Lesson 4 - What you need to know when you run your business out of your home

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Overview

Qualifying for the business use of the home deduction

Exclusive use test

Exceptions to the exclusive use test

Regular use test

Principal place of business test

Activities that don't disqualify your home office

Meeting place for customers test

Separate structure test

Deduction limits

Business percentage

Area method

Rooms method

Recording business percentage

Types of expenses

Expenses related to the business activity

Expenses related to the business use of the home

Direct expenses

Indirect expenses

Unrelated expenses

Deductible expenses

Deductible only when you use home for business

Deduction limits - Gross Income

Example - Determining the home office deduction

What you can't do . . . .

Selling your home when you used it for business

Recordkeeping

Illegal Tax Avoidance Schemes

Lesson Review

Overview

Hello, and welcome to What You Need to Know When You Run Your Business out of Your Home.

In this lesson, we'll provide information on calculating and claiming the deduction for business activities in the home as well as business use of the home. We'll review the requirements you must meet to qualify for a deduction, how to determine the business percentage of home use, the types of expenses you can and cannot deduct either in full or according to the percentage, how to determine the limits on deductions, and where to deduct the expenses on your return. And that term home includes a house, apartment, condominium, mobile home, boat, or similar property which provides basic living accommodations. It also includes structures on the property such as an unattached garage, studio, barn, or greenhouse.

Qualifying for the business use of the home deduction

So, let's start with qualifying for the deduction for business use of the home. 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 exclusively used for your business; second, it must be regular, and third, it must be for your business. That is, the business part of your home must be one of the following: your principal 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 that you use in connection with your business.

First, let's look at the exclusive use test. To qualify under the exclusive use test, you must use that 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, even if not marked off by a permanent partition. You do not meet the requirements of the exclusive use test if you use the area both for business and for personal purposes.

Now it's time for you to test your knowledge. Do you know if this situation qualifies as a business deduction?

Hi, I'm Ruth, and I'm a graphic designer. My computer is in the family room, and that's where I do my design work. My family also uses the room for recreation. Can I claim a business deduction for the use of my family room?

Can Ruth claim a business deduction for the use of the family room?

Actually, because Ruth does not use the family room exclusively for her business, she cannot claim a business deduction for its use.

You're correct. Because Ruth does not use the family room exclusively for her business, she cannot claim a business deduction for its use.

Okay, let's look at another example.

Hi, I'm Greg, and I brew natural sodas in my garage. The garage is not attached to my house, and I use this garage only for brewing and selling.

One part of the garage is used for the brewing, and another part of the garage is where I conduct tastings and sell the soda.

Do I meet the requirements of the exclusive use test?

Does Greg meet the requirements of the exclusive use test?

You're correct. Greg is allowed to claim a deduction for the business use of his garage.

The use is exclusive, regular, and for his business. Actually, Greg is allowed to claim a deduction for the business use of his garage. The use is exclusive, regular, and for his business. 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 if you use part of your home as a daycare facility. Storage of inventory and daycare facilities have separate requirements.

The next test is 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 this test if your business use of that area is only occasional or incidental, even if you do not use that area for any other purpose. Okay it's time to test your knowledge. Let's look at an example.

Hi, I'm Tom, and I'm a painter. I have a separate studio in my home that sometimes I paint in, but most of the time I'm painting outdoors.

Can I claim a business deduction for the use of my studio?

Can Tom claim a business deduction for the use of his studio?

Actually, Tom cannot claim a business deduction for the use of his studio as he uses the studio only occasionally and not on a continuing basis. You're correct. Tom cannot claim a business deduction for the use of his studio as he uses the studio only occasionally and not on a continuing basis.

The final test is the principal 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 principal place of business. To determine this, you must consider all of the facts and circumstances. Your home office will qualify as your principal place of business for deducting expenses for its use if you use your home office 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?

Common activities would include billing customers, keeping books and records, ordering supplies, setting up appointments, and forwarding orders or writing reports. There are activities that you might think disqualify your home office as your principal place of business, but they don't. For example, employing others to conduct your administrative or management activities at locations other than your home, or conducting administrative or management activities at places that are not fixed locations of your business, such as in a car or in a hotel room, does not disqualify your home office as your principal place of business. Occasionally conducting minimal administrative or management activities at a fixed location outside of your home also does not disqualify your home office as your principal place of business.

Finally, the last activity that does not disqualify your home office as your principal place of business is conducting substantial, non-administrative, or non-management business activities at a fixed location outside of 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. Okay, let's take a look at an example and see if you can answer Joe's question.

Hi, I'm Joe, and I'm a self-employed plumber. Most of my time is spent at customers' homes and offices installing and repairing plumbing. I have a small office in my home that I use exclusively and regularly for administrative or management details of my business-- phoning customers, ordering supplies, and keeping books. I don't do my own billing; instead, I use a local bookkeeping service to bill my customers. Does my home office qualify as a principal place of business?

Does Joe's home office qualify as a principal place of business for deducting expenses for its use?

You're correct. Joe's home office qualifies as his principal 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. Joe's business meets all the qualifications, including principal place of business; therefore, Joe can deduct expenses to the extent of the deduction limit for the business use of his home.

Actually, Joe's home office does qualify as his principal 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 principal place of business. Joe's business meets all the qualifications, including principal place of business; therefore, Joe can deduct expenses to the extent of the deduction limit for the business use of his home.

Okay, let's look at the next test.

If you don't meet the principal 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 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. Okay, it's time to test your knowledge. See if you can answer Sarah's question.

Hi, I'm Sarah, and I'm an interior decorator. Because of all the samples and pattern books I have, it's usually better for clients to come visit me to look at samples and patterns. I have a room designated exclusively for this purpose, and conduct all administrative and management functions there-- scheduling appointments, preparing design presentations, and book- and recordkeeping. After clients decide on what they want, I spend the rest of the project at their home, supervising the painting, the wallpapering, and the furniture placement. Does my home office qualify as a principal place of business for deducting expenses for its use?

Does Sarah's office qualify as a principal place of business for deducting expenses for its use?

You're correct. Sarah's home office does qualify as a principal place of business for deducting expenses for its use under the meeting place for customers test. Although she carries on most of her business in other people's homes, she does meet with clients in her home in the normal course of business.

Actually, Sarah's home office does qualify as a principal place of business for deducting expenses for its use under the meeting place for customers test. Although she carries on most of her business in other people's homes, she does meet with clients in her home in the normal course of business.

Here's the last test, and it's called the separate structure test.

You can deduct expenses for a separate free standing structure such as a studio, garage, studio shed, or barn if you use it exclusively and regularly for the business. The structure does not have to be your principal place of business or a place where you meet patients, clients, or customers.

Let's now test your knowledge. See if you can answer Joanne's question.

Hi, I'm Joanne. I build custom-designed furniture in my detached garage, but when clients and I discuss the plans together, we talk in the dining room of my house. Does my garage qualify as a separate structure?

Does Joanne's garage qualify as a separate structure?

You're correct. Because Joanne's garage is a separate structure and is used exclusively and regularly in her business, she does not have to meet clients there to be eligible to deduct the expense for its use, subject to the deduction limit.

Actually, because Joanne's garage is a separate structure and is used exclusively and regularly in her business, she does not have to meet clients there to be eligible to deduct the expense for its use subject to the deduction limit.

Deduction limits

And now, let's discuss those deduction limits. Because 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, also known as the business percentage. To calculate 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, but we're going to discuss... two commonly used methods for figuring the percentage: the area method, and the number of rooms method. To use the area method, divide the area used for business by the total area of your home.

For example, if your office is 2 hundred and 40 square feet, and your home is 12 hundred square feet, your business percentage would be 20 percent; that is, 2 hundred and forty divided by 12 hundred. To use 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 house are all about the same size. For example, if you have ten rooms in your house, and you use one of them for your office, your business percentage would be 10 percent; that is, 1 divided by 10.

Now that you know how to calculate business percentage, here's where you record it. Use Part One of Form 8829, Expenses for Business Use of Your Home, to calculate the business percentage of your home business.

Types of expenses

Now that we've discussed all the tests for the business use of the home, let's look at the types of expenses. There are two types of expenses related to using your home for business. The first are expenses related to the business activity in the home, but not to the use of the home itself. The second expenses are for the business use of the home, and these expenses are divided into three categories: direct expenses, indirect expenses, and unrelated expenses.

Let's discuss the first type of expenses, business expenses related to the business activity in the home. These expenses are the ordinary and necessary expenses, such as advertising, business taxes, car and truck expenses, salaries, supplies, and travel. These expenses are not limited to the business use of the home percentage or the deduction limit, and they are deductible in full on Schedule C Form 1040, Profit or Loss from Business.

The second type of expenses is for the business use of the home. As we mentioned above, expenses for the business use of the home are divided into three categories: direct, indirect, and unrelated expenses. The part of a home operating expense that you can use to calculate a deduction depends on whether the expense is direct, indirect, or unrelated, as well as the percentage of your home that is used for your business.

Direct expenses are expenses only for the business part of your home; these expenses are generally deductible in full, unless subject to the deduction limit, which we will be discussing soon. A good example is painting or repairs made only in the area used for business or having high speed internet service for your business so you can advertise business through your Website and communicate via email with customers.

Indirect expenses refer to expenses for running your entire home but are deductible based on the percentage of your home used for business. They may also be subject to the deduction limit. Examples of indirect expenses are homeowners insurance, utilities, and general repair such as a new roof or gutter cleaning.

Unrelated expenses are expenses from the parts of the home that are not used for business, such as lawn care or improvements to rooms not used for the business. These expenses are not deductible. Certain expenses are deductible whether or not you use your home for business. If you qualify to claim business use of your home expenses, you can use the business part of these expenses to calculate your business use of the home deduction. These expenses are real estate taxes, deductible mortgage interest, qualified mortgage insurance premiums, and casualty losses. There are, however, 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 the deduction limits we mentioned earlier. 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, however, the gross income from that business is less than your total business expenses, your deduction for certain expenses for the business use of your home is limited. These expenses are limited to the gross income from the business use of your home minus the following: ordinary and necessary business expenses, as well as the business part of the expenses, such as your mortgage interest, real estate taxes, and casualty losses, that you could deduct even if you did not use your home for business. Expenses that cannot 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 calculate 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. Let's look at an example.

Let's work with Miguel, a small business owner, to help him determine his home office deduction. Miguel already has a copy of Form 8829, Expenses for Business Use of Your Home as well as the instructions to complete Form 8829. To start... let's look at Part One, Part of Your Home Used for Business.

First, Miguel, you need to determine the area of your home used regularly and exclusively for your business and enter that number on line 1.

That would be 2 hundred and 50 square feet, so I enter 2 hundred and 50.

Next, enter the total area of your home on line 2.

And that would be 25 hundred square feet, so I enter 25 hundred.

Now, divide the area of your home used for business by the total area of your home.

That is, divide line 1 by line 2 and enter the result as a percentage on line 3. Let's see, 2 hundred and 50 divided by 25 hundred comes to 10 percent.

Miguel, because you are not operating a home daycare business, you can skip lines 4, 5, and 6. Instead, reenter the percentage from line 3 on line 7. And that's it, Miguel, you have completed Part One.

So far, so good. With Part One completed, we're now on to Part Two.

In Part Two, Miguel, you'll calculate your allowable deduction.

We start with line 8, where, Miguel, you'll enter the amount from Schedule C, line 29, plus any gain derived from the business use of your home and shown on Form 1040 Schedule D, Capital Gains and Losses, or Form 4797, Sales of Business Property, minus any loss from the trade or business not derived from the business use of your home and shown on Schedule D or Form 4797.

Could you run that by me again?

I know it sounds confusing, so let's go over line 8 in more detail. If all the gross income from your trade or business is from the business use of your home, the source for your entry on line 8 is the amount from Schedule C, line 29. But don't write in that number yet. To that number, add any gain derived from the business use of your home and shown on Form 8949, Sales and other Dispositions of Capital Assets, or Form 4797, Sales of Business Property, and subtract any loss shown on Form 8949 or Form 4797 that are allocable to the trade or business in which you use your home but are not allocable to the use of your home. What if someone files more than one Form 8829? If a business owner files more than one Form 8829, include only the income earned and the deductions attributable to that income during the period you owned the home for which Part I was completed.

Miguel, how are you doing?

I think I'm doing okay. It looks like line 8 comes to 25 thousand, 5 hundred, and 50 dollars.

Great. Now, let's look at lines 9 through 22. You'll see that most of those lines have two columns, one for direct expenses and one for indirect expenses.

Enter as direct or indirect expenses only expenses for the business use of your home; that is, expenses allowable only because your home is used for business. For lines 9, 10 and 11, though, enter only the amounts that would be deductible whether or not you used your home for business; that is, amounts allowable as itemized deductions on Form 1040 Schedule A, Itemized Deductions, or amounts allowable for net disaster loss on Form 1040A or Form 1040 Schedule L, Standard Deduction for Certain Filers. If you did not operate a business for the entire year, you can deduct only the expenses paid or incurred for the portion of the year you used your home for business.

Other expenses not allocable to the business use of your home, such as salaries, supplies, and business telephone expenses, are deductible elsewhere on Schedule C and should not be entered on Form 8829.

Can you remind me of the difference between direct and indirect expenses?

Sure. Direct expenses benefit only the business part of your home. They include painting or repairs made to the specific area or rooms used for business. Enter 100 percent of your direct expenses on the appropriate line in column a. Indirect expenses are for keeping up and running your entire home. They benefit both the business and personal parts of your home. Generally, enter 100 percent of your indirect expenses on the appropriate line in column b. I would like to point out an exception, however. If the business percentage of an indirect expense is different from the percentage on line 7, enter only the business part of the expense on the appropriate line in column a, and leave that line in column b blank.

For example, suppose your electric bill is 8 hundred dollars for lighting, cooking, laundry, and television. If you reasonably estimate 3 hundred dollars of your electric bill is for lighting and you use 10 percent of your home for business, enter 30 dollars on line 20 in column a. Do not make an entry on line 20 in column b for any part of your electric bill.

Okay, let's see what I can enter into those lines and columns. Those expenses are 45 hundred dollars for deductible mortgage interest and 1 thousand dollars for real estate taxes, and they relate to my entire home. So, I enter them in column b on lines 10 and 11, respectively. I add lines 9, 10, and 11, and enter the total, 55 hundred dollars, on line 12.

And for line 13, Miguel, you're going to multiply line 12, column b, by line 7.

So I multiply 55 hundred dollars by 10 percent-- that's the business percentage I calculated earlier-- and that comes to 5 hundred and 50 dollars.

For line 14, then, you are going to add line 12, column a, and line 13. That would be the 5 hundred and 50 dollars, the business part of these expenses. For line 15, subtract line 14 from line 8. So I would subtract the 5 hundred and 50 dollars that I entered on line 14 from the 25 thousand, 5 hundred, and 50 dollars that I had entered on line 8. That result is 25 thousand dollars. And that 25 thousand dollars would be the most you could deduct, Miguel, for other home office expenses.

The third step is calculating your deductions for the operating expenses for your home.

Let's see, I paid 3 hundred dollars to have my office repainted.

And you enter that 3 hundred dollars on line 19 in column a. All your other expenses you would enter on the appropriate lines in column b.

And that would be... 4 hundred dollars for homeowners insurance, and that would be entered on line 17 in column b. Then there's the 14 hundred dollars for roof repairs-- I enter that on line 19 in column b. Finally, there's the 18 hundred dollars for gas and electric related to my entire home, so I enter that on line 20 in column b. These expenses total to 36 hundred dollars.

For line 22, Miguel, you're going to add lines 16 through 21, for both the direct and indirect expenses.

That's easy-- a total of 3 hundred dollars for direct expenses, and a total of 36 hundred dollars for indirect expenses.

And because you use only 10 percent of your home for business, Miguel, the business part of those indirect expenses is 3 hundred and 60 dollars, and that's the number you would enter on line 23.

As you don't have any carryover of operating expenses from last year, let's go to line 25.

Here, you'll add line 22, column a, line 23 and line 24, if it applies.

So I add the 3 hundred dollars of direct expenses from line 22, column a, to the 3 hundred and 60 dollar total for the indirect expenses on line 23. I don't have anything for line 24, so on line 25 I would enter the total, 6 hundred and 60 dollars.

And, Miguel, because that amount is less than your deduction limit of 25 thousand dollars from line 15, you can deduct it in full. And remember, the 24 thousand, 3 hundred, and 40 dollar balance of your deduction limit, from line 27, is the most you could deduct for depreciation. You can calculate your allowable depreciation for the business use of your home in Part Three of Form 8829.

I've already completed that part. My allowable depreciation is 2 hundred and 70 dollars.

You're going to enter that 2 hundred and 70 on both lines 41 and 29.

Looks like I'm nearly done. What's left?

First, you're going to complete lines 31 and 32. Then, you are going to complete line 33 by adding together the business portion of your otherwise deductible expenses from line 14, your operating expenses from line 26, and your depreciation from line 32. That total is 1 thousand, 4 hundred, and 80 dollars. Because you didn't have any casualty loss portion entered on line 34, you will also enter the 1 thousand, 4 hundred, and 80 dollars on line 35. That number represents the allowable expenses for business use of your home. And don't forget to enter that same number on Schedule C, line 30.

Finished! Thanks for the information. This wasn't as difficult as I thought it would be.

We're glad we could help, Miguel. The material we just covered with Miguel was one example of how to complete Form 8829. Your situation may be different, and we encourage you to read the instructions to Form 8829 for more information as well as consult with a tax practitioner, if necessary.

Let's say that Miguel was just starting out and his tentative profit turned out to be 13 hundred dollars instead of 25 thousand, 5 hundred, and 50 dollars. In this case, he would subtract the business part of his mortgage interest and taxes, 5 hundred and 50 dollars, to calculate his deduction limit of 7 hundred and 50 dollars. In addition, he could still deduct the entire 6 hundred and 60 dollars he calculated for the business part of the operating expenses for his home. He could only claim 90 dollars of the 2 hundred and 70 dollars for depreciation; however, he could carry forward the remaining 1 hundred and 80 dollars to a year when he has more income. The point here is that you cannot 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.

Now, let's talk a little about business owners deducting 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. IRS Publication 587, Business Use of Your Home, has further information on all of the above topics. Like our other publications, you can find it online at www.irs.gov.

Selling your home when you used it for business

If you used your home for business, some special rules apply when you sell it at a profit, or what is sometimes referred to as a gain. Briefly, you pay tax on the part of the gain that is equal to what you claimed or could have claimed for depreciation over the years. For more information on the sale or exchange of a home, see IRS Publication 523, Selling Your Home.

Recordkeeping

We'd also like to remind you about the importance of recordkeeping, which was covered in an earlier lesson.

Recordkeeping is vital when you have a home business, and you must keep records that provide the information needed to calculate your deductions for the business use of your home.

Illegal Tax Avoidance Schemes

Also, we want to touch on a tax avoidance scheme related to home-based businesses. 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 then claim personal expenses as business expenses. No matter how convincing any information you read about this might be, non-deductible personal living expenses cannot be transformed into deductible business expenses. We encourage you to go to www.irs.gov for information on how to avoid these types of schemes.

Lesson Review

Let's review what we've learned. In this lesson, we discussed the requirements you must meet to qualify for a deduction for the business use of your home, how to determine the business percentage of home use, the types of expenses you can and cannot deduct either in full or according to the percentage, how to determine the limits on business use of the home deductions, and where to deduct the expenses on your return. We've also briefly talked about the effect of claiming these expenses when you sell your home, recordkeeping requirements, and tax avoidance schemes. Remember, IRS Publications 587 and 523 can provide more information; we also encourage you to visit the Small Business and Self-Employed Tax Center at www.irs.gov/smallbiz. It is also important to note that there are special rules that apply to home-based daycare providers.

If you run a daycare business from your home, you'll find the special rules and publications that apply to your business at www.irs.gov/smallbiz.

Thank you for joining us for this lesson on home-based businesses. Best wishes on your home-based business.