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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:
- The home office is the principal place of business for your
business.
- There must be a separately identifiable place in your home for
the business.
- 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:
- 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.)
- 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.
- 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 |
