Easy Way to Home-Office Tax Deductions

Being self-employed you essentially have two hurdles to clear to get home office tax deductions approved and accepted by the IRS. The first hurdle is pretty much straightforward: You must use the home office space regularly and exclusively for your business. Regularly means indeed often, rather than occasionally. More important, exclusively means exclusively – no if’s, but’s or whatever about it. You can have absolutely no personal use of it during the year (or at least none that you admit to in public). Even admitting that you use the office space at home to balance your personal check book will void the tax deducation for the home office. So, be carefull with what you do and how you do it to avoid stepping into trap.

The second tax hurdle is much higher than the first, but there are four ways to get around it.

The first way is if your home office is your principal work place of business. This means that you do most of the work there. This is usually no problem at all for people that do work 100% self-employed with no income from any other sources (as employees that is). The home office also qualifies as your principal place of business (meaning it’s deductible) if you use it for administrative and management activities, but do actual customer facing work at the customer’s office. So, if you run your business from home, but do actual work at customer locations you are safe to deduct your office. A third exemption applies if you use the home office to meet with clients at your home office location.

And last but not least there is a 4th option to deduct expenses of your home office. If your home office is in a building that is separate from your home, it qualifies. That means setting up your home office in a detached garage or outbuilding will help you to qualify for this big tax deduction. But keep in mind that you must use your home office exclusively for your business, and you must do so regularly.

What is a Home Office worth when it comes to tax deducations?
Let’s assume you pass all the former scenarios. Now you want to know what the home office can do for you in regards to tax deductions. For sole proprietors, this can be estimated through Form 8829 (Expenses for Business Use of Your Home).

You can deduct 100% of expenses that are directly related to the home-office space — for example, painting, cleaning and the insurance premium for a home-office on your homeowner’s insurance policy (you did not forget about this one, didn’t you). The same applies for your office telephone line and utilities, if you have separate hookups for the home office.  You are also allowed to deduct a percentage of indirect expenses that relate to your entire residence. These deductions include parts of the mortgage interest, your property taxes, home owner association fees, or parts of your rent if you don’t own your home, depreciation if you do (depreciation over 39 years), utilities (water, gas, electricity), home security monitoring, or even things like the garbage pickup, general house maintenance and house repairs, insurance and so forth. You get the idea.

So, now that you know what you can deduct you need to figure out how much of your indirect expenses you can write off. IRS Form 8829 makes you believe you must use square footage, and most people do so. Count only living space in figuring the percentage (not your garage, unfinished basement or covered patio). Also, if you have a bathroom adjoining your office that’s never used otherwise, treat the square footage as part of your office.

Despite what the form says, you can also use any other “reasonable method” to compute the business use for your indirect business related expenses. The easiest method is to count the number of rooms in your house and divide the totals accordingly. If you have a total 10 rooms (we do not count in bedrooms for that purpose, but actual rooms), you can deduct 10% of your indirect expenses. But this calculation assumes your rooms are generally the same size. So if your 10×10 office is one of five rooms in your 3,000-square-foot house, deducting 20% for office use obviously won’t fly if you get audited. So, to be safe you should work with actual square footage numbers to be able to survive an audit.

Important to note: One limitation on home-office deductions is that these deducations cannot put your business in the red (meaning your business makes a loss for the tax year). But that doesn’t mean the deductions are fully wasted. Any amount that puts you below the break-even point gets carried over to the following tax year. And (!!) this limitation doesn’t apply to the partial mortgage interest and property taxes, which are generally fully deductible no matter how much money your business loses.

An important note on home-office deductions. To defend yourself in case of an audit, take pictures of your home office (with absolutely no personal items visible) to back up your claim that the space is used only for business. Keep the photos handy and eventually attach them to your very first tax return when you use it.

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December 25, 2007 | Filed Under Tax Advice

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How the Home Equity Loan Interest Tax Deduction Works

One nice feature of home equity loans is that borrowers may get a tax deduction on interest paid for the loan. However, keep in mind that this kind of deduction requires careful planning and cannot be used unlimited.
 
Deducting Mortgage Interest
Tax payers can claim a tax deduction on interest paid on a loan secured by their first or second home. Nowadays most home equity loans actually fit this category, but borrowers can get confused if they have more than one “second” homes or mortgages. For example, you may use a home equity loan as part of a debt consolidation program. Suddenly, the interest you pay becomes tax deductible – not just an expense. The interest deduction from your home equity loan is not unlimited. You can generally deduct interest you pay on the first $100,000 of a home equity loan. After that, it depends. If the home equity loan was used to improve your first or second home – or to purchase a second home as an example – you can eventually take the deduction on the amount up to $1 million or the value of the home. Please refer to IRS Publication 936 Section 2 for more details. There are some gotchas if you file your taxes and need to pay AMT. As far as the alternative minimum tax (AMT) goes, your home equity loan deductions will only help you if you used the money for home improvements. Debt consolidation using your home will not work out as expected in that case.

One important thing to keep in mind is that if you use a home equity line of credit to consolidate your debt, make sure you apply the savings towards the loan principal. After all you are dealing with your house, the place where you live. You do not want to end up losing your house due to excessive spending on your credit cards for non-essential items.

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December 25, 2007 | Filed Under Tax Advice

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Common Tax Planning Mistakes

Tax Defense

Tax planning mistakes can cost you a lot of money. With some basic knowledge and planning, you can avoid costly tax errors. Here are some basic tips that help you to avoid tax planning mistakes.

1) Do not Ignore the Alternative Minimum Tax (AMT)
The AMT is a separate income tax system with its own difficult set of rules. Read our Tax Guide on the AMT

2) Charitable contributions
Take charitable contributions into your tax planning consideration. You may think the clothes you give to charity are not worth much, but if used properly giving clothes to charity can lower your tax bill significantly. You may be surprised when the final numbers come in. Please note that the new tax law now says you can’t deduct anything unless the clothes are in good condition or better. Keep track of out-of-pocket expenses you incur while working for a charity. An example might be the cost of stamps you buy for when mailing out letters for a fundraiser.
 
3) Maximize your 401K Contributions
Pre-Tax Income you contribute to your employer’s 401(k) plan not only reduces your taxable income dollar-for-dollar, but this money also grows tax deferred until you have to withdraw them in your golden years of retirement. This is one of best and easiest tax shelter employees can take advantage of. Best of all - if your employer matches contributions, such as the first three percent of the money you put in, you are getting free money.

4) Adjusting the Tax Withholdings When You Change Jobs
Switching to a new job is a perfect time to review your overall withholding settings. This is very important if you will earn more money from the new job. After you have adjusted your federal income tax withholdings, don’t forget about reviewing your state withholding allowances as well. This will avoid any unpleasant surprises at filing time.

December 23, 2007 | Filed Under Tax Advice

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