How to Calculate Home Office Expenses and Depreciation
Deduction Tips for Freelancers
Freelancers and others who operate home businesses can generally take a deduction for their home office expenses. Some rules apply, but they are not particularly burdensome. You might also have a number of business expenses and assets you can claim as deductions.
The Rules for Claiming Home 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 tax-deductible business expenses subject to the following rules:
- You cannot deduct more than your net business profit. If your home office deduction is calculated to be $3,000, but you only made $2,000, you are limited to a $2,000 deduction. Any unused home office deduction can be carried over to the following year so it is not lost entirely.
- Your office space must be used only for business purposes. If it does double-duty as your family's TV room, it does not qualify as your "office." 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 does not necessarily mean that you cannot serve clients elsewhere, but you must manage your business from your home office rather than at any other location.
How to Calculate Your Home Office Expenses
You should report the home office deduction on federal form 8829, Expenses for Business Use of Your Home, which is filed along with your Schedule C, Profit or Loss From Your Business, on your personal 1040.
First, you must determine the percentage of your total home expenses that are allocated to your business use. You can calculate this percentage in one of two ways:
- Percentage of square feet: Measure the size of your home office, and measure the size of your home. The ratio of the two will yield your home office percentage.
- Number of rooms: Count the number of rooms in your home. Your home office percentage will be one divided by the number of rooms.
Allowable home office expenses include your rent, mortgage interest—although not the principal part of your mortgage payments—property tax, renters or homeowners insurance, homeowners association fees, utilities, and repairs. You would apply your percentage rate to all these expenses, then tally them up to arrive at your deduction.
For example, if you pay $1,600 per month in rent and your office represents 20 percent of the total square footage of your apartment, you could deduct $3,840 of the rent you paid over the course of the year: $1,600 times 12 months times 20 percent. If your electric bills for the year totaled $1,200, you could deduct $240 of that or 20 percent. Now you're up to a deduction of $4,080 without including your renters' insurance or gas bill.
Although you cannot deduct a percentage of the principal portion of your mortgage payments, 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.
Deducting Your Business Assets
A business asset is any property with a useful life longer than one year that's used 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. If you want to take the full deduction in the year of the purchase, this is called a Section 179 deduction, and it is calculated in Part 1 of Form 4562. If you want to spread out the cost over a number of years, you are "depreciating" your property.
Should You Depreciate or Use Section 179?
Section 179 usually produces the largest deduction because you are claiming the entire cost all at once. This reduces both your income tax and self-employment tax.
But spreading the cost out over several years also offers an advantage. It allows you to move some of the expense to future years. This can reduce income tax and self-employment tax in smaller increments over an extended period of time.
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.
Depreciating over three years can give you additional deductions in future years. This can be particularly advantageous if you expect your income to increase in future years. Conversely, if your freelance income this year is unusually high, using the Section 179 deduction can help keep your tax liability in the current year as low as possible.
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.