Let's face it: the tax deduction for business use of your home may be used, abused, and fantasized about more than any other deduction in the rule books. Although most entrepreneurs agree that they'd be crazy not to claim the deduction -- if they qualify for it -- persuading them to discuss the specifics of the tax benefits they've received and the tax strategies they've relied on is almost impossible.
"People don't like to draw attention to themselves on this subject," is the way one financial adviser puts it. That's probably understandable: plenty of business owners believe that they raise the risk of an audit simply by claiming the deduction.
But let's deal with reality here. For those entrepreneurs who carefully track their business expenses and keep comprehensive tax records, the home-office deduction can add up to a lucrative benefit. After all, as Jeffrey S. Levine of Alkon & Levine, in Newton, Mass., explains, "In our firm's experience, the average federal taxpayer is in the 28%-to-31% tax bracket, the average state income tax is in the 5%-to-6% range, and Social Security tax for a self-employed person -- which is the way many home-based business owners start out -- is 15%. So in many cases self-employed people are looking at a combined tax bracket of around 48%, which means, very simply, that every dollar you can document and deduct in home-business expenses will save you 48¢ in taxes."
Now for some background. For several years the home-office deduction was a dicey matter, thanks to a 1993 case in which an anesthesiologist battled his way to the Supreme Court in an effort to defend his right to deduct expenses relating to a home office. In denying his claim, the Court established a restrictive set of guidelines that basically allowed a deduction only in cases in which taxpayers earned their revenues at home. (Since the anesthesiologist performed his job at a hospital, he didn't qualify.)
Fortunately, Congress intervened with a new set of rules that went into effect this year. Those broadened the guidelines, permitting businesspeople who used their home offices exclusively and regularly for administrative and management purposes (such as paying business bills, writing marketing material, and calling clients and suppliers) to take the deduction, so long as those functions were not also performed in any other location.
Two caveats: Although today's guidelines are looser, they are still specific, so check with an accountant or lawyer to make certain that your company meets the standards. Also, the home-office deduction is limited if your business's gross income is less than or equal to its expenses. (In those cases, the unclaimed expenses can be postponed for future use.)
If your company meets the current guidelines, you should be able to deduct the following expenses that are relevant to your home-based operation:
- Depreciation on business furniture and equipment. According to the IRS, you can depreciate furniture and equipment, such as computers, desks and chairs, file cabinets, copiers, and fax machines, over five to seven years.
- Depreciation on the portion of your home that is used for business purposes. You can depreciate the business part of your home over 39 years. Keep in mind that this is the one deduction that carries a cost with it, since when the home is sold, business owners may owe taxes on any depreciation costs they've deducted. For that reason, analyze the pros and cons with your accountant.
- Other real estate expenses. These would include real estate taxes and home-mortgage interest. As they do with all expenses that are shared between the personal and business parts of a home, entrepreneurs are entitled to deduct the portion of those costs that relate to the business. More on that below.
- Strictly business expenses. Included in this category are the costs of special business-insurance policies (or the cost of amending a homeowner's policy), additional utilities, home-business cleaning, and repairs on office equipment. Other home expenses that can be justified on a strictly business basis (such as the need to install a pricey security system) also qualify for a full deduction.
When you claim deductions on a prorated basis, it's essential to make careful calculations and be prepared to back them up in the event of an audit. Ron Kolquist, a partner at Larson, Allen, Weishair & Co., advises business owners to "draw up floor plans of their homes that clearly document the square footage used for personal and for business purposes. Then you can deduct home-office expenses based on the percentage of the home's total square footage used exclusively for business."
Owners can also claim business use of the home based on a room count, but unless all rooms are basically the same size, the owners may not be able to substantiate the deduction. Overstating your claim about which portions of the house you're using for business can easily backfire. So don't try to claim shared spaces like bathrooms or kitchens.
The tax deduction for business use of the home can be tricky. Ken Hawk, the founder and CEO of iGo.com, in Reno, Nev., says that when his start-up was based out of his home, he "relied on the advice of a top-quality CPA for everything related to taxes, and that person handled my personal return as well as the company's." He emphasizes that "it's really important to pay attention to the letter of the law. There's no point in creating problems for a company that otherwise has great potential."
Kolquist notes, "In 17 years of practice, I've only needed to support a home-office deduction four times. And in each case my client and I brought in a marked-up floor plan and successfully proved our case." He adds, "Of course, keeping some photos in your files that can also back up your claim probably wouldn't be a bad idea."