Save big by deducting your home-office costs

More than half (53 percent) of all small businesses in the United States operate out of a home, according to the Small Business Administration’s Office of Advocacy. That's more than 10 million enterprise owners whose commute may be just a short walk from the kitchen.

While many new business owners can’t wait until they can afford professional office space, many others are content to stay at home. Why? Because not only does moving cost them money, but the IRS is willing to pay them to continue working from home.

Here's how it works. Home-based business owners who report their business results on Schedule C on IRS Form 1040 can deduct portions of their annual rent, mortgage interest, real estate taxes, homeowner's insurance, and more. These are primarily sole proprietors. And their perk is called the home-office deduction.

What the IRS considers a 'home business'

These deductions are available to home-business owners who can meet the "exclusive use" test. Simply moving your laptop onto a kitchen table won't meet the IRS criteria. However, the IRS doesn't require that the exclusive business space be walled off from other areas of the home, which is helpful to loft-space residents.

Another qualification for taking a home-office deduction is to establish the office as the headquarters location for business administration, or its principal place for serving customers.

The starting point for calculating the annual deduction is based on the amount of space in a home dedicated solely to business activities. Let’s say, for example, an entrepreneur rents a two-bedroom, 1,200-square-foot apartment for $2,000 a month. The bedroom that is used exclusively as a business office is 180 square feet in size. Because the business office represents 15 percent of the apartment size, the entrepreneur would be able to deduct 15 percent of the annual rent for an impressive $3,600 tax deduction. Business owners who store inventory or product samples in a home can add storage space to their square footage calculation, too.

Home owners have similar opportunities to write off real estate taxes, mortgage interest, and depreciation. There are some caps on deductions for jumbo mortgage holders, but overall the cumulative tax savings can be lucrative to business owners.

Full deductions versus space percentage deductions

Perhaps the trickiest aspect of calculating home-office deductions is to understand which expenses qualify for a 100 percent business deduction write-off—or a deduction that is limited to the allocation of space percentage, as with the apartment example above.

Here are some important distinctions.

• Repairs and maintenance.   The cost of painting a home office would generally be deductible in full as a direct business expense. However, if a home needed a new roof that benefited the entire house, then the tax deduction would be based on the allocation of space percentage.
• Telephone lines.   A first phone line into a home is considered by the IRS as a personal expense. Yet secondary phone lines that one uses exclusively for fax or Internet access can be fully deductible at 100 percent of cost. Cell phone expenses are not that straightforward because it might be difficult to prove "exclusive use." As such, a more conservative approach would be to deduct long-distance calls related to business activities as a direct business expense. At a minimum, entrepreneurs should list their cell phone under a business name rather than a personal name.
• Utilities.   Utility expenses that apply to an entire house such as security monitoring, electric, garbage collection, and cable Internet costs can be legitimate home-office deductions, subject to the space allocation percentage. So if all your of home utility bills add up to, say, $2,000 a year, and your home-office space allocation percentage is 15 percent, then say hello to a $300 tax deduction.
• Insurance.   As a rule, I encourage small-business owners to get a general liability insurance policy that is separate from home owners or apartment insurance. The entire cost of a separate policy would typically qualify for a business deduction. Otherwise, small-business owners with home-based businesses can deduct a portion of their homeowner's insurance premiums that relate to the specific tax year.
• Office furniture and equipment.   Because office furniture and equipment can be used for several years, the IRS typically requires taxpayers to "depreciate" purchase costs over a period of years. In general, it is acceptable to depreciate computers and other office equipment over five years, and furniture over seven years. If, for example, you purchase a new computer for $3,000 and elect to use the straight-line depreciation method (which writes down the useful value of property at an equal annual rate), then your annual deduction amount would be $600.

Of course, the IRS always includes a few gotchas to make tax reporting extra challenging. One of the more common mistakes startup entrepreneurs make is taking an entire year’s worth of home-based business deductions for a company that has been operational for a few months. So, if you have been in business for six months, then simply cut all your home-based business deductions in half.

Extra work at tax time can mean significant savings

It's true that taking home-office deductions may add a few extra hours of number crunching at tax time. However, few business owners can potentially reap several thousand dollars worth of savings in just two or three hours of work time. Also, once business owners establish a home as a principal office location, they can also write off car expenses and mileage for "business stops" to customers, the bank, or the post office. Again, it all adds up.

In fact, for 2005, in the latest statistics available, the IRS said some 3.18 million returns claimed home-office deductions, amounting to $8.8 billion in write-offs.

To learn more about home-office and vehicle expense deductions, visit the IRS Web site. Search for publication numbers 587 and 463.

About the author   Susan Schreter is a Seattle-area investment banker and venture-funding expert serving startup entrepreneurs and fast-growth company executives. She also teaches business financing and entrepreneurship at business schools, angel forums, and microfinance organizations in the United States and internationally. Write to Susan at susan@takecommand.org.