Are you considering starting a business out of your home or working a remote position for the first time? If you haven’t thought about how your state and federal taxes will be affected, you might want to hit pause for a minute to make sure your new venture is set up for success. Business might be booming, but you could be missing out on some major tax deductions.
Starting a Business Out of Your Home?
Whether you rent or own, if you use part of your home to run your business, you might be able to deduct expenses related to your business.
“The biggest mistake those who work from home make when filing their taxes is forgetting to claim deductions related to their home office all together,” says Mark Jaeger, director of Tax Development for TaxAct. “The beauty of a legitimate home office is it can turn what are normally considered nondeductible personal expenses into tax savers and ultimately reduce taxable business income if they qualify.”
How to Figure Out If You’re Eligible for Home Office Deductions
The Internal Revenue Services (IRS) identifies two basic requirements to qualify for home office deductions:
- You regularly use part of your home exclusively for conducting business
- You can prove your home is the main place you do business
“It’s important to remember a home office must be regularly and exclusively used for conducting business in order to take the deduction,” says Jaeger.
According to Amanda Kendall, licensed enrolled agent and owner of True Resolve Tax Professionals in Denver, that means “no kids playing on the computer after office hours; no workout equipment in the corner (unless you are a fitness trainer), no kids toys lying around, etc.” Kendall also says it’s preferred that your home office has a private entrance, but that’s not a requirement.
“In audits, we are starting to see where home offices are being disallowed if a taxpayer cannot prove a legitimate business purpose for the home office,” says Kendall. “Maintaining records is no longer being considered a legitimate purpose. What the IRS is looking for is if the office is used to produce income. For example, a sub-contractor who maintains his records in his office but gets all his work from one company and is not required to market himself or prospect his own jobs would not have a business purpose. However, a therapist who has a home office where patients are seen, records are maintained and billing is done has a legitimate home office business purpose.”
OK, I’m Eligible. Now What?
There are two ways to file for home office deductions: the “simplified option” and the “regular method.” The simplified option “significantly reduces record-keeping by allowing the filer to multiply a prescribed rate by the allowable square footage of the office in lieu of determining actual expenses,” says Jaeger. According to Gail Rosen, practicing CPA and owner of Gail Rosen, CPA, in New Jersey, deductions using the simplified option are calculated by multiplying $5 with the home’s square footage used for the qualified business use up to 300 square feet. This is limited to a maximum deduction of $1,500, according to Kendall. Depreciation, utilities or other home office expenses cannot be claimed using the simplified option.
Rosen says the regular method requires a lot more paperwork than the simplified option (there’s a reason it’s called the simplified option) because it involves multiplying your actual home office expenses by the business use percentage, which is the business square feet divided by total square feet. Here’s how the IRS breaks it down:
“I generally find that using the actual expense method [regular method] generates a larger tax deduction than the simplified method,” says Rosen. “Each year, I recommend that taxpayers review which method is most advantageous to them. The tax law allows us to switch methods, if beneficial, on a year-to-year basis.”
So what qualifies as home office expenses under the actual method?
“Anything you need to keep your business running is considered a business expense, including office supplies, computer equipment, advertising, and so much more,” says Josh Zimmelman, owner of Westwood Tax & Consulting in New York. That “so much more” might also include utilities, depreciation, insurance, garbage, mortgage interest, real estate taxes, rent, condo fees, repairs, security system, and snow plowing, according to Rosen, and landscaping costs, office furniture, and office decor, according to Jaeger.
Kendall recommends keeping a file folder just for home office deductions to make tax time way less stressful. “Every month when they get their utility bills, mortgage statement, etc., drop it into this folder so that at year’s end they are not scrambling to find what they paid in utilities for the year.”
Kendall also says it’s a good idea to take pictures of your home office after you’ve set it up so you have proof of what the home office looked like just in case you’re audited after you’ve moved to a new house.
Are You an Employee Working from Home?
You don’t have to be a business owner to deduct home office expenses. If you are employed by someone else and work from home, you might qualify for some home office deductions. Zimmelman says this is particularly true for people who work from home at the convenience of their employers as long as the employer is not paying the employee’s rent. If your employer requires you to use the Internet or the phone, you can deduct a percentage of your Internet and phone bills as long as your employer isn’t already reimbursing you, says Zimmelman.
“If you’re an employee of someone else’s business, you should keep a detailed log of when you’re working from home and the resources required to do so,” says Zimmelman. “You should save records of any expenses you paid for your business (e.g., receipts, cancelled checks, etc.); any evidence that your home office is used exclusively and regularly for business; any evidence related to your home’s depreciation; itemized phone bills and call logs; and records of your vehicle expenses and a mileage log.”
The IRS also offers detailed information on what’s considered a home office deduction for people who work from home, so make sure you consult them or a tax expert before filing.
Are you ready to file your 2016 taxes? Make sure you check out the tax software deals on FatWallet to find savings on tax software and other tax-related resources!