Maximizing Deductions Related to Your Home Business
If you are the sole proprietor of a home-based business, you probably know that legitimate deductions can help lower the amount of federal and state taxes you must pay on the income generated by your business. The IRS classifies home-based business expenses as unrelated, direct, and indirect. You cannot deduct unrelated expenses, and you must prorate indirect expenses and deduct only the percentage of the expense that is related to your business. However, you can typically deduct the full amount of direct expenses. Therefore, you may be able to increase your deductions by shifting some of your indirect expenses to direct expenses. Since tax laws change frequently, you should consult your tax accountant to verify the current laws covering your business expenses.
First Things First
There are three key points that you must keep in mind. First, you must use the space or item exclusively for your business. For example, suppose you have a greenhouse where you grow the specialty peppers that you sell to local restaurants. As long as you do not grow anything that is not business-related in the greenhouse, you can claim the entire space when determining the percentage of your expenses that you can deduct. Similarly, the cost of a laptop that you only use for business purposes should be fully deductible. Second, your home should be the sole fixed location from which you conduct your business. Therefore, if you also conduct business from a rented office, you may not be able to deduct your household expenses. Keep in mind that the critical word is fixed. Traveling to numerous client locations to provide your services or handling business tasks from hotels while you are traveling will not disqualify you from taking the deduction. Lastly, you actually need to be operating a business. For example, if you used your greenhouse to grow orchids as a hobby and give them away to friends and relatives, you are not operating a business.
Examples of Unrelated Expenses
Unrelated expenses are the bills you pay for household costs that are not tied to your business. If you pay someone to mow your lawn, clean your pool, or repair the shower in your master bath, you cannot deduct any portion of these expenses unless you can prove that they are related to your business. Thus, if you are paid to provide swimming lessons, you might be able to deduct at least part of the cleaning costs, but you cannot deduct them if your pool is only used for recreational purposes.
Examples of Indirect Expenses
Indirect expenses are the overhead costs you incur for your home in its entirety and prorate for your home-based business. For example, if you have a new, whole-house HVAC system installed, have your entire roof replaced, or have your gutters repaired, your deduction will be limited to the prorated amount. The same is true for recurring bills that include your business space and the rest of your home, including HOA or POA dues, cleaning services, homeowner insurance, utility bills, security system fees, and internet service.
Examples of Direct Expenses
Direct expenses are those that relate only to your business. These include the costs incurred for supplies to produce the items you sell, furniture and equipment used exclusively in your work area or for your business activities, repairs and upgrades to your business space, bank fees for your business account, and the fees paid to a virtual business address service. If you can shift some of your indirect expenses to direct expenses, you may be able to increase your deductions so that you can claim the actual cost instead of the prorated amount. Here are some tips to help you make the transition, but you should check with your tax preparer or accountant before taking any steps that involve an additional expense.
1. Have a separate meter installed for the electricity used in your business space or spaces. This could be especially beneficial if your equipment consumes a lot of electricity or operates 24 hours a day. It could also be helpful if your business space represents an extremely small percentage of your entire home. However, not every utility company will be willing to install a second meter, and there are usually costs involved if they are willing. You can review your electric bills for the year before you launched your business to determine how much your business activities have affected your expenses. This can help you determine whether a second meter would be beneficial. If you choose to have a second meter installed, try to have the account set up in the name of your business; regardless of the name you must use to set up the account, you should pay it from the account you have dedicated to your business expenses.
2. When having an upgrade made to your entire home, try to obtain a separate invoice that covers only your business space. For example, if you are having the interior of your home repainted, see if your contractor can break the work into two phases so that your business space is not included on the bill for the rest of the house. Use a similar approach if you are replacing the flooring in multiple rooms or throughout your home. You might even want to consider using a different color of paint or type of floor covering for your work area. It would be helpful to have the contractor issue the second invoice in the name of your business. Either way, use the checking account or credit card you reserved for your business expenses to pay the bill.
3. Look for ways to remove your work area from the household grid. For example, if you have a security system, you could have a second system installed that only covers your business space. If your entire family uses the same internet connection, see if there is a way to obtain a second connection just for your business; depending on where you live, this could be a second provider, the same provider, or virtually impossible. If you are able to have a second meter installed, removing your business space could also help lower your electric bill for the rest of your house. To illustrate, if you use a window unit to cool your home office, you could adjust the thermostat controlling the rest of the house without sacrificing your comfort.
If none of these steps are feasible, look for ways to make an area qualify for the deduction or expand the square footage to increase your percentage.
1. If your work area does not qualify because it is not used exclusively for your business, see if there are changes you can make. For example, you use a workshop to produce the items you sell, but you also use it to store and maintain your lawn equipment and tools, repair household items, or pursue a hobby. Can you purchase a separate shed or transfer the items and activities to your garage? If you can eliminate other activities and items, you should be able to include your entire workshop in the calculation to determine the percentage of your home that you can claim as a business space.
2. Remember that a space can qualify even if it is not a separate room. All that the IRS requires is that the space be identifiable and used exclusively for your business activities. Do you have an extra closet that you could convert to a workspace for crafting your products? If you have been unable to claim the deduction because your desk and computer are located in a room that is also used for other activities, can you place screens to make the space separately identifiable? You do not have to install permanent partitions, according to the IRS, as long as the area is not used for any other purpose and is separately identifiable.
3. If the problem is that other family members are sharing your equipment and space, it may be easier to create a separate area for them. For example, if the only computer in the house is the one you use for business, a second computer in the family room or dining room might solve the problem. The same solution might apply if you have the only scanner, the best printer, or the only sewing machine.
Although every effort has been made to provide accurate information, tax laws can change, and every home business is different. Therefore, you should discuss the issues with your CPA before implementing any of the above tips.