Because expenses related to running your business are generally tax-deductible--and the IRS has relaxed the rules on what is an allowable home-office deduction--the tax advantage of being homebased is more attractive than ever. "If your home is your principal place of business, or if you use a home office to meet with customers in the normal course of your business, you can deduct certain expenses related to maintaining your home office," says Charles L. Norman, a senior manager specializing in entrepreneurial services with Ernst & Young LLP in Toledo, Ohio.
In the past, the IRS disallowed the home-office deduction if you performed your actual work at other locations, such as client offices, and used your home office simply for administrative functions. But that changed in 1999, says Norman, when a home office will be considered a principal place of business if you use it for administrative or management activities and there's no other fixed location where you conduct similar activities. In other words, even if you perform much of your work outside your home, your home office will be deductible.
Expenses that benefit only the business area of your home, such as the cost of carpeting an office, are deductible. You can also deduct a portion of indirect expenses--the costs involved in maintaining your entire home, such as utilities (electricity, trash collection and the like). Deductions are based on the percentage of space you use for business purposes, so if your office takes up 10 percent of your home's square footage, you can deduct 10 percent of your utility costs. Other indirect expenses include real estate taxes, deductible mortgage interest, casualty losses, rent, insurance, repairs, security systems and depreciation.
Many taxpayers worry that taking the home-office deduction will trigger an IRS audit, but if your deductions are legitimate and you've kept good records, that shouldn't be an issue, says Norman. To maintain complete and accurate records, he advises using any of the popular bookkeeping and accounting software programs to track income and expenses. Set up a filing system for receipts, and discipline yourself to stay current with your record-keeping. "Keep your records for at least three years from the date the return was filed or two years from the date the tax was paid, whichever is later," says Norman.
Also set up a separate bank account for your business. This not only helps document your financial details for tax purposes, but it helps you establish yourself with your banker and other potential lenders, as well as creating a professional image with vendors.