It is easy for just about anyone to start a business from home. Whether people have left an office job because of downsizing or retirement, or have chosen to start a sideline activity for extra income, working from home reduces startup costs and may provide personal benefits (e.g., managing child care or parental care responsibilities). Technology enables an entrepreneur working in a home office to connect with customers, clients, and other business associates around the world. The Small Business Association’s Office of Advocacy reported in March 2014 that 52% of all businesses in the United States are home based (“Frequently Asked Questions,” http://bit.ly/2q14K9O). The ease of starting a home business does not, however, detract from the various legal, tax, and financial concerns that must be addressed.
While zoning laws can be behind the times, they do not necessarily preclude operating a business from home. Issues arise when—
- there are multiple employees or a constant stream of customers, which may disturb the neighbors, create parking problems, or raise other concerns;
- there are noises or odors connected to the business; or
- the business is a type restricted from a residential area.
There may be restrictions on the amount of space that can be dedicated to business use. For example, Miami–Dade County restricts home office space to 200 square feet.
Even when a business can operate from a home, there usually are restrictions on signage. It is therefore essential to check with the city or town about zoning restrictions and related rules.
Even if local zoning rules do not bar a home office, the terms of a homeowners association (HOA) may restrict having certain businesses, or any at all, within the community. Again, a review of covenants, conditions, and restrictions in the HOA agreement will show what is or is not permissible. For example, there may be a bar on commercial vehicles, which would preclude a limousine or moving business, but not necessarily an insurance or interior decorating business. Similar restrictions may be imposed on owners of cooperative apartments.
Even if businesses are permitted to operate from the home, there may be other building or commercial codes that come into play. For example, Massachusetts’s Department of Public Health restricts the types of food that can and cannot be prepared in a residential kitchen for sale outside the home (e.g., in a catering business).
A person operating a business from home should not assume that his homeowners policy covers business-related liability. If, for example, a business client is injured in the home office, this incident may be excluded from a basic homeowners policy. Similarly, if a fire destroys a home, office equipment may not be covered. It is essential for a home-based business to have a separate business owner’s policy (BOP) to cover liability to third parties, as well as damage or destruction to equipment or inventory in the home. Alternatively, it may be possible to adjust an existing homeowners policy to cover these concerns.
Some localities require businesses, even if home based, to obtain a license to operate. For example, Chicago has a regulated business license requirement for home occupations. There may be fees for such a business license (e.g., $250 for two years in Chicago).
The costs of a home office can be deductible, effectively converting personal expenses into a business write-off [Internal Revenue Code (IRC) section 280A]. The following two tests must be satisfied to be eligible for a home office deduction.
Condition 1: qualified use.
The home office must be used for one of the following:
- The principal place of business. Essentially, this means where business revenue is earned, as well as the place where substantial administrative tasks are performed, such as ordering supplies, scheduling appointments, and keeping the books, as long as there is no other location for the business. For example, a plumber who does work at customer locations can take a home office deduction if the space is used for administration of the business.
- A place to meet or deal with customers, clients, or patients in the ordinary course of business. Thus, an accountant with an office in town who uses her home office to physically meet with clients meets this test. Using a home office solely to make phone calls or send email does not satisfy this requirement.
- A separate structure (e.g., greenhouse, freestanding garage) used in connection with the business.
Condition 2: regular and exclusive use.
The space in the home must be used regularly and exclusively for business. The home office space cannot serve a dual purpose, such as a den used for business during working hours and for watching television with the family after business hours (with the exception of day care businesses). In one case [Bulas v. Comm’r, T.C. Memo. 2011-201 (2011)], the costs related to a bathroom built for an accountant’s clients could not be deducted because his children and personal guests used the bathroom occasionally. Such incidental use, however, may not necessarily violate the second condition. In another case [Miller v. Comm’r,T.C. Summary Opinion 2014-74 (2014)], a taxpayer who used part of a studio apartment as a home office was allowed a deduction even though she had to pass through the office space to get to the bedroom area.
Typically, a home office is a spare bedroom or converted attic created as a workspace. A home office can, however, be any part of a residence, including a garage, a freestanding greenhouse, or a barn. The space does not have to be a full room or even a partitioned area to qualify. It may be helpful to take a photo of the space to show that it is, indeed, used only for business.
Deducting actual costs.
The costs of a home office can be figured in two ways: actual costs or an IRS-set simplified method. Under the actual cost method, expenses related to a home office are either indirect costs or direct costs. Indirect costs are those applicable to the whole residence (e.g., home mortgage interest and property taxes, rent, utilities, homeowners/renters insurance, monthly security alarm charges). The portion of these costs taken into account is based on the square footage of the business space; for example, if 10% of the home is used for business, then 10% of the rent is taken into account in calculating the home office deduction.
For personal expenses that are deductible as itemized deductions (e.g., mortgage interest), the portion related to the home office is part of the business write-off; the balance is taken into account on Schedule A of Form 1040 as a personal write-off.
If the home is owned (not rented), the home office deduction includes an allowance for depreciation. The amount of depreciation is based on the lower of the adjusted basis of the home or its fair market value at the time the space is converted to business use (exclusive of the land).
Direct costs are those exclusively related to the business space. For example, repairs to a spare bedroom used as a home office are direct costs that become fully deductible as part of the home office deduction.
Instead of tracking all home-related expenses and categorizing direct and indirect costs, the home office deduction can be figured using a simplified method (Revenue Procedure 2013-13). The deduction under the simplified method is figured by multiplying the square footage of the home office (up to a maximum of 300 square feet) by $5. This method allows a homeowner to fully deduct home mortgage interest and real estate taxes as personal itemized deductions, even though these expenses are essentially factored into the home office deduction.
The election to use the safe harbor deduction can be made on an annual basis. Once it is used for a particular year, however, the election is irrevocable.
Gross income requirement.
Whichever method is used to figure the home office deduction, the amount of the deduction cannot exceed the gross income earned by the business. Thus, for startups, the home office deduction may be limited or barred entirely due to this gross income requirement. Any deduction calculated under the simplified method that is limited by the gross income requirement cannot be carried over and is lost forever. The amount limited under the actual expense method can be carried over and claimed in a future year to the extent of gross income from the business, whether or not in the same residence.
Special issues for owner-employees.
If a business is incorporated, how should home office costs be handled? There are three ways to do this:
- Claim a home office deduction. Use of the home office must be for the convenience of the employer, but an owner-employee of the business obviously satisfies this test when there is no other location. Despite qualifying for the deduction, however, there may be little or no tax advantage to it. The deduction is claimed by the owner-employee as an unreimbursed employee business expense, so only miscellaneous itemized deductions in excess of 2% of adjusted gross income are actually allowed. What’s more, the deductions are also subject to the phase-out of itemized deductions for high-income taxpayers.
- Rent the home office to the corporation. If an owner-employee rents part of the home to the corporation, the corporation deducts the rent; the same rent is, however, taxable to the owner-employee, and no home office deduction is allowed [IRC section 280A(c)(6)]. While this may not be optimal, the rental payment is preferable to a salary increase to cover home office deduction costs because no employment taxes are due on the rental payment.
- Use a reimbursement arrangement. An owner-employee can obtain reimbursement for the costs of a home office under an accountable plan; the costs of the home office become deductible by the corporation, while the owner-employee is not taxed on the reimbursement. If the reimbursement covers mortgage interest and property taxes on the home, the owner-employee cannot take deductions for these amounts. Requirements for an accountable plan are found in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses (http://bit.ly/2rwHTof).
Some businesses operate from mobile homes or recreational vehicles (RV), and owners may try to claim a depreciation for them as well as other business expenses for operating them. This may be difficult to do, as the following cases illustrate:
- Cartwright v. Comm’r, T.C. Memo 2015-212. An orthopedic surgeon used an RV as a place from which to respond to “stat” pages within five minutes when he was on call from the hospital. The Tax Court limited depreciation and an IRC section 179 deduction to modest business use, rather than the amount that the doctor had claimed. The RV was used primarily for recreational purposes.
- Jackson v. Comm’r, T.C. Memo 2014-160. An insurance agent used an RV to meet clients and sell insurance, and it was agreed that about 2/3 of the mileage was for business driving. Nonetheless, the Tax Court disallowed a home office deduction because the RV was also used for personal purposes (i.e., no space within the RV was exclusively used for business). While use of the RV was “appropriate and helpful” to the business, a home office deduction for its costs was barred (although some RV costs were deductible).
- Dunford v. Comm’r, T.C. Memo 2013-189. A consultant who used an RV to travel around the United States could deduct interest on the loan to buy the vehicle, but not other business deductions. The Tax Court ruled that he had blended purposes—personal and business—for the travel, but that the dominant motive was personal (to be near his children and to winter in a warmer climate).
HOME BUSINESS CHECKLIST
- ___ Do zoning laws permit running a business from home?
- ___ Do city/town ordinances restrict signage?
- ___ Does the HOA bar or limit a home-based business?
- ___ Has the requisite insurance been acquired?
- ___ Does the office qualify for the home office deduction?
- ___ Has the impact of the home office deduction on a future sale of the residence been considered?
Audit risk for the home office deduction.
There continues to be a prevailing belief that claiming a home office deduction is an audit red flag, even though there are no IRS audit statistics or IRS warnings on this point. Individuals using a home office who meet eligibility requirements and can substantiate their costs should probably take the deduction.
While a home-based business owner may deduct office costs annually, there can be a financial impact when the home is sold. Gain on the sale of a principal residence is usually tax free up to $250,000 ($500,000 on a joint return) if certain conditions are met (IRC section 121). If the homeowner has been deducting the actual costs for a home office, however (including depreciation), gain on the sale is taxable at 28% to the extent of depreciation claimed after May 6, 1997 (IRC section 1250). This is referred to as “unrecaptured depreciation.” There is no unrecaptured depreciation if the home office deduction is based on the IRS’s simplified option.
Starting a business from home can create income and tax savings; however, many legal, tax, and financial issues come into play. All of these issues should be addressed before business operations begin, and CPAs should advise interested individuals of them.