money

How Tax “Write-Offs” Really Work

Alyssa S. Grossbard

WealthFit Contributor

You’ve probably heard someone say “it’s a tax write-off” right before buying something expensive. Unfortunately for them — tax write-offs aren’t so simple. It takes a lot of planning and accounting to make write-offs worth it. Learn the answer to the question "how do tax write offs work" so you can make better purchase decisions and pay less taxes.

When people throw around the term “write-off” it means either a tax deduction or tax credit. These have different effects on your tax bill.

It’s important to know which ones you’re eligible for and the difference between the two, because knowing how do tax write offs work can save you a significant amount of money in the long run.

What Are Tax Deductions?

When asking how do tax write offs work, some of the answer lies in understanding what a tax deduction is.

This starts with your gross income. It’s the total amount of money you make in a year, from all different sources, including your job, side income, and any investments.

Here in the United States, we have a graduated tax system. The percentage of income the federal government takes in taxes increases as your gross income increases.  

A tax deduction is money you subtract from your gross income for federal tax purposes. Sometimes, deductions are big enough to move you down to a lower tax bracket.

Most Americans (including business owners) take the standard tax deduction, which is $12,000 for a single filer and $24,000 for a married couple in 2019.

The standard deduction is the amount that the Internal Revenue Service (IRS) allows every person filing taxes deduct from their gross income before determining your tax rate.

Here’s an example. If you’re a single person with a salary of $90,000, you subtract the standard deduction of $12,000 and that makes your adjusted gross income $78,000. You will only pay taxes on the $78,000.

If you make $90,000, you are in the 32% bracket for single filers. If your adjusted gross income is $78,000, then you are in the 24% bracket for single filers.

Here’s the key point: the deduction doesn’t just lower the amount of money that’s taxed—it can also put you in a lower tax bracket.

That’s why tax write-offs can really benefit you.

When someone asks how do tax write offs work, that’s the concise way to explain it.

But you can’t take both the standard deduction and the different write-offs. You have to choose between one or the other.

The tax write-offs that are deductions are beneficial if you decide to itemize your deductions. Itemizing means you add up many deductions specific to your business. Again, if you do this, you can’t take the standard deduction.

If you have business write-offs that add up to $20,000, you could take those instead of the standard deduction of $12,000. If your income is $90,000 and you deduct $20,000, your adjusted gross income is $70,000. Assuming a 24% tax rate, your tax bill is 24% of $70,000 — $16,800.

If you had taken the standard deduction, your tax bill would have been 24% of $78,000, or $18,720. In this example, itemizing the deductions saves you $1,920.

If you don’t itemize, the deductions you can take for business expenses are moot. Luckily for business owners, there are many deductions available to make itemizing worthwhile.

What Are Tax Credits?

Unlike a deduction, a tax credit is a dollar-for-dollar refund.

If your income is $90,000 with a tax rate of 32%, your tax bill is $28,880—but a $20,000 credit reduces it to $8,800.

You might think credits are better based on that example. But the truth is that $20,000 credit may not exist. While plenty of deductions are worth that much, most credits are worth a couple thousand at most.

One thing to remember when answering the question of how do tax write offs work: all write-offs are not created equal. Credits are worth more to lower-income earners and phase out as your income increases, while deductions are mostly available to anyone who can properly claim them.

The most popular credits are:

  • child tax credit
  • earned income tax credit

Neither of these credits are specific to business owners.

There are tax credits for:

  • developing a new patent or software
  • spending money to make your office accessible for those with disabilities
  • using alternative fuel
  • providing benefits like health insurance or paid family leave to employees

These don’t phase out as quickly as the basic ones.

But if you’re in the majority of freelancers or entrepreneurs, these don’t apply to you. Most, if not all of your write-offs, will be deductions.

So how do tax write offs work for most small business owners?

You combine the write-offs available for you as an individual with those available for you as a professional to reap the highest rewards.

What are Ordinary and Necessary Expenses?

What kind of business expenses count as tax deductions? The IRS says that an expense must be both “ordinary” and “necessary” to be deductible.

How are those terms defined? An ordinary expense is normal for your industry. A necessary expense is “helpful and appropriate” for your industry.

This means an expense has to be directly related to your business and essential to running it.

For example, the web hosting fees for maintaining your company’s website are both ordinary and necessary. Whatever your industry, you need an online presence in today’s digital era to advertise and connect with clients. Well-maintained websites aren’t free.

Industry practices matter. If you run a kayak school, the kayaks you purchase for children to learn in are both ordinary (all kayak schools need equipment) and necessary (you can’t learn to kayak without being in one).

But if you’re a lawyer and you buy a kayak to “take clients out” it doesn’t count, because you don’t need a kayak to practice law. Make sense?

Likewise, a private chef uses a fancy blender to make food for her clients, but an accountant who buys the same blender to make smoothies for the waiting area doesn’t have that justification.

There’s no hard and fast list covering every industry, but the IRS does tend to audit small business owners who claim interesting deductions, so playing by the rules is strongly advised.

There are, however, some popular deductions that apply to business owners across many different industries. Let’s look at 10 of them.

Self-Employment Taxes

Business owners subject to paying self-employment taxes (“SECA”) can deduct the employer-equivalent portion on their income tax return.

SECA taxes cover Social Security and Medicare contributions. The rate is 15.3%. This includes 12.4% for social security and 2.9% for Medicare.

If you would owe at least $1,000 in taxes on your freelance income for the year, you should be paying SECA taxes every quarter. Be sure to check.

Startup Costs

You can deduct up to $5,000 in costs incurred in creating or acquiring an “active trade or business” although higher startup costs end up going on your tax return for years to follow.

These costs could include anything from purchasing a domain name for your company website, to advertising in the local paper, to paying the fees to incorporate or set up an LLC in your state.

If you are going to incur a lot of startup costs, it is important to thoroughly consult IRS Publication 535 to understand some of the special rules applied to different kinds of startup costs and very large amounts.

Business Supplies and Postage

If you print anything for your business, the cost of the paper and ink count as tax deductions. If you mail what you printed, so does the cost of the postage.

Car

You can deduct the portion of expenses from using your car for business. You can calculate the value of gasoline and car depreciation, or use the standard mileage rate published by the IRS.

Travel Expenses

If you fly on a plane, stay overnight in a hotel, or eat a meal on a business trip, these expenses are deductions. The IRS is strict about what counts.

Your Office

You can write off the cost of your home office if it is your principal place of business. This means it’s the place you work every day.

If you have an office space nearby that you work out of and use the home office on other days, the home office does not qualify as a deduction. But you can deduct the rent on your other office space. You cannot deduct both.

If your home office qualifies, you can deduct costs like mortgage interest, utilities (internet connection, electricity, water) and repairs, for the percentage of your home occupied by the office.

For example, if you live in a 1,500 square foot house and use one 300 square foot bedroom as your office, you can deduct 20% of those expenses. Routine repairs to your office space are also deductible, but big improvements are treated differently.

If you’re deducting expenses for a rented office instead of your home, the same rules applies for things like utilities and repairs.

Insurance

The costs of an owner’s policy, malpractice coverage, and health insurance for you and your spouse and dependents, are all deductible.

Legal and Accounting Fees

If they’re for your business, they’re deductible (you cannot write off your divorce lawyer’s fees as a business expense, even if the stress of getting divorced is hurting your business).

State and Local Taxes

These properly attributed as a business expense are deductible on your federal tax return.

Freelancing

If you have a pass-through business or are a sole proprietor like most freelancers, you can deduct up to 20% of your business income on your personal tax return. This is a new deduction created by the late 2017 tax law.

A “pass-through” business is a business where the owner puts all of the income on his or her individual tax return and the business doesn’t file its own tax return. LLCs are pass-through businesses.

If your business generates $50,000 of profits in 2019, you can deduct $10,000 on your return for the year. This deduction alone puts many business owners over the hump for itemizing, rather than taking the standard deduction.

How Do Tax Write Offs Work?

If you do the math, adding up all of these deductions can put the total above the amount of the standard deduction, saving you money by decreasing the amount of taxable income.

That's the answer to the question: "how do tax write offs work?"

But remember, these write-offs do not give you money back dollar-for-dollar that you spent on a nicer office space or a new computer.

Does that mean you shouldn’t buy a new computer? As always, the answer depends on what the computer is worth to your productivity and your business.

It’ll probably save you a few bucks on your taxes — just not enough to recoup the cost unless it also increases your efficiency because it’s a deduction rather than a credit.

Keep that in mind when you’re incurring expenses for your business. This way you won’t be surprised with a large tax bill the following year.

Share

Written By

Alyssa S. Grossbard

Alyssa S. Grossbard is a 2012 graduate of the University of Oxford, where she majored in history, and a 2015 graduate of Columbia Law School. She is licensed to practice law in New York.

Read more about Alyssa

RELATED TRAINING

 in 

MONEY

article
How Does Life Insurance Work?

Discover the difference between term, whole, and universal life insurance — and learn how to use ”Indexed Universal Life Insurance” to accelerate wealth.

How Does Life Insurance Work?

Alyssa Grossbard

Read Now
article
What Is Hazard Insurance?

Find out what hazard insurance is, how it protects your home in the event of a disaster, and how to NOT overpay for it.

What Is Hazard Insurance?

Alyssa Grossbard

Read Now
article
The Most Effective Tax Strategies To Reduce Taxable Income

Learn how to use tax strategies to keep more of the money you earn. Learn how to use both personal and business tax deductions.

The Most Effective Tax Strategies To Reduce Taxable Income

Alyssa Grossbard

Read Now
article
Sitting At Home? Get a Financial Education Today — For Free

If you’re staying at home to help stop the spread of Coronavirus, or Covid-19, chances are you’ve already filled your time with movies and games. Why not use this time to learn about money? 

Sitting At Home? Get a Financial Education Today — For Free

Cash Lambert

Read Now
article
4 Ways To Conserve Your Money During the Coronavirus Crisis

Follow this simple 4-step process to spend less and save money during the coronavirus pandemic. Plus, pick from our list of 101 side hustles to boost your income.

4 Ways To Conserve Your Money During the Coronavirus Crisis

Cash Lambert

Read Now
live talk
Replace Yourself, Retire with Purpose & Scheduling Priorities

Dustin sits with Best Selling Author and Certified Retirement Planner, Casey Weade. Detailing the spectrum of Retirement, Casey dives into how to set effective financial goals, the rule of 100, and how to retire with purpose.

Replace Yourself, Retire with Purpose & Scheduling Priorities

live talk
Student Debt, ‘On The Side’ Income & Investing Quickstart

Robert Farrington takes us through his journey from working at Target, to hitting his target investment goals. Helping millennials get out of student loan debt and accept personal accountability for their money, his expertise is shared to help build wealth through investing.

Student Debt, ‘On The Side’ Income & Investing Quickstart

live talk
Quit Like a Millionaire

Imagine retiring in your 30's and traveling the world on permanent vacation. Kristy Shen and Bryce Leung live this lifestyle and sit down with Dustin to explain how you can do the same. By going against the norm, investing their money, and quitting their jobs, tune in as they share helpful tips from their new book, Quit Like a Millionaire.

Quit Like a Millionaire

live talk
Do You Have A Powerful Money Mindset?

Dustin sits down with Military Money Expert, Lacey Langford, as she drills the importance of getting your personal finances up to military standards, without all of the yelling. An Army brat, financial expert, military wife, and veteran all rolled into one, Lacey is on a mission to help combat the fear around money.

Do You Have A Powerful Money Mindset?

article
How To Graduate Debt Free

Learn how to graduate with NO student debt by thoroughly researching a career, winning free money, and picking a major with a high ROI.

How To Graduate Debt Free

Erica Gellerman

Read Now
More Cashflow, Less Stress

More Cashflow, Less Stress

How To Boost Your Monthly Income By "Going With the Flow" of Wealth

Dale Gibbons

Watch Now
live talk
Master Your Money in 7 Days (or Less)

Learn the world's SIMPLEST cashflow method, how to reduce personal and business debt, and the 3 critical skills every business owner should have.

Master Your Money in 7 Days (or Less)

Master Your Cashflow

Master Your Cashflow

How To Turn Financial Chaos into Financial Peace By Taking Control of Your Cashflow

Dale Gibbons

Watch Now
Financial Adulting

Financial Adulting

The 20-Something's Guide to Debt, Investing, and a Wealthy Life

Ellen & Micah Long

Watch Now
live talk
What’s Your Money Operating System®?

Hilary Hendershott shares what really causes financial trouble and how she was able to get out of debt as a financial advisor.

What’s Your Money Operating System®?

Zero Student Debt

Zero Student Debt

How To Make a Smart College Investment and Graduate Debt-Free

Ellen Long

Watch Now
live talk
A Candid Conversation with a Private Banker

Discover more about the controversial topics about money and banking your banker probably won't talk to you about. Also, find out where the finance world is headed.

A Candid Conversation with a Private Banker

The Early Retirement Blueprint

The Early Retirement Blueprint

How To Build Wealth Faster & Accelerate Your Retirement Timeline

Tom Wheelwright

Watch Now
Pay Less Taxes

Pay Less Taxes

How To Legally Reduce Your Taxes By Up To 40%

Tom Wheelwright

Watch Now
live talk
Getting Yourself In the Flow of Wealth

Justin Faerman on the flow of creating wealth and avoiding the massive sacrifices that our parents, programming, or society expect of us.

Getting Yourself In the Flow of Wealth

Money 101 for Teens

Money 101 for Teens

The Ultimate Guide To Making, Spending, Saving, and Investing Money

JP Servideo

Watch Now
article
6 Different Kinds of Car Insurance: Which is Right for You?

If you don’t know what your car insurance plan covers—now’s the time to find out. You’ll be surprised by how much you can save.

6 Different Kinds of Car Insurance: Which is Right for You?

Nathan Wade

Read Now
article
Are You a Restaurant Server? Here's How To Budget When You Work for Tips

Learn how to budget when you work for tips. How to take control of your finances in the service industry.

Are You a Restaurant Server? Here's How To Budget When You Work for Tips

Jill Huettich

Read Now
The Hidden Power of Life Insurance

The Hidden Power of Life Insurance

How To Leverage Life Insurance for Financial Security & Wealth Acceleration

Stuart Arakelian

Watch Now