When historians compile the list of the greatest innovations to benefit small business, the home office will surely rank in the top ten. After all, it's deductions like these that leave us with incredible audit stories to share, just like this one:
A legal case from 1981 involved a drug dealer in the Minneapolis area who was caught selling substantial volumes of marijuana, cocaine, and amphetamines out of his house. He was arrested, convicted in court by a jury of his peers, audited by the IRS, and was later told during his sentencing that he owed $17,000 in back taxes on drug earnings he never reported to the IRS. The drug dealer appealed the audit portion of his case claiming that the IRS did not consider his tax deductible costs incurred in running his business from his home. He won the audit for a home office deduction, but still went to prison.
The ability to serve customers and earn a living from the convenience of home has helped thousands of entrepreneurs, and sometimes even questionable earners, minimize operating costs, keep personal and professional responsibilities in balance, and heighten productivity by eliminating the grueling, time-consuming activities of commutes, restricted work hours, and interruptions.
If this deduction is available for all individuals who own and run a business from home, why are people ignoring this deduction when it comes to tax time? The answer can be summed up in one word: audit. If you take a historical glance on the most audited tax returns within the confines of the IRS in the last decade, the small business owners who use the home office tax deduction would rank high up on the list for ‘red flagged’ returns.
So why take this deduction if the risk is high to be audited? The answer is simple if you qualify. You can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. That's a great deal of money for the small business owner with savings that can be tremendous.
How would one know if they qualify?
The home-office deduction is based on two fundamental requirements:
1. Regular and exclusive use
This means that the space in your home is used only for conducting business. It can serve no other purpose, even if it's occasional (e.g., dining room, kid's playroom, spare bedroom for company, etc.) Note, however, that the deduction isn't limited to a full room. If you set aside half of spare room for a home office, you can deduct half of that room's floor space. You can also deduct the floor space for inventory should you have any, like the featured case mentioned above. Again, make sure nothing unrelated to your business takes place in that area.
2. Principal place of business
You must be able to accurately show that your home-office is your principal place of business. However, there are a few "if...then's" related to this requirement. If your business is based elsewhere, but you regularly conduct meetings with clients or customers at home in your office, that meeting space may qualify for the deduction, again as long as no family members are sharing that exclusive home office for other family needs like a toy room, guest bedroom, etc.. When it comes to an audit, it’s better to side with the meaning of exclusive with no gray area attached.
Here are some examples to consider:
- Holding occasional meetings at a dinner table for convenience? No. Why? This space is not exclusively used for your business. You use your dinner table to eat with your family and complete other personal tasks.
- Locking your kids out of the playroom because you need to work? No. Why? Again, this is not exclusive to business use. Though you may ask your kids to leave the from time to time, its main purpose is a playroom for your family and it’s shared for personal use.
- Conducting all business out of a non-shared room in house? Yes. Why? It’s exclusive -- the sole purpose of this space is conducting business.
Similarly, if you have a separate, free-standing structure on your home property such as a studio, workshop, or barn that you use solely and regularly for your business, then it too may be counted as a home-office deduction.
Regardless of how large or small your home-office is, make sure you accurately measure the floor space and divide it by your home's total square footage to determine the deductible percentage for the expenses mentioned above. Most accounting and business tax preparation software programs have built-in features to make these calculations; all you need to do is plug in the correct numbers.
Finally, accurate record-keeping is also important for a couple of reasons. First, I suggest you keep records of when you hold meetings and use your space exclusively for business in your home. Secondly, keeping accurate records are critical because the home-office deduction comes into play when you sell your home and most people don’t consider that factor. Keep that in mind and get busy building your successful business.