I had a great conversation with an individual recently that has prompted me to write this post, again thinking that if this topic was on his mind, it may be on yours too. It was a simple question with, and don’t be surprised here, a not-so-simple answer. Whenever I speak about tax deductions or credits I just cringe. There are so many gray areas, so many loopholes it’s silly. The other thing that makes me cringe is when someone tells me, “My brother in law deducted this, so I am too”. I just say good luck with that and hope it works well for you. People don’t realize that not all tax returns, tax preparers or tax situations are alike. Here is a prime example.
The individual (I will call him Joe) that posed the question to me about being able to deduct the cost of his “home office” on his federal tax return started out by saying, literally, that his brother in law (Let’s call him Vinny for the sake of our story), deducted some $1,400 for the use of his home office for a business related expense item. Joe was going to do the very same thing as well, until I spoke with him and found out that one piece of information he didn’t know about (or that his bro-in-law Vinny didn’t know about).
Like in so many other instances, if you get most of the information, most of the rules, most of the regulations correct, but leave out one – you will be in big trouble with whatever government agency you are dealing with. You won’t get “most” of the deduction if you only have most of the requirements, you won’t get any – any maybe even a fine to top things off.
Here is the rub. Vinny was mostly correct about being able to use a home-office deduction. He accurately calculated the square footage of the area. The area itself was a spare bedroom that was not used for any other purpose. I mention this only because so many of us (myself included) have space in a shared area, a living room, a family room etc. Deduct-ability of this area gets into numerous gray-areas that I simply state I would not include them, but if the business owner persists, then it’s something for him to bring up to his tax preparer.
Back to our story. The area of the home-office was accurately calculated to arrive at the pro-rated percentage of home expense. Mortgage interest, utilities and insurance were all expenses that could be pro-rated based on square footage as a deduction for the home-office. Vinny was also correct when he stated that in order to use the home-office deduction that the home must be the “principal place of business” and used “regularly and exclusively” What Vinny didn’t know, or did not tell Joe was the fact that you can’t deduct the home-office expense if all expenses for the business are grater than the net income of the business.
In other words, if your home based business had a loss for the year, you can’t use any home-office deduction whatsoever. At most you would be able to deduct a portion of the home-office deduction to the point of a zero net income. A fact that almost got Joe into a heap of trouble since his home based business did indeed have a loss for the the year. His plan was going to be to add that home-office deduction and have even more of a loss which would of course offset other income on his tax return. Joe had most of the information correct, but the one part he didn’t have would have cost him all of the deduction to be disallowed and who knows what type of underpayment of tax penalty not to mention the red flag he just threw up in the air saying “Look at me, I’m running a home based business and I am reckless in how I categorize expenses”. Something federal and/or state taxing authorities might notate if they saw this erroneous deduction.
Get the facts, and don’t get them from Vinny, or your own brother in law. Her is a link to the IRS website page that discusses the home-office deduction. You must read Publication 587 – Business Use of Your Home to see ALL of the rules and regulations of this potentially valuable business expense. Certainly discuss the matter at length with your CPA or tax preparer.
My bottom line recommendation is to document as much as possible. Take pictures and or a video of the space, write down the exact dimensions of the room, write down the exact calculation you performed (and show your work) of how you obtained the percentage. Of course, keep records of all expenses that you are taking a percentage of including copies of your monthly mortgage statement, insurance bill, repair bills etc. Remember, if you don’t have documented proof of this deduction, the IRS will be forced to estimate it for you!