Many small business owners, consultants, freelancers, and the self-employed wonder what they are allowed for home business tax deductions to reduce their taxable income. Homeowners want to get the kind of savings legally allowed for these situations without triggering an IRS tax audit.
It’s good to arm yourself with the information you need in your tax return about which qualifying expenses are allowed for business use of your home. After all, we can use all the help we can get during tax season.
In this guide, we’ll go into detail about which items in your home can qualify for tax write-offs so that you can focus on putting any profits you earn back into growing your small business.
Common Tax Deductible Expenses for a Home Business
The IRS defines deductible expenses as the cost of carrying on a trade or business. Under this broad definition, many businesses are eligible for home business tax deductions.
To be deductible, an expense for business use of your home must be both “ordinary” and “necessary.” “An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business.”
It’s also important to separate home-based business expenses from other expenses related to your business, specifically:
- Cost of goods sold
- Capital expenses
- Personal expenses
Cost of Goods Sold
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs. COGS is an important part of your business tax return if you make products to sell or you buy products and resell them. This calculation captures production costs that wouldn’t be included in any other way, and these costs reduce your business taxable income.
On the other hand, operating expenses refer to expenditures that are not directly tied to the production of goods or services, such as rent, utilities, office supplies, and legal costs. If you include expenses in one category, you cannot also add it to the other category.
Capital Expenses for a Small Business
Capital expenses are part of the investment you make in your home-based business, and they must be capitalized rather than taken as deductions. These expenses cover three broad categories:
- Business startup costs
- Business assets
That said, as a homeowner running a small business and looking for tax cuts, you can decide to deduct or amortize certain business startup costs. For the most part, while you can’t take a deduction for a capital expense in the same tax year, you may be able to recover the amount you spend through “depreciation, amortization, or depletion.” These recovery methods allow you to deduct part of your cost from taxes every year.
For the most part, when looking for home business tax deductions and tax credits, you can’t deduct personal, living, or family expenses. The exception to this is an expense used for both business and personal reasons.
For example, let’s say you are self-employed, and you get a personal loan for $50,000. You use $30,000 to market your small business, while $20,000 goes toward family vacations. As a result, 60% of the loan interest could be used as a business expense in your tax return.
Business Use of the Home
A home office, or business space in a home, can also be tax-deductible if it’s in a single-family home, an apartment, condo, or even a houseboat. A hotel or other temporary lodging can’t be claimed as a home office space.
To act as a qualified home business tax deduction, your space must meet the requirements of regular and exclusive use and be the principal place of your business. The former means that you use the room or space to conduct business only. So, if you use your bedroom as an office during the day and sleep in it at night, the room wouldn’t qualify under this definition.
When deciding the amount of your home office tax deduction, you can calculate this by the simplified or regular method:
- The simplified method is good if you want to be spared the pain of detailed record keeping for your tax return. You would multiply the square footage of your qualified home office by the set rate of $5 per square foot. So, if your home office is 100 square feet, you would get a $500 tax deduction. But this method has a maximum allowed deduction of 300 square feet or $1,500.
- The regular method of calculating your home office tax deduction involves determining the actual expenses for the space, which may include mortgage interest, insurance, utilities, repairs, and depreciation. Making these calculations requires knowing what portion of your home is devoted to the business (so, for example, if 20% of your house space is a home office, and your home insurance is $1,000, you might be able to claim $200 as a tax deduction).
As far as your home business property being your principal place of business, this doesn’t disqualify it if you also conduct business elsewhere. For example, if you regularly conduct customer meetings in your home office space, it might still qualify for the deduction even though you also conduct business outside your home, perhaps working in a client office occasionally.
You can also deduct expenses for a separate freestanding structure — such as a studio, garage, or barn — if you use it consistently for your business. For the most part, tax deductions for a home office are calculated according to what percentage of the house space it takes up.
Additional Home Office Deductible Expenses
Other home business tax deductions can include:
- Insurance: If business insurance (as opposed to homeowners insurance) is purchased for your trade, business, or profession, you can usually deduct the cost (if you’re not eligible through a spouse’s work plan). Insurance can include health, dental, and qualified long-term care insurance premiums. Premiums paid for spouses and dependents can also be part of this.
- Money paid to employees: If you have employees, you can generally deduct the wages you pay them for the work they do. Salaries, bonuses, commissions, and some fringe benefits can also be deductible business expenses.
- Retirement plans: Retirement savings plans for your or your employees’ post-work life are also tax-deductible. The maximum contributions for various plans are set by the IRS each year, and contribution limits vary by plan type.
- Rent: You can fully deduct the cost of renting a space for your business. If rent covers both personal and business space in a home office setup, the portion of rent used in a tax deduction would relate to the percentage of space your home office occupies.
- Car expenses: A motor vehicle used for your home business can be deducted, but if it’s employed for both business and personal use, the deduction would be allowed for the mileage used for business only. (The IRS offers a list of current and prior year standard mileage rates.) It’s a good idea to keep good records of your mileage, date, and purpose of each trip, so you can accurately detail your vehicle’s business use in a tax audit.
- Business interest expense: If you take out a business loan, the interest would be tax-deductible. If a loan is divided between personal and business expenses, only the money used for business purposes would be a deduction. Similarly, interest from a credit card purchase can be a tax deduction for a business purchase, but not for a personal one.
- Taxes: With your business at home, you can deduct various federal, state, local, and foreign taxes if they are directly related to your business and its expenses. At the federal level, you can deduct real estate taxes and personal property taxes. The IRS also views licenses and regulatory fees as business income taxes.
- Meals: If you are entertaining a client, traveling for business, or attending a work-related conference, you may be able to expense meals for 50% of their costs, with a receipt as proof. A lunch you eat alone at your desk is not tax-deductible.
- Business travel: If you have to travel for your work, you might be able to claim the cost of transportation, lodging, meals, and other related expenses. Generally speaking, your business travel expenses need to be reasonable deductions; you can’t claim lavish or extravagant expenses.
Determining Your Home Office Deductions
Running a home office can incur many expenses, ranging from setting up an internet connection and paying the percentage of a mortgage or rent devoted to your home office to paying for office supplies and business cards. So, arming yourself with all the possible deductions is the first step in getting a tax break. The biggest mistake you can make in your business income tax is to claim personal expenses for work-related ones — a practice that may come back to haunt you during a tax audit.
When setting up a qualified home business, it’s also a good practice to rely on the services of a partner who can save you time, money, and headaches. The cost-efficient small business services provided by ZenBusiness can help you choose the right business structure for your purposes (such as an LLC, sole proprietorship, general partnership, etc.), register the business, and obtain the correct permits and licenses. They are here to support your business’s success, even during tax season.
Home Office Tax Deduction FAQs
Who qualifies for home office small business tax deductions?
If you use part of your home business property exclusively and regularly for conducting business, you may qualify to make home office small business tax deductions. You can possibly deduct expenses such as mortgage interest, insurance, utilities, repairs, and depreciation for that space. You will have to figure out the percentage of your house devoted to your business activities, so you can claim the right part of your utilities, repairs, depreciation, and more. To qualify as a small business, you must have $25 million or less in average annual gross receipts (indexed for inflation), for the past three tax years, and your business can’t be a tax shelter (as defined by the IRS).
How do I determine my home office deduction?
You can determine your home office deduction by the simplified or regular method outlined by the IRS. With the simplified method, you would multiply the square footage of your qualified home office space by the set rate of $5 per square foot (up to $1,500). With the regular method, you need to determine the actual expenses of the home office space, including mortgage interest, insurance, utilities, repairs, and depreciation. The size of the deduction is usually based on the percentage size of your workspace versus personal space.
How can I avoid an audit?
Some people believe that they will trigger an IRS audit for just about any home office expense they claim. This is not the case — there are too many home businesses for the IRS to audit like this. The key to avoiding audits is to claim any legal and reasonable expenses you can, be honest, and follow any available IRS guidelines.
Make sure there is a clear separation between business and personal expenses in your accounting. Also, keep track of all personal assets you use for business purposes — such as smartphones and internet connections — so you can make accurate claims on your taxes. If you claim a home office, ensure that it passes the exclusive use test. And if you are required to pay estimated quarterly tax payments and self-employment taxes, make sure you put the money aside and pay accurate amounts on time.