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Calculating Home Office & Depreciation

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Claiming expenses for your home office. Taking a deduction for a home office is one of the best things about being self-employed. You get to convert a portion of your personal expenses into a tax-deductible business expense. Do be aware that the home office deduction has limitations: you cannot deduct more than your net business profit. Any unused home office deduction, however, is carried over to the following year.

Figuring your home office expenses. Calculate your home office expenses using Form 8829 (PDF). You calculate the percentage of your total home expenses that are allocated to your business use. You may calculate the 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 1 divided by the number of rooms.

Home office expenses include rent, mortgage interest, property tax, renters or homeowners insurance, utilities, and repairs. Homeowners can also depreciate a portion of the cost of their house. But be aware, that any depreciation taken on the house will produce taxable gains when the house is sold through depreciation recapture.

Deducting Your Business Assets. A business asset is any property with a useful life longer than one year and which is used to produce income. Computers, software programs, and office furniture can all be considered business assets. You have two choices for accounting for these purchases. You can deduct the full cost of purchase in the year the property is bought, or 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 (PDF). If you want to take the full deduction in the year of the purchase, you want what's called a Section 179 deduction, and 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 and will calculate the amount in Part 3.

Depreciate or Section 179? Generally, I calculate depreciation last when preparing my own taxes and those of my clients, since there are several possible depreciation methods that can be used. Section 179 often produces the largest deduction, which reduces both income tax and self-employment tax. But spreading out the cost over several years as the advantage of moving some of the expense to future years (thereby reducing tax and self-employment tax over several years), which can create a smoothing effect on the tax liabilities. To give you an example, each year I buy professional tax software, and the tax code allows me to depreciate the cost over three years or to deduct the expense in the year purchased using Section 179. After three years, however, both methods would produce roughly the same results.

As a general strategy, depreciating assets over time works well when you expect income to increase in the next few years (the deduction will produce greater tax results in the future than it does by taking the deduction this year). Conversely, if your freelance income this year is unusually high, using the Section 179 deduction can help keep your taxes lower (that is, taking the deduction now might yield tax savings greater than deferring some of the deductions to following years).

A secondary strategy I employ is to consider how long the equipment might be used before it is replaced. If an equipment is likely to be replaced in a year or so, that could be a good indication to use the section 179 deduction for that piece of equipment. You can choose to depreciate or use section 179 separately for each asset you purchased. While this makes preparing your tax return a little more cumbersome, it also provides you with greater flexibility in optimizing the final tax calculations.

Depreciation and section 179 deductions reduce both the income tax and the self-employment tax. So it helps to keep an eye on both tax calculations. Freelancers who are concerned about boosting their Social Security might want to depreciate their equipment, as this generally results in the least amount of tax deductions, and correspondingly higher net income and Social Security tax. Similarly, funding levels for self-employed retirement plans are based in part on net income. So greater or fewer depreciation deductions can impact retirement savings as well. If you plan to depreciate your assets, the following material is recommended reading: Tax Topic 704 Depreciation, Publication 946 How to Depreciate Property, and Publication 334, Tax Guide for Small Business.

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