If you have a home office for the purposes of federal income taxes, then there are two ways you can deduct the mortgage-interest expense and property taxes: You can deduct the whole amount as an itemized personal deduction, or you can write off the portion that corresponds to your office as a business expense, and treat the rest as an itemized personal deduction. Which approach is better?
These options may seem interchangeable. After all, if you're writing off the same amount either way, which you are, what difference does it make whether it's classified as a personal deduction or a business deduction?
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Actually, it matters a lot. That's because business expenses reduce self-employment income, which, in turn, determines how much you owe in self-employment taxes -- that is, Social Security and Medicare taxes.
These taxes aren't insignificant. The self-employment tax rate for 2014 is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. For a full-time employee, this burden is split evenly with his or her employer. But self-employed individuals must bear the entire burden. That's why it's important to get this tax deduction right.
For example, let's assume that you're single and self-employed, and you had $100,000 in gross income last year. Let's also assume that you work from home and are able to write off $20,000 in mortgage interest and property taxes, $5,000 of which corresponds to your home office. Finally, just to simplify the illustration, let's assume that you don't qualify for any other deductions or exemptions.
Here's how this works out:
*This equates to half of your self-employment taxes. **This is net income minus deductions for mortgage interest and self-employment taxes.
As you can see, if you write off the entire $20,000 as a personal itemized deduction, then your cumulative tax liability (income taxes plus self-employment taxes) comes out to $29,244. But if you write off $5,000 as a business expense and the remaining $15,000 in mortgage interest expense as a personal itemized deduction, then your tax liability would be $28,574. That equates to a savings of $670.
Thus, to answer the question I posed at the beginning, unless you're interested in paying the government more than you're legally obligated to, then it's definitely in your interest to take advantage of the home-office deduction coupled with the mortgage-interest deduction, as opposed to the latter one alone.
The article How the Home-Office Deduction Works With the Mortgage-Interest Deduction originally appeared on Fool.com.
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