How to Calculate Home Office Expenses and Depreciation
How to Take Home Office Deductions as a Freelancer
Freelancers can generally take a deduction for their home office expenses when they work from home. Some rules apply, but they're 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 one of the best things about being self-employed. You get to convert a portion of your personal expenses into tax-deductible business expenses.
Now, about those rules...
- You cannot deduct more than your net business profit. If your home office deduction works out to $3,000 but you only made $2,000, you're limited to a $2,000 deduction. Any unused home office deduction can be carried over to the following year, however. It's not lost forever or entirely.
- Your office are 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 doesn't necessarily mean that you can't 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
As of January 1, 2013, you have two options for claiming home office expenses on your tax return.
The "simplified" method lets you deduct $5 for each square foot of your home office space up to 300 square feet, as well as some home-related deductions like mortgage interest and property taxes you would enter on Schedule A if you itemize your deductions. The simplified method offers no provisions for depreciation or depreciation recapture.
Many freelancers find that using this simplified option means less of a deduction so they use the more complicated, regular home office calculation method instead. This involves completing Form 8829.
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, and you haven't even calculated your renters insurance or gas bill yet.
Although you can't 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's calculated in Part 1 of Form 4562. If you want to spread out the cost over a number of years, you're "depreciating" your property.
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 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 pretty much the same 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's only going to last a year or two, this might be a good indication 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—it doesn't have to be a blanket, uniform decision covering all your purchased business assets.