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Nothing makes an IRS agent go weak in the knees faster than good records. Copies of things like receipts, utility bills, invoices, billing records, and so on will go miles in helping you prove any deduction, including a home office deduction. Of course, you don't want to spend all of your time filing every little piece of mail you get, so what are you supposed to do?
The answer is electronic records. There are complicated systems out there, but the easiest and cheapest is to just get yourself a scanner. Any scanner will do, but one with a sheet feeder that makes double sided copies automatically is the way to go. (If you can't afford it, a more basic model will do for now, but you'll have to be more disciplined, because it won't be as easy.)
Every time you get a bill that has anything to do with your home, run it through your scanner and scan the whole bill. You don't need the ads that were inserted in the envelope, but scan the bill, the fine print on the back, and even the coupon you are supposed to use to pay. Make sure you fill out the coupon before you scan it. You can scan the check if you want to, but it is probably easier to just make a note of the check number on the payment coupon. Then, you can download all the copies you need at the end of the quarter.
Save the image of the bill to a folder on your computer called Home Office Deduction inside the folder where you keep your business records. Now, when it comes time to claim your home office deduction you can use exact numbers and not guesses.
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There are a million small business accounting software packages out there. Last time I checked, you could get Microsoft Small Business Accounting for free. If you would rather go the online route, try Lessaccounting.com. Of course, there is Quickbooks, and Peachtree, and the various Sage products if you are willing to pay.
Keep a category in your accounting software specifically for your home office. Lightbulb burn out? Put in an expense for replacing it. New curtains because the sun washes out your computer? Put in an entry, and make sure you note the business reason in the comments field. "Could not work between 7:30am and 9:00 am" is a good business case.
Seem silly? It is. But, again, if you pull out records that are this detailed, an IRS agent is going to move onto the next case. They process hundreds of millions of tax returns and audit millions of them. It is all about volume. If someone looks like a tough case, then they aren't going to stick around and try and get an extra hundred bucks out of you. There are bigger, easier fish in the sea.
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Time Keeping Software
Use Microsoft Outlook or whatever time manager you use to keep track of the number of hours you spend in your home office. This doesn't have to be an exact thing, but again, go with the best you can. Mac users rave about something called Slife which right now has no Windows version. Never fear, try 8aweek or RescueTime to help you track your time.
There is no requirement for how many hours you have to be in your home office, but there is a definite benefit to being able to show that you spend 11 hours a day in that basement room you call an office.
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The number one requirement for a home office to be eligible for a home office deduction is that it must be used exclusively (that is 100% of the time) for business. Things like a separate entrance and signage help make this case, but they aren't the only thing. Setup your home office for business. If you've been there a while, clean up and organize everything. Now, stand at the doorway and scan the room. Find anything (and I mean ANYTHING) that can be construed as non-business, and get it out of there. Little Johnny's books? Gone. Your spouse's racketball bag? Gone. Anything that does not scream business is out.
Now, grab your digital camera and take pictures of your office. If you ever are resquested to give more information, you can always send in the photos as evidence that your home office is (or was during that tax year) used 100% for business. As an added bonus, these pictures serve as evidence that your business equipment is being used for business. See, there is that printer that I deducted last year, right next to the big flatscreen monitor I deducted the year before that.
When you buy new business equipment, put it in your home office and get another set of pictures (again no non-businees stuff in the room). Now, you can show over time that your home office deduction is rock solid.
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You won't need any of this if your returns don't get examined. Don't be cocky though, it happens all the time. One little number that is too far off the "norms" and you're return will pop up in the Take an Extra Look Queue*. Everyone knows about full audits, but that is only part of the extra examination. Sometimes, you'll just get a letter saying "Hey send us more proof"** When you send back good proof like you'll have if you follow these hints, then they say "Thanks"*** and move on. If you have junky proof or no proof, you can expect a more personal touch.
Follow these tips and your accountant will be smiling the whole time while he figures out your home office deduction.
* Not the official term
** Not exact IRS wording
*** Not exact IRS wording either
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Online Software Tip
Want to use free software or online software but are worried about giving out your information? Check out my article on Top 5 Online Privacy Tools.