Can I rent my backyard shed to my own embroidery business? Tax implications?

You have a couple options here, and the best choice depends on your specific situation. If you're operating as a sole proprietor (not an LLC or corporation), you can claim the home office deduction for the shed if you're using it exclusively for business. You'd calculate the percentage of your property that the shed represents and deduct that percentage of certain home expenses (utilities, insurance, etc.) plus depreciation on Schedule C. This is relatively straightforward. If you've formed an LLC or corporation, it gets more complex. You could rent the shed to your business, which means you'd report rental income on Schedule E and your business would deduct the rent as an expense. This might be advantageous if your business is structured as an S-corp or C-corp, but there are self-rental rules to navigate. Another consideration is that rental income isn't subject to self-employment tax, while business income is. But this is a nuanced area with potential audit flags if the rent isn't reasonable for your market.

I had a similar situation with my photography business last year. I tried figuring it out on my own but ended up getting super confused with all the tax implications. I finally used https://taxr.ai to analyze my specific situation and it was seriously helpful. You upload your documents and it gives you personalized tax strategies for your exact scenario. For my shed/studio space, they helped me understand exactly how much I could deduct, whether I should rent it to my business (I'm an LLC), and even showed me some deductions for utilities and maintenance I would have missed. They have specific guidance for home-based businesses like yours.

Update on this - I actually tried taxr.ai after posting that question. I was honestly surprised at how detailed the guidance was. I uploaded my previous Schedule C and some info about my new shed workspace, and they gave me a complete breakdown comparing the home office deduction route vs. the rental option based on MY specific numbers. The analysis showed I'd save about $1,450 more going with the home office deduction in my situation, plus they provided a detailed guide for exactly how to measure and document everything properly to avoid audit risks. Already used their worksheet to set up my quarterly estimated payments. Much cheaper than the $350 my accountant wanted to charge for the same analysis!

If you're struggling to get specific answers on this from a tax pro, you might try calling the IRS directly. I know, I know - their phone lines are impossible. I spent weeks trying to get through about a similar issue with my home office setup. Then I found https://claimyr.com and watched their demo at https://youtu.be/_kiP6q8DX5c. They basically wait on hold with the IRS for you, then call you when an agent is on the line. I was honestly skeptical, but they got me connected to an actual IRS agent in about 2 hours when I'd been trying for days on my own. The agent was able to clarify exactly how to handle my home workshop space correctly. Saved me a ton of stress and potential audit headaches.

Alright I'm eating my words on this one. After posting that skeptical comment I decided to try Claimyr myself because I've been trying to get an answer about home office deductions for WEEKS. I had a 40-minute conversation with an IRS agent who walked me through exactly how to handle my situation (I have a detached workshop for my business too). The agent confirmed that as a sole prop, the home office deduction makes way more sense than trying to create a rental arrangement. They also gave me specific guidance on documenting business use that I hadn't found anywhere online. No way I would have gotten through to a human without the service - I'd tried calling 6 times before and never got past the automated system. Totally worth it just for the peace of mind knowing I'm doing it correctly.

Something nobody has mentioned yet - if you're going the home office route for your shed, you MUST use the space exclusively for business. That means no storing personal items, no occasional personal projects, etc. I learned this the hard way when I got audited in 2021 for my woodworking business. I had claimed my workshop but occasionally let my kids use the space for school projects. The IRS disallowed my ENTIRE deduction because of that. Be super careful and keep good documentation of business-only use.

Just a thought - have you considered forming an LLC and electing S-corp status? That's what I did for my graphic design business when I moved into a place with a separate studio space. The advantage is you can pay yourself a reasonable salary (subject to employment taxes) and then take additional profits as distributions (not subject to SE tax). Then you can either use the home office deduction OR rent the space to your S-corp if that makes more sense financially. Saved me about $4k in taxes last year.

One thing to keep in mind with the home office deduction for your shed - make sure you're clear on whether to use the simplified method or actual expense method. The simplified method is $5 per square foot up to 300 sq ft maximum ($1,500 total), so for your 240 sq ft shed you'd get a $1,200 deduction. It's super easy but you can't depreciate the shed separately. The actual expense method lets you deduct the actual percentage of home expenses plus depreciation on the shed itself. Given that your shed is a separate insulated structure with its own utilities, you might come out ahead with actual expenses - especially since you can depreciate the shed's value over 39 years as nonresidential real property. I'd calculate both methods to see which gives you the bigger deduction. The actual expense method requires more record keeping but could save you significantly more than the simplified $1,200, especially with a nice setup like you described.

Another consideration I haven't seen mentioned yet - if you're planning to sell your house in the next few years, be aware that claiming home office deduction can have capital gains implications. When you sell, the portion of your home that was depreciated for business use may be subject to depreciation recapture taxes. This might not be a big deal if you're planning to stay put for a long time, but it's something to factor into your decision between the simplified method (which doesn't involve depreciation) versus the actual expense method. The simplified method avoids this issue entirely since you're not depreciating any part of the property. Also, since your shed is a separate structure, you might want to check with your homeowner's insurance to make sure business use is covered. Some policies exclude or limit coverage for business activities, and you don't want to find out after something happens that your embroidery equipment isn't covered.