What Is a Tax Deduction And How Does It Work?
"What is a tax deduction and how does it work?" That's a common question asked by new self-employed workers. If you are a new or independent contractor or 1099 worker, leveraging tax deductions will save you a ton of money. Read on and we'll break it down for you.
What Is A Tax Deduction?
The more income you have, the more taxes you pay. A tax deduction is simply a deduction that reduces a person's tax liability by lowering their taxable income. Expenses from doing business can be subtracted from a business owners gross income to lower the taxes owed at the end of the year.
With a W-2 job, we can’t write off any expenses to lower our taxable income. But as freelancers, we try to reduce our income from freelancing with as many expense deductions as possible. That is why it is important to use a 1099 tracker to record all of your bills.
You see, it’s normal for freelancers just starting out to make little money the first couple of years. Even experienced freelancers may make little to no income from time to time. When your expenses exceed your income, this results in what’s called a NOL (Net Operating Loss). Although we freelance with the expectation of making a profit, a loss can save on your tax bill. There are a couple things to consider to better understand when these losses can save you money and when too many losses can hurt you.
However, what if you had a NOL from your freelance work?
You can take this loss and reduce your income from your W-2 job on your tax return. For example, let’s say you got paid a $50,000 annual salary from your W-2 job. Your ridesharing side gig cost you more money than you got paid. After expenses, you had a loss of $1,000. On your tax return, you can take this $1,000 NOL and net it against other income. Now your overall income for the year was only $49,000 ($50,000 W2 salary - $1,000 NOL).
If you had the proper tax withheld on your W-2 pay, this situation may even generate a tax refund. Another benefit of reducing your tax return income with your NOL is the possibility to qualify for certain tax deductions and credits you may not have otherwise qualified for due to your income level, such as the Earned Income Credit and Lifetime Learning Credit. Sometimes, you will get a W-2 and 1099 in the same year.
No other income? Report expenses now and see the benefits later.
What if your only income is from freelancing? You may not be able to reap the benefits of those expenses this year but include them on your tax return so your NOL will be reported. You can “Carry Forward” those losses to future years.
For example, let’s say you have a NOL of $1,000 in 2020. In 2021, business is booming and your income after expenses is $10,000. Your income tax owed could be around $1,000. But your NOL from 2020 gets carried over to 2021. Your income is actually $9,000 ($10,000 income from 2021 - $1,000 loss from 2020). Because of your NOL from 2020, you could save around $100 on income taxes.
Be prepared to substantiate freelancing expenses
Having a NOL, especially due to the possible tax benefits, may prompt the IRS to review your deductions. Expenses must be “Ordinary and Necessary” for your profession. A high meal expense for a Business Consultant may not raise red flags, but for a rideshare driver whose primary service is driving from A to B may catch the eye of the IRS. After you track miles for taxes, a high mileage deduction for that same rideshare driver would seem ordinary, but not for a website developer. The proportion of an expense in relation to total expenses could also raise red flags (i.e. high utilities and low rent expense). When deducting your freelancing expenses, determine if they are “Ordinary and Necessary” for your profession and be prepared to prove this to the IRS.
The IRS may not be ok with losses over multiple years
The IRS expects freelancers to earn a profit. The IRS may treat your business as a hobby if you haven’t earned a profit in at least three of the last five years. This classification is important as it dictates what you can and can’t deduct. If your business is classified as a hobby, your expenses are no longer deductible. Your “hobby” income, on the other hand, is still taxable. So it’s best to be prepared to prove to the IRS that your freelancing is engaged in making a profit as this is the primary indicator that your business is not a hobby. The IRS has an FAQ section that dives into the “Business vs Hobby” topic a little further.
It’s ok to not have much income from freelancing.
Losses are expected when you first start freelancing. Even experienced freelancers have more expenses than income at times. The important thing to remember is how NOL’s can benefit you. However, be prepared to prove your business expenses and that your freelancing is a business rather than a hobby. it is best to be organied with your deductions. Check out this great alternative to Quickbooks self-employed.