A Shop Built for Personal Use

• If you built the shop for personal use, it counts as a home improvement. While the cost of building the shop is not directly deductible from your income, you can still benefit on your taxes in two ways.
  
  The first way involves interest on a mortgage. If you took out a mortgage on your home to build the shop, then the interest on that mortgage is deductible from your income, according to Internal Revenue Service (IRS) Publication 936.
  
  The second way arises from the fact that the value of the shop is added to the tax basis of your home. The tax basis of your home is that value that you deduct from the sale price of your home to determine how much profit you made. So if your current tax basis is $150,000, you build a $10,000 shop and sell the home next year for $200,000, then your profit on the home is $40,000 instead of $50,000, reducing the amount of taxable profits on the sale of your home.
  
  

A Shop Built for Business Use

• If you built the shop for business use, it is classed as a capital expense, and a few more rules apply. According to IRS Publication 587, you must regularly and exclusively use the shop for business in order to qualify for a deduction. This means you can't use the shop both for your lawn tools and for your hardwood floor business.
  
  If the shop qualifies, you can claim depreciation as a business expense, which means you may deduct a percentage of the value of the shop each year over its useful life. The shop's value depreciates over its estimated useful life, which by default is 39 years for non-rental real property. Depreciation is calculated using the Modified Accelerated Cost Recovery System (MACRS).
  
  Some of the ancillary costs of owning the shop may be deductible as business expenses. For instance, if you have a separate insurance policy on the shop, pay interest on a loan you took out to build the shop or have a separate utility billing for the shop, you probably can deduct those expenses as business expenses. IRS Publication 535, which is linked in the Resources section, provides more information on allowable business expenses.
  
  

State Taxes

• The same deductions that you can apply to your federal taxes often also apply to your state taxes, particularly if you deduct mortgage interest. Check your state's income tax guidelines for differences in how these deductions are handled.
  
  

Warnings

• If you claim your shop as a business expense, ensure it passes the test of being used regularly and exclusively for business.
  
  If you depreciate the value of the shop over time as a business expense, you cannot also add it to your tax basis when you sell the home.
  
  If you paid state sales tax on your shop, don't claim it as a federal tax deduction unless it exceeds the amount of the state income taxes you paid this year. You can claim either state sales tax or state income tax as a federal tax deduction, but not both.