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6 Things Small Business Owners Need To Know About Deducting Rent

6 Things Small Business Owners Need To Know About Deducting Rent

Every small business owner has to stay on top of their taxes. Not only are they expected to keep their business afloat, but they also have to track every transaction and pay the right amount to Uncle Sam. Thankfully, there are ways to reduce your income tax liability.

Enter the tax deduction

Tax deductions are one of the easiest ways to reduce your income tax bill. Also known as a write-off, a deduction allows you to deduct business-related expenses from your taxable income. You simply take the amount of the expense and subtract that from your income. But not all expenses are deductible; they have to meet IRS rules.

Rent as a tax deduction

The IRS allows small business owners to deduct rent as a business expense as long as the property being rented is used for business activities. Whether you rent a small workspace or an apartment that doubles as your office, rent represents a huge chunk of your tax deductions.

If you want to make the most of your deductions, it's important that you understand the nuances of the process. Here are a few things you need to know about rent as a tax deduction.

Are you buying or leasing?

The tax rules for renting and purchasing are different, which is why you must first determine if the payments are for rent or the purchase of a property. 

Payments made under a lease agreement are generally deductible while payments that lead to equity or ownership (e.g. conditional sales contract) are not deductible. The situation becomes more complicated for rent-to-own agreements, in which you rent a property for a predetermined period of time, with the option to buy it before the lease expires.

If it is not clear from the contract if the agreement is a lease or a conditional sales contract, you might want to consult a tax professional to clarify your situation.

Is your rent unreasonable?

While business-related rent is generally deductible, unreasonable rents paid are not. A rent becomes unreasonable if the amount paid is higher than the market value or a professional appraisal.

The IRS presumes that arm's length transactions are reasonable, since both parties are independent, possess equal bargaining power, and are acting in their own self-interest. 

However, if the business owner and the lessor are related, unreasonable deductions may trigger an IRS audit. Rent paid to a related person is considered reasonable if the amount is comparable to the market rate or what a stranger would pay for the same property.

Does your home double as your office?

If your home doubles as your workplace (i.e. principal place of business), you may qualify for the home office deduction. The home office deduction allows you to write off a portion of your home expense as a business expense. The deduction applies to both owned and rented homes.

To qualify for the deduction, your home office must meet two IRS requirements:

Regular and exclusive use

You must use a part of your owned or rented home (e.g. house, condominium, apartment, houseboat, mobile home, or other similar structures) regularly and exclusively for conducting business. 

If you run a business out of your den, garage, or a freestanding structure like a barn, you can also claim that specific area as your home office. However, you can't claim the home office deduction if you're living in a hotel or motel.

To determine eligibility, the space must be "regularly and exclusively used" for business. A room in your home exclusively used for work and meetings meets this important IRS test, but working in the living room where your family unwinds does not. If the space is used for both personal and business activities, it does not meet the IRS definition of a home office.

If you work in a space that is also used for personal or non-business activities (e.g. bedroom, dining room), you can place a physical partition to show that a portion of the room is separate from the rest of your home.

Principal place of business

Your home office must be used as your principal place of business. To meet this test, you must ensure that your home office is where you conduct your most important business activities and where you spend most of your work hours. 

Let's say you run a consultancy business. If you spend most of your time in your garage office, then the space counts as your principal place of business. This also includes the space you use for meeting and dealing with clients on a regular basis, provided it is not used for other personal activities. Note that there are separate rules for storage facilities and daycare providers.

Do you pay your rent in advance?

Always remember that rent paid for a business is only deductible in the year it is paid. This means if you paid your rent in advance (e.g. for the entire duration of a 5-year lease), you can only deduct the amount that applies to the use of the property during the tax year. 

While you cannot deduct the entire advance payment in one tax year, you can deduct the rest of the payment over the period to which it applies.

Did you cancel your lease?

If for some reason you canceled your business lease, the IRS may permit you to deduct the expenses related to the cancellation of the lease.

How to maximize your rental deductions?

Deducting rental expenses can be confusing. Contracts aren't always clear-cut and home office deductions are notoriously complicated. If you want to make the most of your rental deductions, talk to a tax expert.

The tax experts at TFX can help you maximize your tax savings and guide you through the steps of claiming rent as a tax deduction. For over 25 years, we have helped countless small business owners save money on their taxes.

Ines Zemelman, EA
Founder of TFX