If you’ve got a side gig in addition to your regular job, you’re not alone. According to a survey from Quicken, 43% of American workers earn extra money from jobs they do outside of regular work hours.
Millions of these side-giggers are sole proprietors, meaning that they’re the only person who owns and runs their business. Sole proprietors include freelancers, independent contractors, delivery drivers and others who bill their clients directly and receive the full amount of this non-employment income without payroll tax deductions.
Sole proprietors are responsible for paying federal and state income taxes and Social Security and Medicare taxes on any of this income.
However, one benefit of running your own business is that you may be able to deduct certain business expenses from your side-gig earnings.
One potentially huge tax break may be available if you work out of your home (or, if you handle the management and administration of your business from your home).
This is the IRS home office deduction.
While this deduction could lower your tax bill by thousands of dollars, it’s important to make sure you do it correctly, in case the IRS or your state tax regulator ever audits you.
Two general methods
The IRS offers two methods for calculating home office deduction amounts:
- The simplified method; and
- The standard method.
The first step in either process is to calculate the square footage in your home or apartment you use for your business.
For purposes of this article, let’s say that you operate your business from a single 15’ by 15’ room. This means that you’re using 225 square feet for your home office.
With this information in hand, you can decide which method to use.
The simplified method
Most sole proprietors use this method, since it’s relatively easy to calculate and doesn’t require a great deal of documentation.
You simply deduct $5 for every square foot of space you use for your business. For example, for your 225-square-foot home office you could potentially deduct $1,125 (225 square feet x $5). The maximum annual deduction is $1,500.
The standard method
With the standard method, you deduct a portion of what you pay for various household expenses based on the percentage of the dwelling you use for business purposes.
The easiest way to calculate this percentage is by dividing the square footage of your home office space by the total square footage of your dwelling (not including land).
Let’s say your home is 1,500 square feet and your home office is 225 square feet. Using the square foot method, you could potentially deduct 15% of indirect home-related expenses (225 divided by 1,500) that are used for your business.
These indirect expenses can include:
- Mortgage interest (but not payments);
- Rent;
- Utilities (including Internet and broadband bills);
- Homeowner’s insurance;
- Depreciation; and
- Maintenance and repair.
So, for example, if your yearly electricity bill was $2,000, you could theoretically deduct $300 from your non-employment income tax bill.
Other standard calculation methods
The square footage method is generally the easiest one to use. But if the resulting percentage is pretty small (which might happen if your dwelling is very large), you might want to consider two other methods.
- The “rooms” calculation method. Assuming most rooms in your dwelling are the same size, you can divide the number of rooms you use for your business by the total number of rooms.
- The net square footage calculation method. Instead of using total square footage, calculate only the combined total square footage of rooms you could use for your business. This allows you to exclude square footage for “ineligible” areas like kitchens, basements, bathrooms and hallways.
Depending on the method you choose, the results could give you a higher deductible percentage. Here’s a completely hypothetical example.
Full deductions
If you pay for repairs or improvements to the room or rooms you use for your home office (such as replacing windows, floors, carpets or fixtures or painting) you may be able to deduct the full value of these expenses.
Reporting home office deductions
You’ll need to calculate and enter home office deductions on IRS Form 8829. You’ll then include the total amount of these and other business deductions on IRS Schedule C, Profit or Loss from Business. You’ll need to file both of these forms with your tax returns.
But before you grab a tape measure to start calculating your usable square footage, you may want to talk to an accountant or tax professional.
They can help you create a tax planning strategy that outlines which kinds of deductions you’re available to take as a sole proprietor and the kinds of records you need to keep to justify these deductions in case the IRS come a-calling.
This material has been provided for general informational purposes only and does not constitute tax advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax professional on any tax-related issues.
This article was authored by David Jaeger and Jeffrey Briskin. David is a financial advisor with Canby Financial Advisors, a SEC-registered investment adviser. SEC registration does not constitute an endorsement by the SEC nor a statement about any skill or training. David can be reached at 508.598.1082 or djaeger@canbyfinancial.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
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