Whether you do contract work or have your own small business, tax deductions for the self-employed can add up to substantial tax savings.
With self-employment comes freedom, responsibility, and a lot of expense. While most self-employed people celebrate the first two, they cringe at the latter, especially at tax time. They might not be aware of some of the tax write-offs to which they are entitled.
When it comes time to file your returns, don’t hesitate to claim the benefits you get for being the boss. As a self-employed success story, you’ve earned them.
“Many times an overlooked deduction is educational expenses. If one is taking courses or buying research material to be more effective in their work, this can be deductible.”
Individual Retirement Plans (IRAs)
John L. Hillis, president of Hillis Financial Services in San Jose, California, said the best tax write-off for the self-employed is a retirement plan. A person with no employees can set up an individual 401 (k).
“The individual can contribute $17,500 in 2014 as a 401(k) deferral, plus 25 percent of net income,” Hillis said.
If you have employees, Hillis recommended a SIMPLE (Savings Incentive Match Plan for Employees) IRA – an IRA-based plan that gives small employers a simplified method to make contributions to their employees’ retirement. As of 2014, an employee may defer up to $12,000, Hillis said, and employees over 50 may contribute an additional $2,500.
“A third retirement plan is Simplified Employee Pension IRA (SEP IRA),” Hillis said. “The employer may contribute the lesser of 25 percent of income or $52,000 in 2014. If the employer has eligible employees, an equal percentage of their income must be contributed.”
Hillis asserted that retirement plans are “absolutely the No. 1 tax deduction. The government is helping fund retirement.”
Business use of home or dwelling
Accountant and consultant Jéneen R. Perkins, principal of Éclat Enterprises LLC, in Milwaukee, Wisconsin, said most self-employed taxpayers’ businesses start as home-based businesses. Those people need to know portions of business costs are deductible, she said, adding, “It is very important that you keep track of expenses relating to your housing costs.”
If your gross income from your business exceeds your total expenses, then you can deduct all of your expenses related to the business use of your home, Perkins said. If your gross income is less than your total expenses, your deduction will be limited to the difference between your gross income and the sum of all business expenses you would pay if the business was not in your home. Those expenses could include telephone lines, the Internet, and other costs to do business.
You must also have a home office that is truly used for work. Hillis said the Internal Revenue Service may require you to document this.
Deducting automobile expenses
If you travel for business, even short distances within your own city, you may deduct the dollar value of business miles traveled on your tax return, Perkins said. The taxpayer may file the actual expense he incurred, or use the standard mileage rate prescribed by the IRS, which is 56 cents as of 2014. The IRS allowable mileage rates should be checked every year as they can change.
“If you decide to use actual car expenses, be sure to include payments, depreciation, registration, insurance, garage rent, licenses, repairs and maintenance, and parking and toll fees,” Perkins said. “If you decide to use the standard mileage rate, it would be in your best interest to keep a log – daily, weekly or monthly – of miles driven to distinguish personal use from business use.”
Depreciation of property and equipment
Some self-employed people may purchase property and equipment for a business. If they expect that property to last longer than one year, it should be depreciated on the tax return, Perkins advised.
Perkins said that claims regarding property, according to the IRS, must meet the following criteria: You must own the property and it must be used or held to generate income. The property should have an estimated useful life, meaning you should be able to guess how long you can generate income with it. It may not have a useful life of one year or less, and may not be purchased and disposed of in the same year.
Certain repairs on property used for business may also be deducted.
Any educational expense is potentially tax-deductible.
“Many times an overlooked deduction is educational expenses,” Hillis said. “If one is taking courses or buying research material to be more effective in their work, this can be deductible.”
Think about any books, web courses, local college courses, or other classes or materials that you have purchased to improve your job or business. It’s easy to forget a work-related webinar or business e-book that was purchased online, so remember to save e-receipts.
Perkins also mentioned subscriptions to trade or professional publications and donations to business organizations, both of which are frequently necessary for the continuation and growth of your business.
Other areas to explore
Other deductions that can be easily missed are advertising and promotional expenses, banking fees, and air, bus, or train fare. Restaurant meals and other entertainment costs may be written off as long as they are necessary business expenses.
In addition, Hillis said to consider health insurance premiums, which in most cases represent a credit rather than a tax deduction.
“A credit goes directly against one’s taxes, rather than a reduction of income,” he said.
Regardless of which expenses you discover that you may write off, the most important thing is to keep accurate records throughout the year. Save receipts, including e-mail receipts, and file or log them so you have easy access to them at tax time. Not only does keeping receipts, mileage logs, and other expense records make filing taxes easier, but it also facilitates a system that allows you to track changes from year to year.
Long-term tax-saving strategies
Don’t just look at last-minute write-offs when considering self-employment tax deductions. Think about laying down some long-term strategies for money savings from year to year – particularly if you are a high earner.
“Accountants typically tell you what you have to pay,” said Stephen K. Davis, chief investment adviser for Safe Harbor Asset Management in Huntington, New York. “They don’t always tell you strategies to reduce your payments.”
To reduce your gross taxable income, consider setting up a defined-benefit pension plan, Davis said. This plan is based on your age and income: The older you are and the higher your earnings, the more you are allowed to contribute. An alternative plan is an age-weighted profit-sharing plan, which is similar and can benefit those who have several employees.
Another strategy for high-earning business owners who own their own building through a limited liability company or similar business structure is to pay themselves rent, said Davis. This rent is used to pay down the mortgage, but it is also considered a business expense for tax purposes.
Self-employed professionals required to have liability insurance should consider setting up their own insurance company. A captive insurance company is one that insures the risks of the business – or businesses, in the case of a cooperative. Its premiums can be tax-deductible.
But, Davis warned, if money accumulates and claims are minimal, the money taken out is taxable under capital gains. Davis emphasized that this is not a retirement strategy, but that it can save you money by allowing you to “pay yourself” instead of an insurance company and still deduct the premiums.
With any of these more complicated, long-term strategies, consult with a business attorney or financial planner to ensure you have the best plan possible for your business.
The Home Office Deduction
Top Tax Write-offs for the Self-Employed, Home Office Deduction Guide
Many people whose small businesses qualify them for a home office deduction are afraid to take it because they’ve heard it will trigger an audit. But if you deserve it, take advantage. These tips can help you determine if you qualify and rest easy when you do.
Take the deduction, carefully
Will a home office deduction trigger an audit? The answer is generally “no.” Changes in the rules in the late 1990s made it easier for people who work out of their homes to qualify for these write-offs. So if you qualify, by all means, take it.
The biggest roadblock to qualifying for these deductions is that you must use a portion of your home exclusively and regularly for your business. The office is generally in a separate room or group of rooms, but it can be a section of a room if the division is clear—thanks to a partition, perhaps—and you can show that personal activities are excluded from the business section.
The law is clear and the IRS is serious about the exclusive-use requirement. Say you set aside a room in your home for a full-time business and you work in it at least ten hours a day, seven days a week. Let your children use the office to do their homework, though, and you violate the exclusive-use requirement and forfeit the chance for home-office deductions.
The rule doesn’t mean you’re forbidden to make a personal phone call from the office, or that you have to rush outside whenever a family member needs a moment of your time. Although individual IRS auditors may be more or less strict on this point, some advisors say you meet the spirit of the exclusive-use test as long as personal activities invade the home office no more than they would be permitted at an office building. (Two exceptions to the exclusive-use test are discussed later.)
There’s no specific definition of what constitutes regular use. Clearly, if you use an otherwise empty room only occasionally and its use is incidental to your business, you’d fail this test. But if you work in the home office a few hours or so each day, you’d probably pass. This test is applied to the facts and circumstances of each case the IRS challenges.
Principal place of business
In addition to passing the exclusive- and regular-use tests, your home office must be either the principal location of that business, or a place where you regularly meet with customers or clients. If you are an employee and have a part-time business based in your home, you can pass this test even if you spend much more time at the office where you work as an employee.
There is, though, the question of what constitutes a business. Making money from your efforts is a prerequisite, but for purposes of this tax break, profit alone isn’t necessarily enough. If you use your den solely to take care of your personal investment portfolio, you can’t claim home office deductions because your activities as an investor don’t qualify as a business.
Taxpayers who use a home office exclusively to actively manage several rental properties they own, though, may qualify for home office tax status—as property managers rather than investors. As with the regular-use test, whether your endeavors qualify as a business depends on the circumstances. The more substantial the activities, in terms of time and effort invested and income generated, the more likely you are to pass the test.
What if your business has just one office—in your home—but you do most of your work elsewhere? First, remember that the requirement is that the office be the principal place of business, not your principal office.
As long as you at least use the home office to conduct your administrative or management chores and you don’t make substantial use of any other fixed location to conduct those tasks, you can pass this test. This rule makes it much easier to claim home office deductions for individuals who conduct most of their income-earning activities somewhere else (such as outside salespersons, tradespeople, or professionals).
If your home office is in a separate, unattached structure—a loft over a detached garage, for example—you don’t have to meet the principal-place-of-business or the deal-with-customers test. As long as you pass the exclusive- and regular-use tests, you can qualify for home business write-offs.
Day care facilities and storage
The exclusive-use test does not apply if you use part of your house to provide day care services for children, the elderly or handicapped individuals. If you care for children in your home between 7 a.m. and 6 p.m. each day, for example, you can use that part of the house for personal activities the rest of the time and still claim business deductions. To qualify for the tax break, your day care business must meet any applicable state and local licensing requirements.
Another exception to the exclusive-use test applies to a portion of your home used to store product samples or inventory you sell in your business. Assume your home-based business is the retail sale of home-cleaning products and that you regularly use half of your basement to store inventory. Occasionally using that part of the basement to store personal items would not cancel your home office deduction. To qualify for this exception, your home must be the only location of your business.
Business percentage of house or simplified square foot calculation
Your home office business deductions are based on the percentage of your home used for the business or a simplified square footage calculation.
Percentage of your home method:
The most exact way to figure this proportion is to measure the square footage devoted to your home office and find what percentage it is of the total area of your home. If the office measures 150 square feet, for example, and the total area of the house is 1,200 square feet, your business percentage would be 12.5% (150 ÷ 1,200).
An easier way is acceptable if the rooms in your home are all about the same size. In that case, you can figure the business percentage by dividing the number of rooms used in your business by the total number of rooms in the house.
Special rules apply if you qualify for home office deductions under the day care exception to the exclusive-use test. Your business-use percentage must be discounted because the space is available for personal use part of the time. To do that, you compare the number of hours the day care business is operated, including preparation and cleanup time, to the total number of hours in the year (8,760).
Assume you use 40% of your house for a day care business that operates 12 hours a day, five days a week for 50 weeks of the year. That’s 3,000 hours out of the total of 8,760 hours in the year. That’s 34% of the available hours, so your business write-off percentage is 13.6% (40% of 34%).
Simplified square footage method:
Beginning with 2013 tax returns, the IRS began a simplified option for claiming the deduction. This new method uses a prescribed rate multiplied the allowable square footage used in the home. For 2014 the prescribed rate is $5 per square foot with a maximum of 300 square feet. The space must still be dedicated to the business activity as described above.
With the simplified method, if the office measures 150 square feet, for example, then the deduction would be $750 (150 x $5).
NOTE: With either method the qualification for the home office deduction is made each year. So you might qualify one year and not the next, or vice versa.
If you are eligible for home office deductions, the tax savings can be well worth the additional work required to qualify. And remember, TurboTax makes it easy to determine if you qualify and how much you can write off.
Here are some examples of key home office deductions using the percentage of your home method:
Money spent to repair or maintain the business space is deductible. If you paint the room that is your home office, for example, the entire cost can be deducted. Although no part of the cost of the firs telephone line on your home can be deducted, the full cost of a special line for your business and other direct expenses—such as the cost of long distance business calls—can be written off.
These will probably be your most fruitful home office deductions. Because part of your home qualifies as business property, part of the costs of running it can be converted from non-deductible personal expenses to business write-offs. If your office space takes up 20% of the house, you can deduct 20% of your bills for utilities, homeowners insurance, homeowners association fees, security, and general repairs and maintenance.
Interest and property taxes
Mortgage interest and property taxes are deductible expenses if you qualify for home office deductions. But with a home office you convert part of those expenses from personal itemized deductions to business write-offs. Because business expenses reduce self-employment income, they can also trim what you owe in Social Security taxes.
Deducting rent, or depreciating
If you rent the home where your office is located, this computation is easy: You deduct the same percentage of your rent as the percentage of your home devoted to your business. If you own your home, you depreciate the business part of the house. Figuring the right amount to deduct is complicated (TurboTax will help) but you only have to do it once; then you’ll enjoy the savings year after year.
- If you generally have to pay the Alternative Minimum Tax (AMT) when you itemize deductions, a home office deduction may be a factor contributing to your AMT status. If so, you may want to forego the home office deduction. This consideration is only relevant if you are an employee and not a self-employed person.
- If you include home depreciation as part of the home office deduction and eventually sell your home at a profit, you will have to pay a capital gains tax on the total amount of depreciation deductions you took while you were living there, assuming you sold the home for a profit.
- Limit on write-offs – the law puts a cap on how much you can deduct for the business use of the home. Basically, your home office deductions can’t exceed your home-based business income. In other words, home office expenses can’t create a tax loss to shelter other income.
- The home office deduction is not a red flag for an IRS audit.
- Whether you qualify for this deduction is determined each year.
- Deducting a home office is treated differently depending on your business type.
- The simplified method can make it easier for you to claim the deduction but might not provide you with biggest deduction.
- 0.1 Individual Retirement Plans (IRAs)
- 0.2 Business use of home or dwelling
- 0.3 Deducting automobile expenses
- 0.4 Depreciation of property and equipment
- 0.5 Educational expenses
- 0.6 Other areas to explore
- 0.7 Long-term tax-saving strategies
- 1 The Home Office Deduction