A friend of mine has decided to start his own business and formed an LLC. He will be working out of his home. He was telling me about business use of the home for tax deductions. His business plan sounds good, but said he might not turn a profit until next year or even the year after that. He said the method was to pay things like utility bills, figure out the percentage for business use of the home and then write a check back to reimburse himself.
So I wondered if it was worth the extra accounting effort to track business use of the home expenses until the business turns a profit?
You don’t need to bill yourself for the use of the home. You just calculate a percentage of the total of each cost based on percentage of the area of your home used for business at tax time. It’s a little more complicated if your business uses a larger percentage of the electric bill than the percentage area of your home office as an example. But if you have an office that is 10% of the area of your house you can deduct 10% of any cost associated with your home.
Not so unless the space is used 100% for business. So if anyone else uses that computer, you can’t declare it. It’s a pretty high barrier, and having a dedicated room is a must.
As for profit, the IRS allows you to claim business expenses if you make a profit in three out of five consecutive years. But that’s more a guideline than a rule. If you can show an effort to make a profit, they probably won’t challenge you. A tax expert once told me that you should make the claim if you have any basis for it. The IRS will only demand the back taxes and interest if you can show you were legitimately trying to make a profit.
Tip: The IRS looks down upon not reporting income, but don’t care if you don’t take every deduction. You can leave them out. Then, as long as you have some income, you can claim to have a profit. In other words, say you have $100 in income and deductions of $55 for office expense and $75 for professional dues. Just deduct the dues and you have a profit.
It’s worth it, but he needs to set aside an office space that no one else uses for their personal life. It can be only a portion of a room if partitioned.
Your deduction is limited to your profit. Any excess deductions are carried forward to a future year. Which, if you ever do make a profit, can be used to offset actual tax. Until then it’s 100% a paperwork exercise with no impact on his total business + personal cash flow.
The above is a bit simplified vs. reality. The OP’s friend is already heading off on a tangent. Spending $100 on a consult w a tax CPA before he digs an even deeper hole than he has already would be an excellent investment with a strong ROI.
A dedicated room is not a must, just exclusively used space. However, a recent court case highlighted how risky that is: the deduction was denied because you had to walk through the space to get from one part of the house to another. Thus, not exclusive use, the IRS argued, and the courts agreed.
Losses are always deductible. The hobby vs business issue only determines where they are deducted and how much. As a hobby, losses are deducted on Sch A, limited to the amount of revenue, which is reported on 1040 line 21. As a business, losses are subtracted directly from revenue, both on Sch C.
The 3/5 rule merely sets the presumption. It’s like the innocent until proven guilty idea in criminal courts. If you are profitable 3/5 years, then the burden of proof is on the IRS to show that you were not a business. If you have losses 3/5 years, the burden of proof is on you to show that you were not a hobby, and it’s really not all that hard to do if you keep decent records. The IRS ultimately has 19 different things they look at - experience, changes to operations, prior profits, appreciation of assets, personal enjoyment, etc. It’s the analysis of these factors that makes the final determination.
As for leaving income out… this is questionable. There are rulings around some of the low income credits (like EIC and ACTC that require certain amounts of income for maximum benefit) where courts have required the deduction of expenses There is even guidance from the IRS suggesting that estimates of things like mileage should be taken… even when more authoritative sources say that mileage must be documented to be taken. So the only clear pattern we see in these conflicted areas is that the IRS’s position will tend to be the one that increases your tax liability.
There is one more thing to worry about - at least it was 17 years ago when we sold a house. If you buy another house gains in value from your old home are not taxed. However gains on the area of your house used for a business are. So, if you have 10% of your house dedicated to a business and make $100K on the sale, $10K is taxable.
My wife works from home, and her office would easily qualify, but we don’t take the deduction because of this, which has turned out to be a really good move. We didn’t make enough on selling our old house for it to be a problem.
But check for current law.
I remember this, moved at about the same time as you. I don’t recall how the accountant worked it all out so I didn’t owe anything (or not enough to notice) but I was able to show there were a lot of improvements done specifically for the office plus the percentage of all improvements done on the house.
I think the wrong question is being asked. Isn’t it really
“Personal business without a profit. Is it worth it?”
If it’s truly a business with the intent of making money but you have losses, you deduct the loss. If you continue to have losses, you wind it down.
If it’s not truly a business but it’s a different activity that costs money that you’re trying to deduct, then it’s something different. That’s why the hobby loss rule exists.
Thanks for commenting on this. So if he does turn a profit in the 3rd year, and he carried over business use of the home deductions from the 2nd year, then he can deduct them? Could he carry them over from the 1st year too and used in the 3rd year there is an expected profit? Or can these only be carried over from one year to the next?
Real improvements (not maintenance items like painting) are deducted from the selling price when computing profit on the house, so I think the improvements would help whether or not they were done specifically for the office. We added a sun room as far from my wife’s office in the dungeon as possible, and it still helped.
What I don’t remember is whether you as homeowner pay the tax on the gain or you as business owner do - not that it usually makes a difference, though.
The question being asked is correct. He’s an experienced software developer and has decided to devote full-time to the development of an application to sell. He knows that it’s going to take time to develop, test, and market it and isn’t expecting it to have a sale until sometime in 2017. My question was about all the book keeping he was doing and if it was worth it until he has an actual profit.
The answer is really “ask a CPA,” but mine discourages me from doing it because the small benefits aren’t worth the effort and risk. I believe also that if you’re claiming part of your house as an office you can’t take the mortgage interest deduction for that part of the house, but say it with me “IANACPA.”
Expenses roll over cumulatively & indefinitely until you have enough profits to offset them.
But overall, as you’re probably seeing from the various replies, this is a complex area of tax, and more so for startups. Your friend would be 100% droollingly stupid to spend or do or file anything without getting specific detailed tax advice from a CPA. This is NOT an area to DIY unless you like getting audited for several years’ returns.
The whole home office thing is not necessarily a red flag. But screwing it up most certainly is. And oddly enough, most folks who screw it up do so in similar fashion, so the IRS audit-finder knows just what to look for.
When I started a business many years ago, all my deductible expenses had to be added up until I realized my first revenue. All these expenses were then amortized over the next five years (one fifth the total as a deduction per year).
Business improvements to the business portion of your person residence may have to be depreciated (straight-line, mid-month convention, for 27-1/2 years) until such time this portion is returned to the personal part of your home. At this time the remaining basis to the business asset is added to the personal residence basis, thus stopping the business depreciation.
One can run a business at a loss year after year after year, there’s no requirement to profitable. But as DrDeth points out, be ready to justify every single deduction to the IRS. My rule of thumb is if I don’t have the receipt, I don’t deduct it. There are special rules concerning using any business loss as an offset against another businesses taxable profits. The main thing is for the losing business’ reason to exist is primarily something other than paying less taxes.
If you buy two widgets for $50,000 each, put them together into a waggle then sell it for $100,000 … you’ll be getting a form 1099 … so better than reporting it as “other income” and paying taxes on the entire $100,000 … go ahead and file a Sch C. You’re not required to pay taxes so filing this way doesn’t avoid paying taxes.
Yeah, then you really are asking the wrong question.
The question you’re asking about losses and use of home only apply to a business that is currently operating, but what you describe here is a business in startup phase and that will not begin operating until 2017.