Should I be wary of the "Home Office" deduction?

Don't fear the Home Office Deduction.

More than half of small businesses in the US are home-based, yet most don't claim a home office deduction. And while efforts to simplify this deduction continue to get stuck in committee (thanks, Congress!), many small business owners continue to fear (and have been told) that claiming a home office deduction is a red flag for IRS audits. But that's not necessarily the case. If you follow the rules, not only will you be fine, you'll save a lot of money.

Rather than talk about all of the rules and conditions, which you can read here, I'm going to outline the key points for home-based businesses that sell products online, via channels like eBay, Amazon or Etsy.

First, let's talk about what it means to claim a home office deduction. Basically, you add up a bunch of the costs that come with owning and maintaining your home (or apartment,) and write off a percentage of those costs based on how much of your home you use for business. Some of the costs you can write off include:  

  • Rent or mortgage interest;
  • Property taxes (if you own);
  • Utilities like electricity, gas, garbage disposal and cleaning services;
  • Homeowners or renters insurance;
  • Repair costs for the areas you use.

Now let's talk about eligibility. The first thing the IRS looks at is whether you use part of your home "exclusively" and "regularly." If you have a dedicated area of the house where you do your selling - using the computer, packing, labeling, etc., and it's the principal place you do your selling (e.g. you don't have a retail storefront somewhere else,) you should be in great shape. You don't even need to use a separate room or create a partition. The most important thing is to have an area of your home that you use for nothing other than running your business.

I like to think of it this way - keep the kids and family out of your business, and not only will it be good for your sanity, it will help with the IRS.

If that sounds reasonable, it gets better. If you use a portion of your home to store inventory, you don't need to use it exclusively for business to deduct costs. In fact, let's look at the language from IRS publication 587.

Storage of inventory or product samples.
If you use part of your home for storage of inventory or product samples, you can deduct expenses for the business use of your home without meeting the exclusive use test. However, you must meet all the following tests.

  • You sell products at wholesale or retail as your trade or business.
  • You keep the inventory or product samples in your home for use in your trade or business.
  • Your home is the only fixed location of your trade or business.
  • You use the storage space on a regular basis.
  • The space you use is a separately identifiable space suitable for storage.

So, not only can you claim the space you use to do your selling, you can also claim the space you use to store your inventory. So go measure the amount of room you use, then head on over to Form 8829 and start claiming the deduction you're entitled to. And take a picture of your space - the more evidence the better.

One final restriction - you can't claim a home office deduction that's more than the amount of income you generated from the business. This is to prevent people from using a small side business to shelter other income from taxation.

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