Home-Based Business

The nature of the business you are operating will be the major influence in your choice of location and the physical layout of your site. One option that continues to grow rapidly is a home-based business. Continually improving technology has fueled the trend. People are pursuing careers as everything from personal chefs to Web site designers, all based from a home office.

Insurance

As a home-based business owner, you will want to review the types of insurance that apply to a small-business owner. But you also want to make sure that you are prepared for the unique situations that can occur because you work from home.

Most important, make sure that the issuer of your homeowners’ insurance knows your business is operated from home. If you have not planned for potential problems in advance, you might find that there is no coverage for a business-related accident that happens on your premises. Even fire insurance might not be valid if the insurance company was not made aware of your home-based business.

There are many options to adjusting your homeowners’ policy to cover your specific business situation. In general, you will want to make sure that business equipment and furnishings are covered, ideally at the cost of replacement. And liability for business-related accidents should be taken into account. If you store inventory somewhere on your premises, that would be another area for discussion with the insurance agent or company representative.

The important point is to talk to your insurance agent or the company representative so that you are managing potential risk.

Are there any special insurance policies that cover both home and home-based business needs?

You can obtain riders to your homeowners’ policy that cover many of the contingencies of your home-based business. And some companies have special policies that are designed for the purpose. You can expect business property (including your computer) to be covered under those, as well as other liabilities.

What are the main considerations for insuring my home-based business?

Here are a few topics to make sure you discuss with your insurance agent:

  • Replacement cost: If a disaster destroys your business property, you want to be able to replace it without a loss. A replacement cost provision is designed to allow you to replace a used computer or used furniture with a comparable new item.
  • Liability: Business-related accidents that happen at your home—or away from your home if you have a business purpose—can be disallowed if you only have traditional homeowners’ insurance.

Zoning and Private Lane Use Restrictions

If your dream is to commute 10 feet down the hall to your home office, one of your first steps should be to make sure you understand your local zoning regulations. Since your town, city or county’s role is to maintain the residential qualities of its neighborhoods, you may find unexpected rules and restrictions for your home business. And, if your residence is governed by a homeowners’ association or you are a renter, there may be other limitations on how you can conduct your business.

What can be regulated?

You may encounter rules that govern whether you can hire employees to work with you from your home, or they may limit the number of employees that you are allowed. Similarly, some cities limit the amount of space in a home that can be used for your business.

Environmental factors may be addressed in your regulations. The obvious ones—managing waste disposal, chemicals or other hazardous materials—could be addressed in local ordinances. A business that emits fumes or odors may be not allowed in your residential area. On a broader scale, rules are designed to keep all the neighbors happy. Parking or the types of commercial vehicles allowed on your street might be restricted.

Tip: To find out about the ordinances in your locality, you can check the library for zoning rules, or you can inquire at your local zoning department.

Can my homeowners’ association restrict my use of my home for business purposes?

Besides town, county or state regulations, your home may be governed by a homeowners’, condo or co-op association, or a lease agreement with your landlord may include additional restrictions.

Be sure to check your homeowners’ association or lease documents to see if you can operate a business from your home. There might be specific limitations; for example, a condo association might allow a home-operated business as long as it does not involve a constant flow of patients or clients coming and going through the building.

What will happen if I am already running a home-based business, and I find out that it is illegal?

In the worst case, you will be forced to move your home-based business, or even close it down, if you are found to be violating local zoning laws or private regulations.

On the other hand, you might be able to make changes which satisfy the concerns of your local government or neighbors. For instance, if your business means a steady stream of deliveries is an annoyance to neighbors, you might use a nearby mailbox drop service.

What if I do not think the local home-based business rules in my community are fair?

Home-based business rules and regulations are based on maintaining a quality of life within your neighborhood, and they are often overlooked if neighbors do not complain. It is even possible that nearby families can see a positive, safety aspect to your presence in the area during the day.

This is an area where compromise and negotiation may be great tools in reaching your goal. After all, you live there too, and it may help if neighbors understand you have a personal interest in the quality of life there.

At the local level, you could apply for a zoning variance or even to effect a change in ordinances. The number of home-based businesses is growing each year, and local governments will feel a pressure to respond to the trend.

How do I proceed if I want to get a zoning variance or even a change in the local ordinances?

You can deal with a zoning problem in three stages.

  • First, negotiate with the staff of your town or city’s zoning department. You might agree, for instance, to always park a truck used for your business in the garage, rather than leaving it on the street.
  • Second, request a zoning variance from the city. Basically, you are asking for an exception to the ordinance, and you will want to be prepared with some solid reasons why the variance should be granted. If you have been operating from home for the prior 5 years without complaint from neighbors, this is the kind of point that will help you accomplish your goal.
  • Finally, you can get involved politically and try to change the regulations. If you are on the border of a commercial area, you could ask that the commercial area be extended to include your business. Or you could go even further and ask that the entire area be rezoned.

Home Office Tax Deductions

Many expenses that you incur while working from home are tax deductible—even items that you do not specifically write checks for, such as depreciation.

You can think of these expenses that the IRS allows you to deduct as falling into two major categories. First, you can deduct expenses used in the course of your businesses—telephone, supplies, postage, etc.

Second, you may be able to deduct a portion of the costs of running your business from home. Beginning with rent or mortgage interest, you can potentially deduct utilities, insurance, real estate taxes in proportion to the amount of space your office uses in your home. Repairs and improvements that relate to the business can also be deductible.

Historically, the IRS had rigid rules that often eliminated home office deductions. The regulations have been relaxed somewhat in the past few years, but it is vital to meet the IRS’s specific requirements. And, as they say on their Web site, “even then, your deduction may be limited.”

To deduct expenses that apply to the business portion of your home, you must meet four requirements.

  1. exclusive use: a space dedicated just to the business;
  2. regular use: a consistent and continuing use of the work area;
  3. for your trade or business; and
  4. one of these three options: your principal place of business, a place where you meet with clients or patients, or a separate, unattached structure that you use in connection with your trade or business.

What does the IRS mean by “exclusive use” in determining whether I can deduct my home office?

To the IRS, exclusive use means that a separate area of your home is used only for your trade or business. It can be a separate room or a clearly identifiable space. The space does not have to be specifically marked off.

A key point is that you cannot use the area for personal purposes. That means you cannot, for example, use your work space to pursue a hobby of family history.

Is there an exception to the IRS “exclusive use” rule in determining whether I can deduct my home office?

Yes. If you consistently use a distinct part of your home to store inventory or product samples, and if your home is the only fixed location for your trade or business, you do not have to meet the exclusive use test. Another exception is if you use part of your home for a day care business.

Can I deduct home office expenses even if I do not meet patients, clients or customers there as part of my business?

Meetings are just one of the ways to support deducting home office expenses. In addition to meeting the exclusive, regular and for your trade or business requirements, the IRS says the business part of your home must meet just one of these:

  • your principal place of business;
  • a separate structure (not attached to your home) that you use to pursue your trade or business; or
  • a meeting place.

In other words, you do not have to meet with others to satisfy the requirements if your home work space is your principal place of business, either in your home or in a separate structure.

Can I deduct a home office if I live in a condo or rent an apartment?

You do not need to live in a house to qualify for a home office deduction, although you still need to meet the requirements set by the IRS.

If, for example, you are an interior designer and spend the majority of your time shopping for decorating products for your clients or meeting where they live, you may still qualify for the home office deduction. If you maintain your schedule and other records, have a primary telephone line and order products from your home office, you can be eligible to take the deduction.

What are some tips for meeting IRS requirements?

As in any dealings with the IRS, you will benefit from maintaining records that support your case.

  • Keep a calendar and a log of your business activities so that you can demonstrate how you spend your time. (Many consultants who bill by the hour already keep these detailed records.)
  • Use a dedicated business phone line and make sure it, along with your address and business name, is included in your letterhead and other correspondence.
  • Be ready to document your office space with layouts and possibly photos.

How do I determine the amount of home office expense I can deduct?

Once you are sure you meet the IRS regulations for a home office deduction, you will need to take two more steps. First, compile your home-related expenses that will be eligible for the deduction. This includes a mortgage or rent payment, property tax, casualty losses and repairs. You will also calculate depreciation for the home.

Then you need to estimate the portion of the dwelling that is dedicated to your home business. This can be done by using square feet, dividing the number of square feet used by the home office by the home’s total. Or you can use the proportionate number of rooms, assuming all rooms are about the same size.

You may have what the IRS calls “direct” expenses, meaning they apply only to the work area. The business can deduct the entire amount of a direct expense. Painting only the business area is an example of a direct expense.

Can I depreciate home office furniture and equipment?

Even if you do not qualify to deduct home office expenses, such as mortgage or rent, utilities and depreciation, you may be entitled to take depreciation for furniture and equipment. This would apply whether you are the business owner or are working as a home-based employee.

Even if you may have paid cash for the whole amount of a business asset, for tax purposes you will take depreciation as an expense over a number of years that are roughly the same as the expected life of the asset. This “noncash” expense will help reduce the amount of income eligible for income tax; thus business owners want to take as much depreciation as allowed by the IRS.

The rules for depreciating business furniture and equipment depend on many factors. The IRS regulates depreciation based on the type of property, the percent of time it is used for business use versus personal use and whether it was purchased originally for business use or personal use.

How does depreciation work?

Let us start with an example. If you are a professional photographer, you might buy an expensive camera which you expect to use over many years. You would like to be able to deduct this expense right away from your income tax.

But the IRS has other ideas. Since your equipment has a long expected life of use, you cannot deduct the entire expense in the first year. You are allowed to depreciate the expense over the approximate expected lifetime of the camera.

Each year, you can deduct a portion of the expense of the camera until you have reached the amount you paid for it.

How do I know how much depreciation expense I can take each year?

The simplest form of depreciation is called straight line. Basically, you divide the cost of your asset by the number of years of expected life and take that equal amount each year until you have depreciated the entire cost.

Accelerated depreciation is favored by businesses because it allows bigger amounts of depreciation expense in the earlier years of the item’s life.

For example, if our photographer paid $1,000 for his or her camera and expects a 5-year life for it, he or she would be able to expense $200 per year using straight line depreciation. With accelerated depreciation, he or she would take a larger amount of depreciation in the first years and a smaller amount in the later years, still totaling the $1,000 original cost of the camera.

Why does depreciation matter?

Depreciation is listed as an expense for tax and accounting purposes, but there is no actual cash outlay by the business. Since the effect of depreciation is to conserve cash, it benefits cash flow. Stronger cash flow gives the business owner more flexibility in managing its finances and even for additional investment.