DANGEROUS DEDUCTIONS
by: Cary Christian

Operating a business from your home paves the way for taking some valuable tax deductions. The tax law allows you to deduct from your income expenses that are related to the production of that income. If you're using your home for business, that means a portion of the following expenses might be deductible for income tax purposes:

* Electric bills
* Phone bills
* Internet service
* Depreciation on computer hardware
* Amortization of computer software
* Depreciation of furniture used in your business
* Real estate taxes
* Interest expense on your mortgage
* Insurance on your home and possessions
* Rent
* Depreciation on your home

To determine the portion of these expenses that are deductible, you need to determine the portion of the expense that relates to your business. For example, if you use 25 percent of the total space of your home solely for your home business, you could argue that at least 25 percent of your electric bill, real estate taxes, interest on your mortgage, insurance on your house and any other expense directly related to your housing should qualify as deductible expenses related to your business. You could also take 25 percent of the cost of your home and depreciate it for tax purposes. Sounds good, doesn't it? Makes the middle class tax shelter all that much better.

There is almost no downside to taking most of these deductions,
assuming you can adequately demonstrate the business use of your
home. However, you should think twice before you claim depreciation on a portion of your home.

When you claim a portion of your home is used strictly for business, you are converting that portion from your personal residence to a business asset. As you probably know, tax law contains several provisions that allow deferral or complete exclusion of any tax on the gain from the sale of your personal residence. It is vitally important that you realize these exclusions do not apply to the portion of your home used for business purposes. Also, you will have to recapture the depreciation you claimed in prior years as taxable income because the depreciation deductions reduce your basis in the home. As a result, when you sell your home you will have a major, unwanted tax consequence. In the extreme circumstance where your home has not appreciated very much in value, you might even find that you owe more in taxes than your profit on the sale!

If you plan on keeping your home indefinitely, this probably makes no difference to you since it is the sale that creates the problem. If you think you may sell your home within five years, you're probably much better off not claiming depreciation on your home.

If you decide not to claim depreciation on your home, you can still deduct the other expenses mentioned above. Just make sure no area of your home qualifies as a "home office" used strictly for business purposes by being able to show you carry on other non-business activities in every area of your home. Why? Because the tax law contains a rule that states depreciation related to a business asset is the amount "allowed or allowable." In other words, if a portion of your home is deemed by the IRS to qualify for depreciation deductions, you'll realize the same tax problem on the sale of the home as described above even though you did not take the deductions on your return.

If you want to see a complete example of how the above tax trap works, email me and I'll provide it to you.

You also need to be aware of certain books, websites, articles or organizations that tell you to incorporate your business and write off all your personal expenses as business deductions. I'm sure you've seen them: buy a car, write it off. Don't pay an allowance, pay your children a salary and deduct it. Buy a new TV, pay for it with a corporate check and deduct it. This will not fly. It is the easiest of scams for an IRS agent to spot. You will be audited and face severe penalties. Some have even gone to jail.

Expenses are deductible when they are incurred in the active conduct of a trade or business, not because they are incurred by a corporation. Paying them through a corporation does not change the nature of the expense. If it's a personal expense, it's personal. Period. If you pay a personal expense through a corporation, it becomes income paid to you by the corporation, so you gain nothing except extra paperwork to keep track of business versus personal expenses and the possibility of getting hit with employment taxes you would not otherwise have been liable for.

It makes perfect sense to deduct all the expenses that ARE related to your home business activities. But please, please watch out for these scams that would have you go too far. They seem to be popping up more and more often. If you read something along the lines of what I've described, please contact me about it before following advice that will get you into trouble.


Copyright (c) 2002