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Should we start a small business for the tax break?

October 25, 2012: 6:30 AM ET

My husband and I get clobbered on taxes because we have a rental house in another state that we can't sell, and because of it, we can't buy a house in the state we live in. We make too much ($195,000 before deductions), so the rental mortgage interest is unavailable to use as a deduction. Is it worth it to start a small business at home to try to make some deductions appear? My husband refinished a boat last year that we kept, but he wants to refinish another one or two and then sell them. I, on the other hand, sew and quilt and would like to start an Etsy business. — Julie P.

The problem with your plan is this: In order to decrease your overall tax bill, you'd have to take a loss on your business. Otherwise, you're just applying business expenses against your business income, which means you'll still pay taxes on any profit.

Here's an extremely simplistic example: If you make $1,000 on your Etsy business and incur $600 in expenses, you'll still be paying taxes on the $400 in profits. And if you make $1,000 on your Etsy business and incur $1,500 in expenses, you'll pay less in taxes — but only because you lost money overall. "To lose money for the sake of shrinking your tax bill doesn't make any sense at all," says Andrew Schwartz, a CPA in Woburn, Mass. "If somebody loses a dollar, the most they're going to recoup in federal income taxes is 35 cents. You're better off not losing the dollar."

That's assuming that your husband's boat refinishing business and your Etsy business are, in fact, businesses and not hobbies. The IRS isn't wild about people taking business deductions for activities that are actually hobbies, and has some guidelines on the subject.

If you are, however, refinishing boats and making quilts on a profit-seeking basis, you should absolutely be taking the deductions that are available to you, including a home office deduction, if it's applicable. "If your husband is running a boat refinishing business and he's doing that out of the house, then some of the rent that you're paying will be deductible against the profit you're seeing," says Howard Samuels, a CPA in New York City. "But you're only allowed to deduct a home office if it doesn't make your profits negative."

If you go down this road, you should probably consult with a CPA, at least in the first year, so you understand what is and isn't possible. "If you get audited, the government is going to say, 'Prove you're running a real business,'" Samuels says. "'Where is your website? Where are your business cards?' You're going to have to show that it's legit."

— Kate Ashford

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