There are a variety of tax deductions, but this series will address only business deductions for an unincorporated business, sole proprietorship, or single-member LLC. These expenses are reported on Schedule C of your income tax return.
But first, some important definitions:
Deductions (also known as “tax write-offs”) are amounts permitted by law to be subtracted from your gross income. The general rule is that an item may not be deducted unless the tax law specifically permits it.
Deductions are characterized as expenses, losses, or exemptions. For this series, we only care about EXPENSES incurred in your trade or business. Your business can be your own name, like mine (Renee Taylor, CPA), or it can be something entirely different (Accounting Wizardry, LLC).
An expense is money you’ve spent in the current period (generally meaning the current calendar year) in order to earn income. Those last five words are very important. An expense is not the cash you shelled out on chew toys to keep Fido entertained while you interact with your clients — despite however convenient Fido’s good behavior is for your ability to conduct business with a measure of sanity and grace. A happy Fido doesn’t contribute directly to your ability to earn income, so those toys aren’t deductible business expenses.
To be deductible, business expenses must have a business purpose that exceeds any tax avoidance motive. The primary motive for the transaction must be to enhance your ability to earn a profit.
Business expenses must also be ordinary, necessary, and reasonable. These are important terms with specific definitions, but like all things tax, they’re open to interpretation. It’s best to ask a tax adviser if you have questions.
“Ordinary, Necessary, and Reasonable”
Ordinary: The expense must be of a kind commonly incurred in your particular business. It doesn’t have to occur frequently or regularly. Oils for massage therapists, software for web designers, shears for hair stylists — things of that nature are ordinary expenses for their respective businesses.
Necessary: To be deductible, the expense must be appropriate and helpful to your income-producing activity. It does not have to be essential in order to be necessary. Your trip to the office supplies store is necessary, but your trip to the Bahamas is generally not.
Reasonable: The expense must be reasonable in amount. This issue most often comes up in transactions involving related parties. So if you’re paying your dad $1,250 rent per month for office space in a building that he owns, when rents in your area are normally $750, that excess $500 is considered a non-deductible payment (or gift) to Dad.
And now after all those definitions, let’s look at our first deductible expense.
EXAMPLE: I’m a copywriter who works out of my home. Can I claim a tax deduction for my home office?
UPDATE: In January 2013, the IRS provided a new “safe harbor” method of calculating the home office deduction that may be used instead of Form 8829 described below. The new optional deduction is capped at $1,500 per year based on $5 per square foot for up to 300 square feet. More info can be found here — or by asking your trusty accountant.
Taxpayers who operate a trade or business from home can claim certain deductions (such as mortgage interest, property taxes, insurance, and repairs) on IRS Form 8829 if the area in the home where business is conducted meets both parts of what’s called the Use Test:
- It’s used exclusively for carrying on the trade or business. For example, if your home office is also the living room where you watch TV and hang out with friends, it’s not used exclusively for business.
- It’s used regularly and on a continuing basis as the principal place of business or as a place to meet clients or customers. For example, an attorney works three days downtown in an office. On the other two days per week, he meets with clients and does administrative work in his home office. The home office qualifies for a deduction.
Deductible expenses are allocated proportionally between the home office and the areas of the home used as a residence. Common ways to allocate expenses are based on the total number of rooms in the house, or the total square footage of the home office relative to the total square footage of the house.
Furthermore, the amount of the home office deduction cannot exceed whatever business income remains after deducting all other business expenses unrelated to the home office. (Ummm, wtf did I just say? Basically if your regular business expenses — software, advertising, supplies, licenses and permits, professional fees, and the like — are greater than the income you earn from your business, you can’t take the home office deduction but must carry it forward to a future tax year. This is known as the “home office income limitation.”)
Here’s a super simplified example with a tiny bit of math
Suzie uses one room in her house as the primary location for her graphic design business. Her home is 1,800 square feet. The office area is 250 square feet or 14% of the total area. This year, Suzie pays $5,000 in mortgage interest and real estate taxes, and $3,500 in insurance, repairs, and maintenance related to her home. Depreciation on the house for the current year is $3,000. Suzie earns $40,000 from her graphic design business this year, and has $13,000 in other business expenses. What is Suzie’s allowable home office deduction?
Remember the income limitation discussed above? Let’s see if Suzie meets it.
$40,000 gross income – $13,000 business expenses = $31,000 net income.
So Suzie’s home office deduction can’t exceed $31,000. Safe to say that probably won’t happen. But switch up the variables a little bit and the scenario changes. If she doesn’t make much money, or she bought a ginormous house at the top of the real estate bubble and has a huge mortgage payment…well, then she probably has bigger things to worry about besides whether or not she’s eligible for the home office deduction.
But in our scenario she’s not only profitable, she gets to take the deduction. And what amount is that? Suzie simply multiplies her home expenses by 14% (the total area of her home office) and reports that amount on Schedule C of Form 1040.
Interest and taxes: $5,000 x 14% = $700
Insurance, repairs,and maintenance: 3,500 x 14% = $490
Depreciation: $3,000 x 14% = $420
Total home office deduction: $1,610
Please note that this post serves as just a broad overview of the home office deduction and shouldn’t be relied upon as tax advice. There are other limitations to consider, not to mention the complicated calculation of depreciation on the residence (which is best left to tax software or your accountant).
For more information, you may read the
sleep-inducing helpful IRS Publication 587 or talk with your tax adviser.