What is the easiest tax form of them all? Hint: It only takes 5 minutes to complete and mail! Application for Automatic Extension of Time to File U.S. Individual Income Tax Return at: https://www.irs.gov/pub/irs-pdf/f4868.pdf
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Much mysticism surrounds the home office deduction. Many tax accountants continue to advise their clients to avoid the home office deduction. They may say that any depreciation deduction will have to be recaptured if/when they sell their home. This is true, but it is a silly argument (see Recapture, below).
Depreciation. Depreciation expense for the business use portion of your home is otherwise not deductible. A mere $1,000 deduction for depreciation could save a taxpayer $433. This (and the examples that follow) assumes a 28 percent federal income tax bracket plus the 15.3 percent self-employment tax, which equals a total of 43.3 percent multiplied by $1,000 for tax savings of $433 per year, every year. State income tax considerations have not been included, and would increase the tax savings.
Recapture. Even if you sell your house, the recapture (in effect, a reversal of the depreciation deduction) results in a permanent tax savings of the self-employment tax (i.e., Social Security tax for the self-employed) of 15.3 percent. The permanent tax saved is, therefore, $153 ($1,000 multiplied by 15.3 percent) per year, every year. If there were no permanent tax savings, tax deferral is still achieved (e.g., I reduce taxes for 5 years and have to pay these tax savings back in the 6th year, after 5 years of interest-free use of these tax reductions.)
Recapture Example: You take a depreciation deduction for the business use percentage of your home (i.e., home office) at $1,000 each year for 5 years. You have depreciated/deducted $5,000 ($1,000 per year multiplied by 5 years). You sell the home, for a profit, in year 6. You must recapture $5,000 of depreciation expense. This means that you add this $5,000 to income for your tax return in year 6. Using the Depreciation example (above), you saved $433 each year for 5 years for a total of $2,165. Recall that the self-employment tax (15.3 percent) savings will always remain permanent. You may, however, have to pay back federal income tax savings, at 28 percent, in year 6. This is the 28 percent or $1,400 (28 percent multiplied by $1,000 depreciation each year for 5 years). By the way, if you sold your home at a loss of $5,000 or more, there is no recapture for even the federal income tax savings. In this case, all of the tax savings are permanent!
Utilities and maintenance. The business use portion of otherwise non-deductible utilities, repairs, and other operating expenses also result in permanent income tax and self-employment tax savings. For example, again using $1,000, additional permanent tax savings of $433 result per year, every year.
Non-itemizers. For non-itemizer taxpayers, the business use portion of real estate taxes and home mortgage interest become deductible. Again, using the $1,000 example, additional permanent tax savings of $433 result per year, every year.
Itemizers. For itemizer taxpayers, the business use portion of real estate taxes and home mortgage interest shifts from the taxpayer’s Schedule A to their Schedule C (Chapter 10 of my book). This results in a permanent tax reduction of an additional 15.3 percent for the self-employment tax. Again, using the $1,000 example, additional permanent tax savings of $153 results per year, every year.
A recommendation. If you prepared your own tax return this year, you probably used one of the many inexpensive tax software packages available at office supply stores. For example, I spent $10 (in before-tax dollars, as this expense is tax deductible) for my software, and I will file a 25 page federal income tax return, so you don’t have to buy an expensive package with all the bells and whistles.
Run pro forma’s or “what ifs” throughout the year. Start by measuring or otherwise determining the percentage of your personal residence used regularly and exclusively for the production of income in your home business. For example, assuming that this amount is only 10 percent, “what if” you deducted 10 percent of your home repairs, maintenance, utilities, depreciation, real estate taxes, mortgage interest, etc., as a home office?
Label each “what if” by saving it under a different file name. After completing each “what if,” have the software compute your tax and note the change between the “what if” and your actual tax return federal income tax liability or refund. Then, decide if you it is worth it to you to go through the additional administrative work to pursue the home office deduction. Keep in mind, any additional refund or reduction in liability will recur every year. Also keep in mind that some additional state income tax savings may surface.
This can be a complex area. Figures 4 and 5 in Chapter 11 of my book will prove helpful in developing your understanding of this area of taxation. Limitations and other strategic considerations not covered in this short article may also apply, so be sure to print out a copy of this article (and your “what ifs”) and discuss them with your tax accountant!
DEDUCTIONS FOR FREELANCERS THAT YOU MAY NOT KNOW ABOUT!
1) Author’s magazine subscriptions may qualify as “ordinary” and “necessary” business expenses (see Chapter 4).
2) These deductions may be taken even if are not yet generating a profit from your writing (see Chapter 3).
3) Even “books” may be depreciated or expensed (see Chapter 12), if useful for the production of income (see Chapter 4).
4) Also, the business mileage to leave your “home office” and shop for or buy these books is deductible (see chapter 13), even if you do not formally take the “home office” deduction (see Chapter 11).
5) And anything you do to reduce THIS year’s tax, reduces NEXT year’s estimated tax payments (see Chapter 15).
Adapted from Chapters 3, 10 and 11 of Tax Planning Strategies for the Self-Employed (3rd Edition) by A.J. Cataldo, Ph.D., CPA, CMA
A.J. Cataldo no longer prepares tax returns for money, but would be happy to assist any of the subscribers of writersweekly.com with any short self-employment and related tax questions. Just put “WRITERSWEEKLY TAX QUESTION” in the subject box and send it to his home email address at ajcataldo@comcast.net .