The low startup cost of building a business at home provides an opportunity for people to supplement their income, monetize their hobbies, or even make their dream jobs come true. Home businesses can also be subject to tax deductions that make the process a little easier.
Here’s how your home business can leverage certain tax deductions that may save you money in the long run.
The ‘exclusive use’ test
Broadly speaking, you must be able to show that a portion of your home is your principal place of business, and that this space is regularly and exclusively used for conducting business. If you do not have a dedicated space for business in your home, you are not allowed to take the home office deduction. The IRS refers to this as the “exclusive use” test.
For instance, a spare room in your home that is only used as your business office can be claimed for the home office deduction. However, a bedroom or living room where you work on business tasks cannot be claimed, because you use those spaces for other personal purposes.
There are exceptions to the "exclusive use" test, including businesses that store inventory or product samples or use their home as a daycare facility.
Additionally, you must be a registered business owner or independent contractor to take the home office deduction. You cannot take the home office deduction if you simply work from home as an employee of a business.
[Read: How the Small Business Sector Has Grown Throughout the Pandemic]
What can I deduct from my taxes as a home-based business?
The following list contains the most common deductions home-based business owners claim on their tax returns. Consult with an accountant or financial professional to determine whether you are eligible for any of these deductions or any others that exist outside this list.
Home-related expenses
Home office-related deductions are based on the percentage of your home that you use for business. To obtain this number, divide the square footage of your office space by the total square footage of your home. It is important that these calculations are accurate and that you only deduct the appropriate percentage of each expense.
If you do meet IRS guidelines, you can deduct the following home-related expenses:
- Homeowner's insurance.
- Homeowners association fees.
- Cleaning services or cleaning supplies used in your business space.
- Mortgage insurance and interest.
- Utilities, including electricity, internet, heat and phone.
Repairs and maintenance
If you make home repairs or upgrades related directly to your business space, you may also write these expenses off on your taxes. The amount you can write off depends on whether the expense is direct (it only benefits your home office) or indirect (it benefits your entire home).
- Direct: If you spend $100 to fix a window in your home office, you may deduct the full $100 on your taxes.
- Indirect: If you pay $1,000 to repair a leak in your roof, you may only deduct a percentage of that expense equivalent to the percentage of your home used for business.
Other business expenses
To qualify as a deductible, a business expense must be considered both ordinary and necessary, meaning the expense is common and helpful for your trade or industry. The following expenses may be deducted on any home-based business tax return, regardless of whether you are eligible for the home office deduction:
- Cost of goods sold. If your business manufactures products or purchases them for resale, you can include some of your expenses to calculate the cost of goods sold. The following expenses can be figured into the cost of goods sold: storage, factory overhead, direct labor costs and the costs of products or raw materials, including freight.
- Capital expenses. Capital expenses are costs that you are required to capitalize, rather than deduct, because they are a part of your investment in your business and are, therefore, considered a business asset. In general, the three types of costs you can capitalize are business startup costs, business assets and improvements.
- Business use of your car. If you use your car as a part of your business, you are allowed to deduct certain car expenses. As with home expenses, the vehicle use for business deduction must be calculated based on the percentage of miles driven for business purposes, versus personal trips.
- Employee payments. Generally, you can deduct the cost of paying employees.
- Retirement plans. This type of savings plan offers tax advantages when you and your employees set aside money for retirement.
- Rent expenses. According to the IRS, rent is any amount you pay for the use of property that you do not own. Rent deduction is only applicable if you do not and will not receive equity in or title to the property.
- Interest. If you borrowed money for business activities, you may deduct the interest expense.
- Business taxes. You are allowed to deduct various federal, state, local and foreign taxes that directly affect your trade or business.
- Business insurance. You can deduct insurance as a business expense if it is both ordinary and necessary for your trade, business, or profession.
- Travel expenses. You can claim a deduction for travel-related expenses if you reimburse them under an accountable plan.
- Supplies and materials. You can generally deduct the cost of business-related supplies and materials consumed or used within a tax year.
- Professional services. Fees incurred from professional services that are ordinary and necessary, such as accounting, consulting, legal or contract labor, can be deducted as a business expense.
- Marketing and business development. Generally, expenses that are used to find new customers and keep existing clients can be deducted.
The IRS provides a detailed explanation of these types of expenses and what is eligible for deduction.
[Read: Tax Basics for Businesses]
While the IRS rules about home office deductions are very strict, it's not automatic that you will get audited simply for claiming your home office.
How to calculate the home office deduction
There are two different methods you can utilize when calculating and determining home office deductions: the regular method and the simplified method.
Regular method
First, you can go by the percentage of your home which is being used for business. This works by measuring the size of your home office as a percentage of the total square footage of your residence. For example, if your office was 75 square feet and the total area of your home is 1,000 square feet, the calculated business percentage would be 7.5%.
Any direct business expenses can be deducted in full, and any indirect expenses can be deducted at that business percentage. (If you are filing your taxes as a self-employed person through Form 1040, you can use Form 8829 for outlining the business use of your home.) In keeping with our example, you could deduct 7.5% of your rent or mortgage since that money is spent on your office space. You can generally apply that thinking to your electric and internet bills as well.
If you only use a home workplace or office part of the time, you will need to calculate the percentage of time that you use the percentage of space.
Simplified option
A simpler calculation would be to divide the number of rooms in your home you use for business by the number of rooms in the house; however, this calculation is only accurate if all the rooms in your house are a similar size. Special rules also apply for certain professions, such as those who use their home as a daycare.
The second method for claiming a deduction uses a determined rate, which is then multiplied by the amount of square footage that is being used for business within the home. The prescribed rate can change from year to year, and in 2023, is currently set at $5 per square foot with a 300-square foot maximum. This would mean that a deduction for an office measuring 200 square feet would be $1,000, because you’d multiply the square footage by the $5 per square foot rate (200 sq. ft. x $5 per sq. ft.).
Which method is best for you?
While the second, simplified method may be easier to calculate and claim the deduction, it may not offer entrepreneurs all the deductions they qualify for. In 2023, the simplified method will only allow for up to $1,500 in deductions. Take a look at your receipts and expenses from the year to see if the $1,500 limit is a good fit for you. The simplified option will likely work best for those just starting freelancing or a small business since they will likely have fewer expenses.
If your business is more developed and has more expenses, the regular option should be a better fit. With a $10,000 maximum deduction, the regular option can encompass all the details of your home business: a new office chair, a Hootsuite subscription, or painting the office. Not all expenses will qualify for the maximum $10,000 deduction, and eligibility and qualifications may change from year to year. It’s important to stay up to date on the current qualifications and rules for a home office deduction.
Accounting tips for home-based businesses
Accounting is incredibly important for any business, but home-based business owners will need to pay special attention to their finances and expenses if they want to save the most money during tax time.
Here are a few key tips to exercise throughout the year in preparation for tax season:
- Create a separate space for your business. If you want to take a home office deduction, ensure your workspace meets the “exclusive use” test.
- Separate business and personal expenses. Maintaining distinctly separate accounts for business finances and personal finances will keep your books clean and organized when you need to evaluate your business income and expenses.
- Track all business use of personal assets. If you use assets like your laptop, cell phone and car for both business and personal purposes, be sure to keep a record of any business use so you can accurately calculate the percentage used for business.
- Account for estimated and self-employment taxes. Unlike a traditional job in which an employer withholds taxes, Social Security and Medicare payments from an employee’s check, business owners must pay these expenses. Sole proprietors, partners, LLCs and S corporations are generally required to pay estimated quarterly taxes.
- Set up an accounting system. To make tax season as easy as possible, implement a consistent, organized accounting system for yourself to keep track of receipts and invoices. Take special care with business dinners, work-related travel, vehicle expenses, and home office receipts.
- Prepare a profit and loss statement. Even if it isn’t required of you for other purposes, calculating your profits and losses leading into tax season can help minimize the likelihood of a surprise. It also gives you an opportunity to get your receipts in order and ready to be handed to the accountant.
- Establish a small business payroll if necessary. If you have any employees or independent contractors, you will need to have a payment schedule and the appropriate tax forms. Keep track of the name, address, and rate for each independent contractor in order to complete end-of-year forms.
- Factor in location. If you have clients in other states or countries, you may need to report income in those places as well. Additionally, you likely have to pay more taxes on international income. For these, keep track of the amount of income in USD instead of the country’s currency.
- Apply for funding. Consider applying for a small business loan, especially if your business has experienced hardship due to the pandemic or other external factors. Calculate the ROI of the loan, factoring in what expenses you hope it will cover, what you expect to gain from it, and how much the interest will set you back.
- Develop a system for review. The tax practices of a small, budding freelance business vs. the needs of a larger company with multiple employees will be wildly different. Schedule and conduct periodic reviews of your accounting methods so you can adjust as needed. Additionally, keep an eye on the time and cost of your accounting methods so you can gauge your need for external support.
- Consider using accounting software. Implementing accounting software can cut down on the time and cost you spend preparing for tax season. This is where your previous calculations come in. If the cost of accounting software makes sense for you, the right software can be a great fit for small and home-based businesses.
- Hire an accountant. You can learn a lot about accounting and tax regulations through independent online research, but there's no substitute for the advice of an experienced professional. Follow our guide to choosing an accountant if you're looking for the right CPA or accounting firm for your business.
Will I get audited by the IRS if I take the home office deduction?
It is a common belief that claiming the home office deduction will automatically trigger an IRS audit; however, while the IRS rules about home office deductions are very strict, it's not automatic that you will get audited simply for claiming your home office. There are measures you can take to reduce your chances of getting audited.
Before taking the home office deduction, you’ll want to make sure your business qualifies to avoid claiming any deductions you aren’t eligible for. Maintain records of all your business expenses and purchases, and ensure that your residence, home office usage, and type of employment qualify for this expense.
The IRS has an automated system that helps detect red flags. The system will compare your tax situation and deductions to others in your industry. If you claim something that others in your profession don’t generally claim, or claim “too much” space in your home as your home office, the system may see that as a red flag and lead the IRS to investigate further.
If you do decide to take the home office deduction, it's essential to follow the IRS guidelines to the letter, as they change somewhat frequently.
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