In the previous post, "Home-Based Business", I spoke a little about the deductions that can be used relating to your business taxes. I will dive a little deeper in this one. The more you know, the more you can grow!
Failure to qualify for the home deduction doesn't prohibit you from operating your business out of your home. It only means that one possibly large expense, the cost of the space itself, is not deductible on your federal income taxes. You can still deduct all legitimate business expenses other than those directly related to the business space. The "Home Expense" rules apply to sole proprietors, spousal partnerships, and one owner LLs. Partnerships, corporations, and multi-owner LLCs may be able to claim a home expense deduction on several factors that were covered in the previous posts. 
TAKING THE HOME DEDUCTION:
There are two options for taking a home deduction: You can deduct actual expenses, or you can take a standard flat rate deduction.
Deducting actual expenses involves keeping detailed records of expenses, making multiple calculations, filing an additional tax form (Form 8829, Expenses for Business Use of Your Home), and, if it is a home you own, possible tax problems when you sell the home. By comparison, the flat rate deduction (the IRS calls it the Safe Harbor Method) is simple to figure, does not require Form 8829, and eliminates any tax complications when  you sell your home.
Although the flat rate deduction is much easier to calculate and requires much less paperwork than using actual expenses, it probably will result in a lower deduction amount. Also, if your business is showing a loss, the flat rate deduction has some limitations. You can calculate the home deduction both ways and then decide which will give you the biggest deduction and the fewest hassles. Once you select a method, you are not stuck with it for future years. You can use one method one year, and the other method the next year if you want. 
OPTIONS:

• Option #1 (The Flat Rate aka "Safe Harbor" Deduction): The deduction is $5 per square foot of business space, up to a maximum of 300sqft.  So the maximum annual flat rate deduction is $1500. This flat rate option is in lieu of deducting actual expenses for the space itself. Office furniture and equipment, as well as all other normal business expenses other than those directly related to the space, are deductible in addition to the flat rate. 
  • Part-year Business: If you have more than one business, the 300sqft maximum is for all businesses combined. If a spouse or housemate also has a business, that person is also entitled to a $5 per sqft deduction for up to 300sqft, but not for the same portion of the home. If two people share the same space, the combined deduction cannot be more than $5 per square foot. 
  • Business Loss: The deduction cannot exceed the net profit from your business. You can take the flat rate deduction only up to the point your profit drops to zero. If  you business is already showing a loss, you cannot take the deduction at all. Any unused part of the flat rate deduction cannot be applied to future years. Below you will read about Option 2, deducting actual expenses allows the deduction to be carried forward to future years if the business is showing a loss. 

In the above sample floor plan a couple have businesses that are separate and therefore they can either use the flat rate deduction for the first floor living space that's converted into an office for one business usage as well as the second floor bedroom that's converted into an office for the second business usage. 

• Option #2 (Deducting Actual Expenses): If you choose this option, deductible expenses include a percentage of your rent if you rent your home, or a percentage of the depreciation if you own your home, and an equal percentage of home utilities, property tax, building maintenance and repairs, garbage pickup, mortgage interest, and insurance. You can determine the percentage based on square footage or, if the rooms in your home are about the same size, by the number of rooms. Expenses that are only for the business, such as office cleaning, painting the office, air conditioning, decorating, or buying extra insurance coverage, are 100% deductible if they are 100% for the business; you do not prorate them. The only exceptions to the deductions are for landscaping and lawn care, which the IRS says are not deductible, although the Tax Court has overruled the IRS several times. 
  • Another Tax Trap: If you are deducting actual expenses and your home business is located in a separate structure on the same property--such as a detached garage, barn, even a structure specially built to house your home business--when you sell your home, this structure is not eligible for the tax exemption homeowners get when they sell their homes. Any profit on the sale of the separate business structure is fully taxable. This quirk in the law applies only to separate structures, not to a business located inside your main residence or in an attached garage. This problem is also eliminated by taking the flat rate deduction.
  • Tax Trap for Homeowners: If you are deducting actual expenses, you will run into tax complications when you sell your house. Any depreciation you were allowed must be "recaptured." This means that you add up all the depreciation during all the years you used your home for business, and pay tax on that depreciation when you sell the house. This is a complicated law, and an unwelcome tax, that you can avoid by taking the flat rate deduction.
  • Business Loss: If your business shows a loss, part of your home expenses is not deductible this year. You may deduct all your regular business expenses (other than expenses for the space itself) and may deduct interest and property taxes on the home, regardless of profit or loss. Keep in mind the remaining home expenses may be deducted this year only if your business shows a profit. Any expenses you cannot deduct due to this limitation can be carried forward to the next year, and future years if the next year's income is not sufficient, and deducted then, again only up to the point where they do not create a loss next year. This is different than Option 1, the flat rate deduction. If the business is showing a loss, the flat rate deduction cannot be carried to future years. 

SPECIAL SITUATIONS (For Both Option 1 and 2):

• More than one business location: If your business is also operated out of another location, such as a store, you are still eligible for a home deduction in addition to the cost of renting the store, if the home meets the above requirements. You can have a separate "principal place of business" for each trade or business you operate. 
• More than one home: A home deduction is allowed only for your "principal place of business," which can't be two different places. You can't run a business out of two homes and get two home deductions. If you move to a new home during the year, you can have two principal places of business for different parts of the year, but curiously, the IRS will allow you to take Option 2, itemizing expenses on both homes, part of the year on one home and part on the other. If you are operating two different businesses out of two different homes, you can take the home deduction for each business. You now have two principal places of business independent of each other.
• Child care and day care businesses: The home deduction is allowed only if your business is officially licensed as a child care or day care business (unless your business is exempt from state licensing rules) and your business cares for children, or people age 65 or older, or people who are unable to care for themselves. Only the space used for the care activities can be deducted, and only for the days used. Space used for part of a day is eligible for a full-day deduction. No need to prorate it for hours of use. Child care and day care businesses are exempt from the exclusive use rule. You get a full deduction for rooms used in your business even if they are also used for non-business purposes. 
• Lodging businesses: If you operate a separate hotel or inn on your property, it is not considered a home business. You do not have to meet the "Home Expenses" rules. If you operate a bed-and-breakfast, boardinghouse, or rooming house in your home, only the portion of the home used exclusively for the business can be deducted. Shared space such as a dining room and your own private space cannot be deducted. However, you could have an office in your private space and get a deduction for the office in addition to the deduction for the lodging space, if the office meets the requirements.
• Sharing economy rentals: Renting out rooms through online platforms such as AirBNB comes under the same rules as boardinghouses and bed-and-breakfasts. (See "Lodging Businesses" in the previous paragraph).
• Renting your home to your business: Some business owners rent their home to their business and take a business deduction for the rent expense. This is not usually a good idea. While this gives your business tax deduction, it saddles you with taxable rental income and a possible loss of your home tax exemption.
• Partnerships, corporations, and multi-owner LLCs cannot take the "Home Expenses" deduction, not directly anyway. The owner of the business (the person whose home is being used for business) can get a reimbursement from the business for the owner's home expenses, and then the business could deduct the reimbursement as a business expense. The IRS requires that this type of arrangement have an "accountable reimbursement plan," which is a written policy that the expenses are business related and that the expenses are business related and that the expenses are substantiated (you have receipts). Also, the partnership or LLC agreement or the corporate bylaws should include this requirement. If you do not have the reimbursement plan and the written agreements, your business cannot take the deduction. The owner of the business (not the business itself) could still deduct some of the home expenses on the owner's personal tax  return, but the deductions are not considered business deductions and do not reduce the business profit. 

May is "Small Business Month" and it's always great to do business with other businesses as well as customers. Many times small business owners can be unclear about many expects of the administrative and legal processes that need to be considered when starting their business as well as during the time or operating it. I enjoy learning and broadening my knowledge of various subjects. I have physical, electronic, and audio libraries to prove it. 

Do you know...as far as the IRS is concerned, a home-based business is no different than any other business. Home business owners file business tax returns, report the earnings as business income, and deduct business expenses. The expenses that home-based businesses can deduct  are exactly the same as the expenses every other business can deduct, with one important exception: the home itself. 

If you use part of your home for business--your office, workshop, store, warehouse, or whatever you are using your home for--the cost of the space (the rent or, if you own your home, the depreciation) and some of the expenses directly related to the space, such as utilities and maintenance, can be deducted only if the space meets special IRS requirements. The two basic rules are (1) a principal place of business, and (2) regular and exclusive use.

• Rule #1: A principal place of business. Your home must meet at least one of the following four requirements.
  • 1. The home must be your principal place of business, defined by the IRS as "the most important, consequential, or influential location."
  • Or...2. The home must be used regularly (not just occasionally) by your customers or clients.
  • Or...3. The home must be used regularly to generate sales, such as making calls and preparing estimates.
  • Or...4. The home must be the sole fixed location where you conduct substantial administrative or management activities for the business: where you do your paperwork or your research, order supplies, or schedule appointments. You don't have to do all you administrative or management work at home, but it should be the main location for these activities.
• Rule #2: Regular and exclusive use. 
  • To be eligible for the home deduction, in addition to meeting Rule #1 above, a specific part of your home must be used regularly and exclusively for business. It can be a separate room or even part of a room, as long as it is used for the business and nothing else. PERIOD. No television in the office. No personal paperwork at the desk. (NO GAMES ON THE COMPUTER.) The business area can't double as a guest room, kid's room, or anything else, even when you are not working. 
  • There are two exceptions to the exclusive rule:
    • (1) If your home is your sole location for a retail sales business and if you regularly store your inventory or your samples in your home, the expense of maintaining the storage area is deductible even if it isn't exclusive use of the space. 
    • (2) If you operate a licensed day care facility in your home, you do not have to use the space exclusively for business.

These requirements are fairly simplistic and are very easy to meet for most home-based businesses. Still, lots of home businesses DO NOT TAKE THE DEDUCTION because of a widespread belief that deducting your home office or workspace is likely to lead to a TAX AUDIT, which is NOT TRUE! Actually, the IRS does not audit home-based businesses any more than other small businesses, at least not home businesses that report a profit. The IRS is more likely to audit a home business if the business has a loss, especially if the loss is offsetting other income and reducing income taxes. The IRS is also more likely to audit a home business, or any business for that matter, that takes large deductions for expenses like travel and entertainment, which are considered on of the "RED FLAG" deductions.
So the message is: "Don't worry about the IRS. Deduct everything you are entitled to."
There is one other tax deduction, in addition to the home expense deduction, that is limited for home-based businesses. The cost of a land-line telephone into the home CANNOT, in some cases, be deducted. It's a little law that's slowly becoming obsolete as more and more businesses are switching to cell phones, smartphones, and internet connections, which do not come under this land-line law. 

Other business use of the home: The Home Expenses deduction applies not just to businesses that are home based but also to any business where the owner of the business uses his or her home for business purposes. Many mobile businesses--businesses that travel to customers--quality for the home expenses deduction. Contractors, salespeople, entertainers, freelancers, consultants, and others who earn income outside the home may be eligible for the home expenses deduction. Even businesses that have separate business locations outside the home may be eligible for the deduction. All IRS rules for deducting home expenses are explained under the Home Expenses post next.