Freelancers and others who operate their businesses from home can often claim a tax deduction for their home office expenses. Some rules apply, but they're not particularly burdensome. You might also have a number of other business expenses and assets you can depreciate or claim as Section 179 deductions.
The Rules for Claiming Office Expenses
Taking a deduction for a home office is a significant benefit of being self-employed. You can convert a portion of your personal expenses into a tax-deductible business expense subject to a few rules.
- You can't deduct more than your net business profit after claiming other work-related deductions. For example, you're limited to a $2,000 deduction if your office expenses work out to be $3,000, but you only made $2,000. Any unused portion of your home office deduction can be carried over to the following tax year so it's not lost.
- Your office space must be used only for business purposes. It doesn't qualify as your "office" if it does double-duty as your family's TV room. The Internal Revenue Service calls this "regular and exclusive use."
- Your office space must be your principal place of business. In other words, you run your freelance operation from that location. This doesn't necessarily mean that you can't serve clients elsewhere, however. You just have to manage your business from your home office rather than at any other location.
Calculating Your Home Office Expenses
You can report the home office deduction on federal Form 8829, "Expenses for Business Use of Your Home." This form is filed along with Schedule C, "Profit or Loss From Your Business," on your personal Form 1040.
First, you must determine the percentage of your total expenses that are allocated to your business. You can calculate this percentage in one of two ways:
- Percentage of square feet: Measure the size of your home office, and measure the overall size of your home. The ratio of the two will yield your home office percentage. You can claim 20% of your home's expenses if your office takes up 20% of your home's total space.
- Number of rooms: Count the number of rooms in your home. Your home office percentage will be one divided by the number of rooms you have.
All the rooms in your home must be close to the same size if you use the second method.
Allowable Home Expenses
Allowable home office expenses include your rent, mortgage interest—although not the principal part of your mortgage payments—property tax, renter's or homeowner's insurance, homeowners association fees, utilities, and repairs. You would apply your percentage rate to each of these expenses, then tally them up to arrive at your deduction.
For example, you could deduct $3,840 of the rent you paid over the course of the year if you pay $1,600 per month and your office represents 20% of the total square footage of your apartment: $1,600 times 12 months times 20%. You could deduct $240 or 20% for electricity if your electric bills for the year totaled $1,200.
You're up to a deduction of $4,080, and you haven't even included your renters' insurance or gas bill yet.
The Simplified Option
The IRS introduced a second, much simpler method of calculating your home office deduction beginning in tax year 2013. Appropriately titled the "Simplified Option," it works out to $5 per square foot of the business or office space in your home. Unfortunately, it caps out at 300 square feet. It might save you a lot of tedious record keeping if your work space is smaller than this, but otherwise, you might be limiting your deduction to less than it could be.
You might want to do rough calculations both ways, once using the simplified method then again using the regular method, to figure out which arrives at the greater deduction and makes the most sense for you.
Deducting Your Business Assets: Depreciation
You can't deduct a percentage of the principal portion of your mortgage payments, but you can depreciate a portion of the cost of your house if you own your home. You can also deduct the cost of any repairs made directly to your office area.
Unfortunately, any depreciation you take on the house will produce taxable gains through depreciation recapture when and if you ever sell it.
You can depreciate business assets as well. A business asset is any property with a useful life of longer than one year that you use to produce income. Computers, software programs, and office furniture are all good examples.
You have two choices for accounting for these purchases:
- You can deduct the full cost of purchase in the year you buy the asset.
- You can spread out the cost of the purchase over a number of years.
Both options involve figuring your expense on Form 4562, Depreciation and Amortization. It's referred to as a Section 179 deduction and is calculated in Part 1 of Form 4562 if you want to take the full deduction in the year of purchase. You're "depreciating" your property if you decide to spread out the cost over a number of years.
Should You Depreciate or Use Section 179?
Section 179 usually produces the largest deduction because you're claiming the entire cost all at once. This reduces both your income tax and your self-employment tax. But spreading the cost out over several years also offers an advantage. This can reduce income tax and your self-employment tax in smaller increments over an extended period of time. It also allows you to move some of the expense to future years when you might need the deduction more.
As an example, let's say you buy professional software. The tax code allows you to either depreciate the cost over three years or to deduct the expense in the year of the purchase using Section 179. Both methods produce a similar result after three years, but using Section 179 gives you the biggest deduction in the first year.
The Tax Cuts and Jobs Act increased the maximum Section 179 expense deduction from $500,000 to $1 million in 2018, so it should cover a fair number of assets.
Depreciating over three years can give you additional deductions in future years. This can be particularly advantageous if you expect that your income will increase. But using the Section 179 deduction can help keep your tax liability in the current year as low as possible if your freelance income this year is unusually high.
You might also want to consider how long you expect to be able to use the equipment before it must be replaced. If you think it will only last a year or two, it might be better to use the Section 179 deduction for that particular asset. You can choose to depreciate or use section 179 separately for each asset you purchase.