Tax Saving Tips For Home Based and Business Owners

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Comment by C.W. Whitaker on August 27, 2008 at 12:41am

Home Based Business (Consult Your Attorney or Tax Consultant For Advice)

There is a very good chance that you are one of those people who visit our site who is already in business. You are running your own home-based or micro business already to supplement income or for the pure fun of it. Good for you, no sense working for the Man your whole life, right?

It is also very likely that you are operating as a sole proprietorship, you have not incorporated a business entity, and you have no partners to speak of (except maybe a grumpy spouse or cat who doesn't like the hours you spend on your ``project" instead of them). The good news is that you have business expenses just like everyone else, and you #$% better be deducting them! Please see our section on common business deductions to make sure you are not missing out on any deductions.

As you probably know, most expenses related to your business are deductible, whether those expenses are incurred at home, on the rode or wherever. But there is one deduction only home-based businesses can claim: deduction of part of the cost of a home.

Home Office Deduction

If you run your business out of your home, you are probably eligible for the ``home office" deduction. Note: you do not have to own your abode to deduct a portion of the cost! Moreover, it does not have to be a house. Apartments, condominiums, boats, or anywhere else where you can sleep and eat can qualify for the home office deduction.

In order to claim the home office deduction, you must meet the following criteria:

1. The home office is the principal place of business for your business.

2. There must be a separately identifiable place in your home for the business.

3. The space so set aside must be regularly and exclusively used for business.

If all three requirements are satisfied, then you can deduct a portion of the cost of your home, be it rent, mortgage payment or otherwise. We will look at each requirement in depth.

Principal Place of Business

There are really two requirements to satisfying this first test. If your home is your principal place of business, and it is the only place where you work on your business matters, you probably will get the deduction. If you spend a large portion of your time performing business-related matters outside your home office, you may have trouble satisfying this first of the three tests. You see the law says that when some of the business's work is performed outside the home as well as at your home office, whether the taxpayer is eligible for the home office deduction depends on both the relative importance of the tasks completed at the office versus the ones performed outside the home office and the amount of time spent outside the office.

If you perform the most important functions outside your home office or spend the majority of your business time outside the office, forget it, you are ineligible for the home office deduction. But if you spend the majority (at least 51%) of your business-related time working in your home office and perform the most important work there, then you should qualify. Some commentators have noted that this rule provides taxpayers with an incentive to shade the truth. As law-abiding citizens, we cannot suggest that you misrepresent your work habits in order to obtain a deduction. And so while others might strongly argue that the IRS has trouble checking up on how many hours you spend at your office and where some tasks are performed, we cannot say ``you should misrepresent your work habits in order to obtain a deduction that rightfully belongs to the hardworking small business people of America. Enough said.

You should note, however, that beginning January 1, 1999, the home office deduction law will change and the above analysis will be changed. See our Hot Topics page for more information concerning the upcoming Home Office Deduction Change.

Separately Identifiable Space

If you satisfy the ``Principal Place of Business" requirement, you then must satisfy the second requirement of the home office deduction test. It gets a little silly at this point. The IRS prefers that the space allocated to the home office be a separate structure, such as a converted unattached garage or small structure apart from the house. But if you have a room converted to office use (i.e., no bed or other personal affects), this should satisfy the IRS requirement of a separately identifiable space.

Regular and Exclusive Use

If one and two are satisfied, the third and final requirement which must be satisfied in order for you to claim the home office deduction is the requirement that the home office space is put to regular and exclusive use for the home business. This means that the home office cannot also be the kid's playroom or the TV room, nor can you only use the space for an office once in a while. We know that ``regular use" is kind of vague, and we wish we could provide you with some more guidance but we cannot.

So You Passed the Test, Now What?

Obtain Form 8829 from the IRS and the instructions for Form 8829. Form 8829 is filed with your individual income tax return. Form 8829 is a pain, it is long and it does require some effort but if you plan on taking the home office deduction, you really should file it. You risk attracting the IRS's reptilian attention if you try and take the home office deduction without filling it out.

To calculate the home office deduction, follow these steps:

1. Divide the number of square feet your home office occupies by the total square footage of your home to obtain the percentage of your home devoted to your home office. (This percentage should obviously be smaller than 1.)

2. For renters, you add your total annual rent payments to your total annual utility payments and multiply this number by the percentage derived in step 1. The resulting number is your home office deduction.

3. For Homeowners, first find out from the local property tax assessor the value of your home versus the value of your property lot. (If you cannot get these numbers anywhere, a 20/80 split for the land and home, respectively will probably be the best bet.) Take the amount of you home's value allocated to the actual structure and multiply it by the number of years over which you must deduct the depreciation of your home. (Note there are specific rules concerning how you must depreciate your home. Depending on when you bought your home, you may be able to use a shorter period than the now-standard 39 years. Your accountant can tell you the number of years over which you must depreciate your home. Or check back here in a little while, we are putting together a chart.) Then multiply this result by the number derived in step 1. This will be your home office deduction.

Remember that, just like any other depreciable business asset, you can only deduct up to the amount of your basis in your home! There is also a downside to the home office deduction: tax recapture.

Home Office Deduction Recapture

Starting in May 1997, if you sell your home after deducting a portion of its cost under the home office deduction, you will have to repay any amount of the deduction ``recaptured" in the course of a sale of the home. This means that if you deducted $15,000 of your home's cost, when you sell it, you will owe $15,000 to the tax man since you recaptured your depreciated amounts. NOTE: The standard $250,000 ``exclusion of profits" typically available to homeowners who sell their home does not apply in this instance! In light of this recapture rule, many homeowners elect not to deduct their home office space--it simply becomes too much of a pain. But think about this, if you get ten years of deductions and then have to repay that amount, the government gave you a ``loan" for ten years, right? So it may be worth it, it's up to you.

Renters should always take the deduction, however, they do not have to worry about recapture issues.

Using ``Losses" from Your Micro business to Offset Other Income

Of course every small business is going to make its owners rich, but there may be some losses along the way to fortune. Losses from you home-based business can be used to offset your taxable income from your day job or your spouse's. You should also remember that your ``losses" do not have to consist of only actual cash losses, the losses can be depreciation deductions for your equipment, home office, etc.

Think about this when you are buying a (new) computer, furniture, or paying your utility bills, all of these are potential tax deductions or ``losses" stemming from you home-based business. But in order to get these deductions the IRS requires a few things. Your home-based business must be a for-profit enterprise, it cannot be just a hobby. (Of course there is no reason why your hobby cannot be turned into a profit-making enterprise, right?)

The IRS has a few simple tests to distinguish a for-profit business from a hobby. One is the ``three of five" test. If your business shows a profit for any three years out of five, your enterprise is a for-profit enterprise. It does not matter how much profit you show in those three years, only that there is some profit. So you could have $25 in profit for three years and then claim $20,000 in losses for two of the years! Think about it! Even if you cannot satisfy the three-of-five test, you still may be able to claim deductions on your home-based business, it just gets a little more difficult. If you fail the three-of-five test, you can show a business enterprise by producing receipts, business records, advertising material, day planners, corporate records, state or local licenses and permits and other such indicia of business activity.

Taxes on Home-Based Businesses

Small businesses must make income tax payments on a regular schedule just like any other business. The two taxes you should be most concerned about are the quarterly estimated income tax payments and the self employment taxes.

Quarterly Estimated Taxes If (1) you are going to owe more than $1000 in income taxes AND (2) at the end of the year your tax bill will be less than either 100% of your tax bill for the previous year or 90% of the tax you will owe, then you must make quarterly estimated tax payments. You must make these payments using Form 1040-ES. This form and your payments must be made on April 15, June 15, September 15, and January 15. (These estimated tax payments will include the money you owe for payroll taxes such as Medicare and Social Security. See below!) Please note that most states are also addicted to prepayment of taxes, so you will probably have to send the state some estimated tax payments as well.

When you estimate the quarterly tax payment, what you should do is figure out how much you will probably owe in income taxes at the end of the year. Then plan on sending in one quarter of that amount with each tax payment. Using the previous year's income tax bill is a very good way to estimate the current year's tax payments. S long as you pay about 90% of your tax bill over the course of the four quarterly installments, you will not incur the 9% penalty for failure to comply. But if your adjusted gross income exceeds $150,000, you will need to pay no less than 105% of the previous year's tax to avoid the penalty. (And if your adjusted gross is this high, you probably should have an accountant who is helping you manage your tax affairs.)

You must pay a ``self-employment" tax of 15.3% on all of the net income earned by your business. The self employment tax is made up of two different taxes, the Medicare tax and the Social Security Tax. NOTE: You stop paying the Social Security tax on any additional net income beyond the first $65,400. So if you made $100,000 in net income last year, you would only pay 15.3% on the first $65,400. For the remaining $44,600, you would only have to pay the 2.9% Medicare tax. (All other income taxes still apply as well, of course.) One half of the amount paid as self-employment taxes is deductible