After you figure out how much more you pay in taxes once you become self-employed, you’ll quickly look for ways to maximize your deductions. One good way is to deduct your business assets—things like computers, office furnishings, and so on.
Unfortunately, if you’re new to doing your taxes as a sole proprietor, you’ll also quickly find out how complex the tax code can be. To help you better understand your options, I’ll offer you an overview of what you can deduct as a business asset and the kind of records you need to keep for certain items. I’ll also discuss the following options for deducting a business asset:
- Depreciating the item, deducting a percentage of your cost during each year of its useful life (as determined by the IRS)
- Deducting the entire cost of the item for the tax year in which you purchase it, under Section 179 of the tax code
This advice is intended to point you toward the method of deduction that’s right for you as a self-employed IT professional. Because I don’t have room for all the details here, you should consult the relevant IRS publication or a tax specialist if you have complex deduction issues.
What you can deduct
You can deduct an item as a business asset if it meets these rules:
- The item must be used in your business or to produce income.
- It must be expected to have a useful life of more than one year.
- That useful life must be limited: At some point, it wears out, breaks, is used up, or becomes obsolete.
In addition to actual property, you can deduct the cost of a repair of or maintenance to a business asset if that repair or maintenance is meant to extend the item’s useful life; for example, installing a bigger hard drive in your PC. There are further distinctions for “intangible property,” which refers to things you can’t touch, such as patents, but I’ll stick to what you’re likely to use in IT.
Generally, you can deduct business assets only if you have Schedule C business income relating to them. For example, you can’t deduct the purchase of a computer that you also use for doing some work at home for your employer. There are limited exceptions; consult IRS Publication 946 for more information.
Follow this link to read Meredith’s article “Take advantage of the new rule on the home office deduction.”
The depreciation method
Using the depreciation method of deduction, you deduct a percentage of the cost of an asset during each year of what the IRS considers its useful life (its “recovery period”). Most IT assets—computers and computer-related peripheral equipment, and office equipment such as fax machines and copiers—are classified as five-year property. Office furnishings are considered seven-year property. Depreciation of such assets is figured not only from the year you purchased the item but more specifically from the quarter in which you begin using it in your business—the “placed in service” date.
The IRS provides different methods for figuring the depreciation amount. The complexity of these methods, however, makes an explanation of them beyond the scope of this article. If you want to depreciate, I recommend consulting a tax specialist.
I consider this complexity a reason not to use the depreciation method. On the other hand, if you’ll be in a higher tax bracket in subsequent years than you are now, depreciating your assets will save you more money. Plus, because your deductions are taken from your business profit, depreciating will take a smaller amount from your profits and make it look as though you made more money last year. This might come in handy if you’re applying for a business loan or just to keep your business running at a profit.
Whatever method of depreciation you use, you must continue using it as long as you deduct that item. You can’t switch to a different method of depreciation for that item later. Similarly, if you initially depreciate an item, you can’t switch to a Section 179 deduction in a subsequent tax year.
Using Section 179
Alternately, you can deduct all of the expense of a business asset in one year under Section 179 of the tax code, subject to the following limits:
- You can deduct no more than $19,000 under Section 179 for the 1999 tax year. If you purchase business assets totaling more than this amount, you can depreciate the remaining amount.
- You cannot deduct an amount greater than your taxable income. Note that it’s taxable income, not business income. For example, if you buy $15,000 worth of equipment and you make $2,000 doing freelance Web design and $12,000 at your day job, you can deduct $14,000. In this case, however, you might want to depreciate the item instead. Or, you can carry over the remaining amount to next year’s Section 179 deduction.
Using Section 179 is not only far simpler than depreciating, it also means that you get your deduction now instead of spreading it out over a number of years. In running my small business, I have yet to think of a good reason for not using Section 179.
Business use only
For both methods, you can deduct only the portion of an item that you use for business. For example, if you buy a computer for $2,000 and use it for business 75 percent of the time and for personal use the remainder of the time, you can deduct or depreciate only $1,500 ($2,000 x .75).
To be deducted under Section 179, the business use of the item must exceed 50 percent. Plus, you must use the asset for business at least 50 percent of the time during the period in which you would have had to depreciate it. For example, if you deduct a PC under Section 179 for the 1999 tax year, you must continue using the PC for business at least half the time until 2003, because its recovery period is five years. Otherwise, the IRS will want part of your deduction back.
Documenting “listed property”
No matter what method you use, the IRS requires you to document your use of certain items that can be used for personal as well as business use, even if you use the item 100 percent of the time for business. These types of items are called listed property and include:
- Any passenger automobile or other property used for transportation
- Cell phones
- Any property that is generally used for entertainment, recreation, or amusement, such as photographic and video equipment
- Computers and related equipment
Of course, that list covers most IT business assets. This documentation doesn’t have to be maintained daily, but you want to be able to show the following:
- The amount of the expenditure for the item
- The amount of business use and the total business use for the tax year
- The date of the use
- The business purpose of the use
There is an exception: If you use an item only for business and only at an established place of business, you don’t have to document the use. Your home office counts as your place of business if it meets the separate “regular and exclusive” tests for deducting home office expenses.
Obtaining forms and publications
To deduct a business expense, you’ll need Form 4562, Depreciation and Amortization. If you use this form, you must use Schedule C, not Schedule C-EZ. For information directly from the IRS, consult the following publications:
- Publication 334, Tax Guide for Small Business
- Publication 946, How to Depreciate Property
You can find all forms and publications on the IRS Web site. The search page is at http://www.irs.ustreas.gov/forms_pubs/findfiles.html.
If you have any doubts about the deduction of self-employment business assets, consult a tax professional. To comment on this article, please post a comment below or follow this link to write to Meredith.
Meredith Little has worn many hats under the broad term of freelance writer, including technical writer, documentation specialist, trainer, business analyst, photographer, and travel writer.