore, if you store your inventory of knitting wool for your internet business of selling wool, knitting patterns and knitting needles in your basement, then you will still be able to deduct your basement expenses (or part of your basement expenses) even though your basement is also used as a recreation or workshop area.

=> The Regular Use Test

In addition to satisfying the exclusive use test, you must also satisfy the regular use test.

This means that you must use the specific area of your home you use exclusively for business purposes on a continuing basis. This means more than occasional or incidental use.

IS IT YOUR PRINCIPAL PLACE OF BUSINESS?

Your home will be your principal place of business if you use it exclusively and regularly for the administrative or management activities of your trade or business and you have no other fixed
location where those activities are conducted.

“Administrative or management activities” include activities such as billing customers, keeping books and records, ordering supplies, setting up appointments, forwarding orders or writing reports.

Furthermore, and this is a recent change in the law from 1999 onwards, even if certain administrative or management activities are performed outside your home, you will not necessarily be disqualified from satisfying the principal place of business test.  You may, for example, engage third parties to conduct your administrative or management activities at other locations.  An
outside bookkeeping service is one example.  You may also conduct some of your management or administrative activities from your car on your cellphone without disqualifying your home as your principal place of business.

Alternatively, if you conduct your business at more than one location, whether your home can be considered your principal place of business depends on a consideration of the relative importance of the activities performed at each location.  If this is not determinative, you can then take into account the time spent at each respective location.

If, after conducting this analysis, you home can be identified as your principal place of business then, provided you also satisfy the trade or business and exclusive and regular use tests, you can deduct home office expenses.

IF NOT PRINCIPAL PLACE OF BUSINESS, DO YOU MEET PATIENTS, CLIENTS OR CUSTOMERS IN YOUR HOME?

Even if you can’t meet the principal place of business test, if you use your home to meet with patients, clients or customers in the normal course of your business, you may still be able to claim the deduction. 

You can deduct expenses for the part of your home used exclusively and regularly for business if you physically meet with patients, clients or customers in your home and their use of your home is “substantial and integral” to the conduct of your business.

This means that the use of your home for occasional meetings and telephone calls is not sufficient as the use of your home is not substantial and integral to your business.

IS IT A SEPARATE STRUCTURE?

You may deduct expenses for a separate free-standing structure such as a garage if you use it exclusively and regularly for your business.  It does not have to be your principal place of business or a place where you meet patients, clients or customers.

For example, if you’re an internet consultant whose principal place of business is at an office downtown, but you also use your garage exclusively and regularly as your home office for reviewing client websites and writing reports in relation thereto, you can claim the home office deduction for expenses associated with your garage.

BRINGING IT ALL TOGETHER

To summarize, then, to qualify to deduct expenses for the business use of your home, you must satisfy the following tests:

1.  Your use of the business part of your home must be:
(a) exclusive (unless the storage of inventory or day-care facility exceptions apply); AND
(b) regular; AND
(c) for trade or business

AND

2.  The business part of your home must be one of the following:
(a) your principal place of business; OR
(b) a place where you meet with patients, clients or customers as a substantial and integral part of your business; OR
(c) a separate structure such as a detached garage you use in connection with your business.

CALCULATING YOUR BUSINESS USE

Calculating your business use of the area of your home that you are using exclusively and regularly for business purposes is not complicated.  First, calculate the percentage of the business area of your home as a proportion of your total home area.

Next, add up your rent or mortgage interest, utilities, repairs and maintenance, insurance and property taxes.  Finally, multiply the total by the percentage you calculated above.  If you own your
home, you can also include depreciation on the business portion of your home.

Note though that you cannot deduct your home office if you have a loss from your business or if you would create a loss by claiming the deduction.  If you find yourself in this situation, never fear.  Any expenses you can’t claim this year can be carried forward to future years.

WHETHER TO CLAIM THE HOME OFFICE DEDUCTION

So, that’s the home office deduction in a nutshell.  Not too difficult, is it?  Should you claim it?  Why or why not?

To help you answer these questions, let’s wrap up with a quick look at the pros and cons of claiming the home office deduction.

First, the big con.  Claiming the home office deduction increases your chances of being audited.  So, be sure that your claim is legitimate before you claim it because the odds are relatively higher that the IRS will come knocking on your door.  Don’t let that stop you if you have a legitimate claim that’s worth claiming though as there are some significant advantages in claiming your home office even after you consider the fact that your mortgage interest and real estate taxes are already tax deductible.

To begin with, deducting as business expenses what would otherwise be personal expenses reduces not only your income tax but also your self-employment tax.  Next, if you claim for a home office, you can deduct rent, utilities, insurance and depreciation which you couldn’t otherwise take as expenses. Finally, a home office allows you to deduct more car expenses because it allows you to claim the miles you drive from home to your first business stop of the day and from your last stop
of the day back home.  This would otherwise be undeductible commuting mileage.

Tax law is not a favorite subject of many people, I hazard to guess.  But, dry and brain numbing as it is, strive to have at least a working knowledge of the fundamentals.  This can help you structure your business from the outset in a way that allows you to take maximum advantage of the tax laws that work in your favor and to minimize those that may work against you if you don’t plan your tax affairs effectively.  A good accountant is your best ally when it comes to tax.  This article has hopefully given you a working knowledge of the fundamentals of the home office deduction but consult your accountant as to your own particular circumstances.