Is A Home Business Considered A Tax Shelter?

I’m not going to spend time by simply giving you a list of eligible business expenses or how to take the home office deduction. I’m sure you are pros at all this by now. 

Let’s talk about the lesser-known facts about a home-based business and why the IRS considers them to be as tax shelters:

1) Reporting Business Losses At Home:

Dianne has a retail job but also has a food catering business that she operates from home in the evenings, weekends and on holidays. She reports a cash loss of $5,000 from her business and a $2,500 depreciation on her catering van (that’s considered a paper loss, btw). That’s a total of $7,500 in losses that Dianne can use to offset against her wages from retail, trimming about $1,500 or more from her income taxes (amounts are based on her current tax bracket).

2) Profit Motive Or Running A Business As A Hobby?

People make the mistake of showing fun things such as owning an All-Terrain Vehicle (ATV) or a Yacht as a business, take deductions etc. The IRS tax code prohibits claiming losses for ‘activities not engaged in for profit.” (IRC § 183).

However, in the above example, if Dianne gets audited for claiming those operating losses of $7,500 where her paperwork does not contain any advertising expenses (to support that her business was running for profit) simply because she got most of her business through word of mouth and referrals; she has every right to appeal the auditor’s decision. Dianne was not indulging in a hobby, running a business with a profit motive.

3) The 3 out of the 5-year rule: 

You don’t have to make a profit to be considered a business though you must make an honest attempt to do so. 

The 3 out of the 5-year rule says that you are allowed to show business losses for 3 years as long as the intention was to make a profit. Those losses can be consecutive or non-consecutive. 

If you really tried to make a profit but can’t seem to convince the auditor, you can appeal or go the tax court. 

This rule of 3 out of 5 is not the final word and the IRS continues to look at other factors such how you conduct the business, the nature of activity, other sources of income etc. 

4) Other ways on how to ‘show’ a profit motive or try to ‘look’ like a business: 

Maintain records such as history of making money in the past, advertising expenses, licenses, permits, logs, tickets, lodging, meals, calendar etc. 

Bottom line: It’s the tax returns with business losses that are audited most- home based or NOT. A $60,000 loss will trigger a red flag in the IRS’ system more than a $6,000 loss.

IRS pub 587


Useful Tips: 

  • A business can become a tax shelter by applying real cash losses or paper losses to offset your income from your W2 or other business income.
  • The IRS may disallow losses if it finds out that you were running it as a hobby. 
  • The Safe Harbor Rule allows you to take a maximum of 300 sq. foot multiplied by a rate of $5 per sq. foot for your home office. If calculations drive you up the walls, the IRS allows you to take the safe harbor election on form 8829 towards your home office. 
  • Home office deduction is a great deduction to take but you might have to pay depreciation recapture tax @25% at the time of selling your home. Not everyone knows of it, not even all CPAs! 


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