Hello and welcome to lesson four.
This is a lesson for small business owners who operate their business out of their home.
In lesson four as with previous lessons, there are learning objectives.
At the end of this lesson you will be able to determine if you are eligible for the business use of the home deduction, and determine the deductions you are eligible for.
The purpose of this lesson is to provide information on figuring and claiming the deduction for business use of the home.
The term home includes a house, apartment, condominium, mobile home, or boat.
It also includes structures on the property such as an unattached garage, studio, barn, or greenhouse.
Most taxpayers with home based businesses accurately report their income and expenses while still enjoying the benefits that a home based business can offer.
However, some individuals have received advice that they can operate any kind of unprofitable business out of their home and claim personal expenses as business expenses.
Non-deductible personal living expenses can not be transformed into deductible business expenses no matter how convincing the information and marketing materials may seem.
If you encounter what looks like a home based tax avoidance scheme check it out.
Publication 4035 answers the question, it is too good to be true?
Home Based Business Tax Avoidance Schemes.
Let's move on.
To qualify to deduct expenses related to the business use of part of your home you must meet specific requirements.
Even then the deduction may be limited.
To qualify to claim expenses for the business use of your home you must meet the following test.
First, your use of the business part of your home must be exclusive, regular, and for your business.
The business part of your home must be one of the following: your principle place of business, or a place where you meet with patients, clients, or customers in the normal course of your business, or a separate structure not attached to your home you use in connection with your business.
Let's look at the exclusive use test first.
To qualify under the exclusive use test you must use an area of your home only for your trade or business.
The area you use for a business can be a room or other separately identifiable space.
The space does not need to be marked off by a permanent partition.
You do not meet the requirements of the exclusive use test if you use the area for business and for personal purposes.
Now here's a question for you.
Jessica is an attorney.
She uses her family room to write legal briefs and prepare client tax returns.
Her family also uses the room for recreation.
Can Jessica claim a business deduction for the use of the family room?
Since Jessica does not use the family room exclusively in her profession, she can not claim a business deduction for its use.
Welcome to Lillian's Jewelry.
My shop is located in my garage which is not attached to my house.
I use the garage for my jewelry business only.
In one part of the garage I put my machines and worktables and inventory of gems and metals.
In another part of the garage I have a small showroom.
Every year on my tax return I claim a business deduction for my garage.
Lillian is allowed to claim a deduction for the business use of her garage.
The use is exclusive, regular, and for the business.
Also, the garage is a principle place of business and is a separate structure.
As you know my business is located in my garage.
There's no kitchen in my garage so during the day I use the kitchen in my home to prepare my lunch, I mean I have to eat.
So I claim a deduction for the business use of my kitchen.
Lillian doesn't understand the rules for the business use of the home.
Lillian can not claim a deduction for the business use of her kitchen.
The use of the kitchen is neither exclusive, nor for the business.
Also the kitchen is not the principle place of business, a meeting place for customers, in the transaction of the business, or a separate structure.
There are exceptions to the exclusive use test.
You do not have to meet the exclusive use test if you use part of your home for the storage of inventory or product samples, or as a daycare facility.
The next test is pretty basic.
It's called the regular use test.
To qualify under the regular use test you must use a specific area of your home for business on a continuing basis.
You do not meet the test if your business use of the area is only occasional or incidental, even if you do not use that area for any other purpose.
That's all there is to tell about the regular use test.
Moving right along.
Next is the principle place of business test.
You can have more than one business location, including your home for a single trade or business.
One way to qualify to deduct the expenses for the business use of your home is if your home is your principle place of business.
To determine this you must consider all of the facts and circumstances.
Your home office will qualify as your principle place of business for deducting expenses for its use if you use it exclusively and regularly for administrative or management activities of your trade or business, and have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
So what are administrative or managerial activities?
Here are some common ones.
Billing customers, keeping books and records, ordering supplies, setting up appointments, and forwarding orders or writing reports.
But what if somebody else keeps my books for me?
Does that mean my own office can't be my principle place of business?
There are activities that you might think disqualify your home office as your principle place of business, but they don't.
Here they are: employing others to conduct your administrative or management activities at locations other than your home, conducting administrative or management activities at places that are not fixed locations of your business, such as in a car or a hotel room.
Occasionally conducting minimal administrative or management activities at a fixed location outside of your home.
Conducting substantial, non administrative, or non-management business activities at a fixed location outside your home and having suitable space to conduct administrative or management activities outside your home, but choosing to use your home office for those activities instead.
Here's another question for you.
Jon is a self-employed plumber.
Most of Jon's time is spent at customers' homes and offices installing and repairing plumbing.
He has a small office in his home that he uses exclusively and regularly for the administrative or management details of his business, such as phoning customers, ordering supplies, and keeping his books.
Jon does not do his own billing.
He uses a local bookkeeping service to bill his customers.
Does Jon's home office qualify as his principle place of business for deducting expenses for its use?
Jon's home office qualifies as his principle place of business for deducting expenses for its use.
He uses the home office for the administrative or managerial activities of his plumbing business and he has no other fixed location where he conducts these administrative or managerial activities.
His choice to have his billing done by another company does not disqualify his home office as his principle place of business.
Jon's business meets all the qualifications including principle place of business.
He can deduct expenses to the extent of the deduction limit for the business use of his home.
Okay.
Here's another question for you.
Claire is a self-employed anesthesiologist.
She spends the majority of her time administering anesthesia and post operative care in three local hospitals.
One of the hospitals providers her with a small shared office where she can conduct administrative or management activities.
Claire does not use the office the hospital provides.
She uses a room in her home that she has converted as an office.
She uses this room exclusively and regularly to conduct all the following activities.
Contacting patients, surgeons and hospitals regarding scheduling.
Preparing for treatment and presentations.
Maintaining billing records and patient logs.
Satisfying continuing medical education requirements and reading medical journals and books.
Does Claire's home office qualify as her principle place of business for deducting expenses for its use?
Claire's home office qualifies as her principle place of business for deducting expenses for its use.
She conducts administrative or management activities there for her business as an anesthesiologist.
She has no other fixed location where she conducts administrative or management activities for this business.
Her choice to use her home office instead of one provided by the hospital does not disqualify her home office as her principle place of business.
Because she meets all the qualifications, including principle place of business, she can deduct expenses to the extent of the deduction limit for the business use of her home.
If you don't meet the principle place of business test, you might qualify under the meeting place for customers test.
Your home office may qualify if you meet or deal with patients, clients or customers in your home in the normal course of your business even though you also carry on business at another location.
You can deduct your expenses for the part of your home used exclusively and regularly for business if you physically meet with patients, clients, or customers at your home and the use of your home is substantial and integral to the conduct of your business.
Hey, sometimes I have to call a client from home, does that count?
Sorry, using your home for occasional meetings and telephone calls does not qualify you to deduct expenses for the business use of your home.
Okay.
Here's the last test.
It's called the separate structure test.
You can deduct expenses for a separate free standing structure such as a studio, garage, storage shed, or barn if you use it exclusively and regularly for the business.
The structure does not have to be your principle place of business or a place where you meet patients, clients, or customers.
Here's an example.
A business owner who repairs cars works on the cars in his detached garage and meets with the car owners in the family room of his house.
The garage is a separate structure and the owner does not meet the customers there.
Because the garage is used exclusively and regularly in his business he can deduct the expenses for its use subject to the deduction limit.
We'll talk about the deduction limit later.
Most home businesses are run from a part of the home rather than the whole structure.
Most expenses related to the business use of your home are limited to the percentage of your home used for business or business percentage.
To find the business percentage compare the size of the part of your home that you use for the business to your whole house.
You can use any reasonable method to determine the business percentage.
These are the two commonly used methods for figuring the percentage.
First, the area method, and second the number of rooms method.
For the area method divide the area used for business by the total area of your home.
Say your office is 240 square feet.
Your home is 1200 square feet.
Your office is 20%, 240 divided by 1200 of the total area of your home.
Your business percentage is 20%.
Okay, let's look at the other method for determining business percentage of the home.
For the number of rooms method divide the number of rooms used for business by the total number of rooms in your home.
You can use this method if the rooms in your home are all about the same size.
Let's try out this method.
Here's the scenario.
Peggy has an art studio in her home.
She is allowed to take a deduction for the business use of her home.
The rooms in her house are all about the same size.
There are ten rooms and she uses one for a studio.
Peggy's business use percentage is 10%.
Now that you know how to figure business percentage, here's where you record it.
Use part one of Form 8829, Expenses for Business Use of Your Home, to figure the business percentage of your home business.
We've looked at all the business tests for business use of the home.
Now let's look at the types of expenses.
There are two types of expenses related to using your home for business.
First, expenses related to the business activity in the home, but not to the use of the home itself and second, expenses for the business use of the home.
Expenses for business use of the home are divided into three categories.
Direct expenses, indirect expenses, and unrelated expenses.
Business expenses related to the business activity in the home, but not to the use of the home itself, are deductible in full on schedule C.
These are the ordinary and necessary expenses we talked about in lesson two.
These expenses are not limited to the business use of the home percentage or the deduction limit.
We'll discuss that later.
Examples of some of these expenses include advertising, business taxes, car and truck expenses, salaries, supplies, and travel.
You must divide the expenses of operating your home between personal and business use.
The part of a home operating expense that you can use to figure a deduction depends on whether the expense is direct, indirect, or unrelated, and the percentage of your home that is used for your business.
So what do we mean by direct, indirect, and unrelated?
Expenses only for the business part of your home are generally deductible in full unless subject to the deduction limit.
We'll discuss that later.
A good example is painting or repairs only in the area used for business.
You also might have high speed internet service for your business so you can advertise business through your web site and communicate via email with customers.
Expenses for running your entire home are deductible based on the percentage of your home used for business.
They may also be subject to the deduction limit.
Examples of that are homeowners insurance, utilities, and general repair such as a new roof or gutter cleaning.
Expenses from the parts of your home not used for business are not deductible.
Some examples are lawn care and painting a room not used for business.
Certain expenses are deductible whether or not you use your home for business.
However, if you qualify to claim business use of the home expenses, you can use the business part of these expenses to figure your business use of the home deduction.
These expenses are real estate taxes, deductible mortgage interest, and casualty losses.
Then there are expenses that are deductible only if you use your home for business.
These expenses generally include, but are not limited to, insurance, rent, repairs, utilities and services, and depreciation on your home.
Now let's talk about deduction limits.
If your gross income from the business, operated or managed from your home equals or exceeds your total business expenses you can deduct all your business expenses.
If it is less than your total business expenses, your deduction for certain expenses for the business use of your home is limited.
For those of you who sell a product, remember in lesson two, you learned that gross income is generally the total sales of your business less cost of goods sold.
When you have a business in your home you may be able to deduct a percentage of your home expenses such as insurance, utilities, and depreciation.
These expenses are limited to the gross income from the business use of your home minus the following, ordinary and necessary business expenses, and the business part of your mortgage interest, real estate taxes and casualty losses.
Expenses that can not be deducted because of the deduction limit can be carried forward to later years subject to the deduction limit in those years.
Self-employed individuals show their business income and expenses on Schedule C Form 1040, Profit or Loss from Business.
If you file schedule C you figure expenses related to the business use of the home on Form 8829, Expenses for Business Use of Your Home and you report the deductible amount on schedule C.
I have no idea what you're talking about.
Let's use an example.
Jon uses part two of Form 8829 to figure his allowable home office deduction.
He uses 10% of his home for business.
He has already subtracted his ordinary and necessary business expenses, things like supplies and transportation.
So he knows his tentative business profit.
Let's say it's $25,552.
First he figures the business part of the expenses that would be deductible even if he did not use part of his home for business.
These expenses, $4,500, deductible mortgage interest and $1000 real estate taxes, relate to his entire home.
So he enters them in column B on lines 10 and 11.
Ten percent of these expenses equals $550.
He then subtracts the $550, business part of these expenses, line 14, from his tentative business profit, line 8.
The result, $25,002 on line 15 is the most he can deduct for his other home office expenses.
Next he figures his deduction for the operating expenses for his home.
He paid $300 to have his office repainted.
He enters this amount on line 18, column A because it is a direct expense.
All his other expenses, $400 for homeowners insurance, $1,400 for roof repairs, and $1,800 for gas and electric relate to his entire home.
Therefore he enters them in column B on the appropriate lines.
These expenses total $3,600.
Because he uses only 10% of his home for business, the business part of these expenses is $360.
He adds the $300 direct expenses from line 21, column A to the $360 total for indirect expenses on line 22, and enters the total, $660 on line 24.
This amount is less than his deduction limit, so he can deduct it in full.
The $24,342 balance of his deduction limit, line 26 is the most he can deduct for depreciation.
Next, he figures his allowable depreciation deduction for the business use of his home in part three of form 8829.
Let's say that turns out to be $271.
Finally he figures his total deduction for his home office by adding together the business portion of his otherwise deductible expenses, line 14, his operating expenses, line 25, and depreciation, line 31.
He enters the result, $1,481 on lines 32 and 34 and on schedule C line 30.
Let's say Jon was just starting out and his tentative profit turned out to be $1300 instead of $25,552.
In this case he would subtract the business part of his mortgage interest and taxes, $550 to figure his deduction limit of $750.
He could still deduct the entire $660 he figured for the business part of the operating expenses for his home.
But, he could only claim $90 of the $271 for depreciation.
He can, however, carry forward the remaining $181 to a year when he has more income.
Bottom line, you can't use your home's operating expenses, or your home's depreciation deduction to create a net loss for a business operated out of your home.
Cool, since I have a home business I can deduct my real estate taxes and mortgage interest, twice.
Do not take a double deduction for real estate taxes and mortgage interest.
If you report an amount for the business portion of the taxes and interest on schedule C, make sure you report only the personal portion on schedule A, itemized deductions.
The amounts reported on schedule C and schedule A should be the total interest and taxes you paid for the year.
As we mentioned in previous lessons we don't expect you to remember all of this information.
Publication 587 has the details for business use of a home.
You can view it online at irs.gov.
If you used your home for business some special rules apply when you sell it at a profit, or as it is sometimes referred to, a gain.
For more information on the sale, or exchange of a home, see Publication 523, Selling Your Home.
In a nutshell.
You pay tax on the part of the gain that's equal to what you claimed or could have claimed for depreciation over the years.
The last topic we need to talk about is recordkeeping.
Remember you learned the importance of recordkeeping in lesson one.
Recordkeeping is vital when you have a home business.
You must keep records that provide the information needed to figure your deductions for the business use of your home.
Keep all cancelled checks, receipts, invoices, and other evidence of expenses for the deductions you claim.
And that concludes lesson four.
Here's a summary of what you learned.
In this lesson you learned the requirements you must meet to qualify for a deduction for the business use of your home.
How to determine the business percentage of business use.
The types of expenses you can and can not deduct either in full or according to the percentage.
How to determine the limits on business use of the home deductions.
Where to deduct the expenses on your return.
The effect of claiming these expenses when you sell your home, and recordkeeping requirements.
Running your business from your home can be an exciting and enjoyable experience.
When it comes to your tax responsibilities it requires organization and meticulous recordkeeping.
It's up to you to make sure you pay the correct amount of tax and document all of your deductions.
You've learned you can not operate an unprofitable business out of your home and take personal expenses as business expenses, as some promoters of abusive home based tax schemes claim.
We've given you a lot of information and referenced several IRS publications to help you.
As was mentioned in previous lessons, there are many sources of information available to the small business owner.
Irs.gov/smallbiz answers many questions that small business owners have asked.
It is important to note that there are special rules that apply to home based day care providers.
If you run a daycare business from your home make sure you check irs.gov/smallbiz for the special rules and publications that apply to your business.
Coming up next in lesson five, you'll learn how to set up a retirement plan for yourself and your employees.
We think you'll be amazed at how simple it is to set up a retirement plan.
Thanks for joining me.
For resources discussed in each lesson, please visit the Lesson 10 Supplement.
|