Lesson 4 - Business use of your home
Small Business Tax Workshop

    Overview

    Welcome to the workshop on business use of your home.

    In this program we will provide information from 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 make 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 in an unattached garage, studio, barn, or greenhouse.

    Simplified Home Office Deduction

    The simplified method as announced in Revenue Procedure 2013 — 13 is an easier way than the method provided in the Internal Revenue Code, (the standard method) to determine the amount of expenses you can deduct for a qualified business use of a home.

    The standard method has some calculation, allocation, and substantiation requirements that can be complex and burdensome for small business owners.

    The simplified method is intended to reduce that burden.

    The simplified method or optional deduction is capped at  $1,500 per year based on $5 a square foot for up to 300 square feet.

    You may elect to use either the simplified method or the standard method for any taxable year.

    However once you have elected a method for a taxable year, you cannot later change to the other method for that same year.

    You cannot use the simplified method for a taxable year and deduct actual expenses related to the qualified business use of the home.

    The amount allowed as a deduction when using the simplified method is in lieu of a deduction for your actual expenses.

    Qualifying for business use of the home deduction – Exclusive Use Test

    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.

    Test Your Knowledge

    Now it's time for you to test your knowledge.

    This is Ruth and she is a graphic designer.

    Her computer is in the family room and that's where she does her design work.

    Her family also uses the room for recreation.

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

    The answer is no.

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

    Test Your Knowledge

    OK. Let's look at another example.

    This is Greg.

    And he brews natural sodas in his garage.

    The garage is not attached to his house and he uses 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 he conducts tastings and sells the soda.

    Does Greg meet the requirements of the exclusive use test?

    The answer is yes.

    Greg can 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 day care facility.

    Storage of inventory and day care facilities have separate requirements.

    Regular Use Test

    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.

    Test Your Knowledge

    OK it's time to test your knowledge.

    Let's look at an example. This is Tom, and he's a painter.

    He has a separate studio in his home that he sometimes paints in but most of the time he's painting outdoors.

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

    The answer is No.

    Tom cannot claim but this just deduction for the use of a studio as he uses the studio only occasionally and not on a continuing basis.

    Principal place of business test

    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 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.

    Activities that don’t disqualify your home office

    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 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, not 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.

    Test Your Knowledge

    Okay let's look at an example to test your knowledge.

    This is Jim, and he's a self-employed plumber.

    Most of his time is spent at customer’s home and offices installing and repairing plumbing.

    He has a small office in his home that he uses exclusively and regularly for administrative or management details of his business: phoning customers, ordering supplies, and keeping books.

    Jim doesn't do his own billing.

    Instead he uses a local bookkeeping service to bill his customers.

    Does Jim's home office qualify as a principal place of business?

    The answer is yes.

    Jim'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 principal place of business.

    Jim's business meets all the qualifications including principal place of business. Therefore, Jim can deduct expenses to the extent of the deduction limit for the business use of his home.

    Meeting place for customers test

    OK 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.

    Test Your Knowledge

    OK, it's time to test your knowledge again.

    This is Sarah, and she's an interior decorator.

    Because of all the samples and pattern books she has, it's usually better for clients to come visit her to look at samples and patterns.

    She has a room designated exclusively for this purpose and conducts all administrative and management functions there.

    Scheduling appointments, preparing design presentations, and book and recordkeeping.

    After clients decide on what they want, she spends the rest of the project at their home supervising the painting, the wallpapering, and the furniture placement.

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

    The answer is 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.

    Separate structure test

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

    You can deduct expenses for a separate freestanding 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.

    Test Your Knowledge

    Let's now test your knowledge. This is Joanne, she builds custom designed furniture in her detached garage.

    But when clients and Joanne discuss the plans together, they talk in the dining room.

    Does her garage qualify as a separate structure?

    The answer is yes.

    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 240 square feet, and your home is 1200 square feet, your business percentage would be 20 percent.

    That is 240 divided by 1200.

    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 10 rooms in your house and you use one of them for your office, your business percentage would be 10 percent, that is one divided by 10.

    Now that you know how to calculate business percentage, here's where you record it.

    Use Part 1 of Form 8829, Expenses for Business Use of Your Home, to calculate the business percentage of your home business.

    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.

    Expenses related to the business activity in the home

    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.

    Business Use of the Home Expenses

    The second type of expenses is for the business use of the home. As we mentioned before, 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 web site 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.

    Deductible expenses

    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.

    Deduction limits – Gross Income

    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.

    Example – Determining the home office deduction

    Here's 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 1, Part of Your Home Used for Business. First, Miguel needs to determine the area of his home used regularly and exclusively for his business and enter that number on line one. That would be 250 square feet.

    So he enters 250.

    Next he would enter the total area of his home on line two and that would be 2500 square feet.

    So he enters 2500.

    Now divide the area of his home used for business by the total area of his home. That is, divide line 1 by line 2 and enter the result as a percentage on line 3. 250 divided by 2500 comes to 10 percent.

    Because Miguel is not operating a home day care business, he can skip lines 4,5, and 6.

    Instead he re-enters the percentage from line 3 on line 7. And that's it. Miguel has completed part 1.

    With Part 1 completed, we're now on to Part 2. In Part 2 we'll calculate Miguel’s allowable deduction.

    We start with line 8 where Miguel will enter the amount from Schedule C line 29 plus any gain derived from the business use of his 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 his home and shown on Schedule D or Form 4797.

    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 his home, the source for his 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 his 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 he uses his home but are not allocable to the use of the home.

    Note that 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 1 was completed.

    Miguel’s line 8 comes to $25,550.

    Looking 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 his home is used 9,10,for business. For lines 9,10, and 11 though, Miguel would enter only the amounts that would be deductible whether or not he used his home for business.

    That is amounts allowable as itemized deductions on Form 1040 Schedule A. If you do not operate a business for the entire year you can deduct only the expenses paid or incurred for the portion of the year you use 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.

    Let's again go over the difference between direct and indirect expenses.

    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 $800 for lighting, cooking, laundry, and television, if you reasonably estimate $300 of your electric bill for lighting and you use 10 percent of your home for business, enter $30 on line 20 in column A. Do not make an entry on line 20 in column B for any part of your electric bill.

    Ok. Let's see what Miguel can enter in those lines and columns.

    Those expenses are $4500 for deductible mortgage interest and $1,000 for real estate taxes and they relate to his entire home.

    So he enters them in column B on lines 10 and 11 respectively.

    He adds lines 9, 10, and 11 and enters the total, $5500 on line 12.  And for Line 13, Miguel will multiply line 12 column B by line 7.

    So he multiplies $5,500 by 10 percent.

    And that's the business percentage he calculated earlier and that comes to $550.

    For line 14 then, he'll add line 12 column A and line 13.

    Then he would subtract the $550 that he entered on line 14 from the $25,550 that he had entered on line 8.

    That result is $25,000 and that $25,000 would be the most Miguel could deduct for other home office expenses.

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

    Let's say Miguel paid $300 to have his office repainted and he entered that  $300 on line 19 in column A. All his other expenses would be entered on the appropriate lines in column B and that would be  $400 for homeowners insurance and that would be entered on line 17 in column B. Then there's the  $1,400 for roof repairs.

    He enters that on line 19 column B. Finally there's the $1,800 for gas and electric related to his entire home.

    So he enters that on line 20 in column B. These expenses total to $3,600.

    For line 22, Miguel will add lines 16 through 21 for both the direct and indirect expenses.

    That's a total of $300 for direct expenses and a total of $3600 for indirect expenses.

    And because he uses only 10 percent of his home for business, for Miguel, the business part of those indirect expenses is $360, and that's the number he would enter on  line 23, as he doesn't have any carryover of operating expenses from last year, so let's go to line 25.

    Here, he will add line 22, column A, line 23, and line 24, if it applies.

    So he adds the $300 of direct expenses from line 22, column A, to the $360 total for the indirect expenses on line 23.

    He doesn't have anything for line 24, so on line 25, he would enter the total $660.

    And because that amount is less than Miguel’s deduction limit of $25,000 from line 15, he can deduct it in full.

    And remember, the $24,340 balance of the deduction limit from line 27 is the most he could deduct for depreciation.

    Miguel can calculate his allowable depreciation for the business use of his home in part 3 of Form 8829.

    His allowable depreciation is  $270.

    He'll enter that $270 on both lines 41 and 29.

    The only thing left, is to complete lines 31 and 32.

    Then he'll complete line 33 by adding together the business portion of his otherwise deductible expenses.

    From line 14 his operating expenses from line 26 and his depreciation from line 32.

    That total is $1480.

    Because he didn't have any casualty loss portion entered on line 34, he will also enter the $1,480 on line 35.

    That number represents the allowable expenses for business use of Miguel’s home.

    And remember that same number gets entered on Schedule C line 30.

    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 profit turned out to be $1,300 instead of $25,550 In this case he would subtract the business part of his mortgage interest and taxes, $550, to calculate his deduction limit of  $750.

    In addition he could still deduct the entire  $660 he calculated for the business part of the operating expenses for his home.

    He could only claim $90 of the  $270 for depreciation.

    However he could carry forward the remaining  and eighty dollars to a year of 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.

    What you can't do

    Now let's talk a little about business owners 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 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 taxes 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.

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

    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 more information on how to avoid these types of schemes.

    Review

    Let's review what we've learned.

    In this lesson we've discussed the requirements you must meet to qualify for 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 day care 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 workshop on  home-based businesses. Best wishes on your business.