Home Day Care: Tax Advantage or Tax Headache?

By Duane E. Bennett, CPA, MBA

Deducting a portion of your home as a business expense is difficult and often challenged by the IRS. One test used by the IRS in determining whether a house can be used as a business expense is whether a room within the house is "exclusively" used for the business purpose. This can be very difficult for a homeowner to prove.

However, the IRS has provided an exception to this rule. Home day care providers may find it easier to deduct a portion of the dwelling as a home office , even if areas are not set aside exclusively for day care. For example, a room could be used as a living room at night and a playroom by day. If the day care is operated on a regular basis, this room could be considered a business/personal environment.

How do I calculate the portion of my home expenses deductible as business expenses?

The answer is "time/space percentage." Time (as a percentage of the year) spent in your business multiplied by the area (square footage) of the house used for the day care operation helps determine the amount of home-related expenses that can be deducted from gross income.

The most obvious time is that spent caring for children. But did you know that the same area used to house your children's toys or wash your family's clothes can be deducted if also used in your day care business? (Example: you store day care toys in the same storeroom as your children's toys and you wash items such as kitchen towels, rugs and naptime bedding in your washer.)

What are some of the household expenses I can deduct for my day care business?

Taxes and mortgage interest are normally fully deductible if you itemize your deductions. But by shifting some of these expenses from Schedule A deductions to your day care business (Schedule C), you may be able to reduce your self-employment tax. Self-employment tax, computed on Schedule SE, is a Social Security and Medicare tax for sole proprietors such as day care providers. This results in taxes above and beyond the federal and state income tax you pay on your earnings.

Other expenses you can deduct include utilities, condo fees, insurance premiums and business telephone lines (but not the primary home line).

Additional questions to consider:

1. Do you presently depreciate the business portion of your home as well as other business assets used in the day care?.
2. Have you kept very detailed, accurate records on expenses? Have you prepared all the necessary forms concerning the in-home day care business?
3. Have you funded retirement options (a SEP-IRA, for example) available to you as a self-employed businessperson?
4. Do you have a good record-keeping regimen?
5. Have you set aside enough tax money during the year to prevent a large deficit at tax time?

As always, questions regarding any of this information should be discussed with your tax advisor for proper treatment.

Duane E. Bennett, CPA, MBA, is a Severna Park, MD accountant specializing in family child care businesses. You can reach him at (410) 347-8544.