Worried about late tax filing? Don’t sweat it.

April 8, 2014

It’s getting to that point in the year when many tax filing procrastinators start to panic about the looming deadline. And if they think about just giving up and taking everything to a professional, they’ll find many professionals have to tell clients who haven’t submitted all of their info yet that their return won’t be completed before the April deadline. This leaves people with the choices of…

  1. do their best to do their own taxes and hope everything comes out OK,
  2. take their taxes to one of the “McDonalds’” of tax preparation…the big national chains with plenty of minimally-trained, low-paid part-timers who will enter everything in a computer for you and hope it comes out OK, OR
  3. file their taxes LATE and risk being carted off to federal prison!

Well this post is to let people know that filing your taxes late is not a one-way ticket to the slammer. In fact, in many cases simply filing an extension (more on that later, or skip to it now), and making sure you get your taxes right–even if a little late–is the wisest choice to make.

People make mistakes when they hurry and they’re rushed. It’s human nature. Whether you prepare your own taxes, or pay somebody to do it for you, chances are whoever is working on your return in early April may feel a little pressure to get things done by the deadline. I’m unaware of any studies addressing this issue, but I would consider it almost a certainty that tax returns filed in the first half of April are more likely to contain mistakes than returns filed at other times. And fixing those mistakes later can be costly and time-consuming.

If you have investments, it’s very common to receive “corrected” statements regarding your income in March or April, and sometimes even later. If you have complex investments–particularly if you receive investment income reported on a Schedule K-1–you might not want to rush out and file because there may be corrected statements coming your way.

Also, if you pay somebody to do your return, you’re probably more likely to get that person’s undivided attention, and maybe even a little bit better rate, if you’re willing to work with them outside of the busy part of tax filing season.

But what about penalties and keeping the IRS off your back? Well these are certainly legitimate concerns, but let me explain what the actual consequences of filing late are so you can make an informed choice.

Penalties for filing late are based on your tax due. If you have no tax due because you’re getting a refund, then there’s no penalty. I’ve known clients who wait a few years and then file several years all at once. (I don’t recommend that approach, but some people are comfortable with it.)

If you do owe tax, the penalties are actually fairly minor as long as you file an extension. You can avoid the penalty completely by filing an extension and making a payment with that extension. Of course, if you don’t have your return done, how are you supposed to know how much to pay, right? Well, there are tools you can use to estimate your tax liability (TaxCaster is a pretty user-friendly, free tool to use for this purpose). Aim high with your estimate, and then when you file you’ll get the excess back–often with interest!

If your estimate comes in low, but you filed the extension, the late payment penalty is only 0.5% of the amount of underpayment, per month the payment is late. So if you owe an extra $5000, and you file and pay only one month late, then your late payment penalty is a whopping $25. Two months late…$50. So even for a fairly significant tax liability, the late payment penalty is often less than the cost of a parking ticket. There’s interest as well. But at 3% annually, this is almost too low to worry about.

One other consideration is whether filing late raises “red flags” or guarantees an audit. I’ve never seen any evidence that people who file extensions and file a few months late face a higher audit risk. The only possible downside is the IRS has 3 years to audit your return from the filing deadline or when you actually file, whichever is later. So filing after the April deadline can extend the time the IRS has to review your return. But if the IRS hasn’t selected your return for audit in 3 years, I wouldn’t worry much about the chance they’ll choose you in that extra month or two.

Of course, if you owe taxes and fail to file an extension by the filing deadline, then the situation is very different. If you owe money and haven’t filed a return or extension, the late filing penalty is 5% per month…ten times the rate for simply paying late. This can add up fast. So if you don’t think you’re going to be able to file by the deadline, then just follow these instructions and get that extension filed (it’s easy).

Step by Step Instructions for Extension filing

If you’re not using software that offers free extensions, you can still easily file an extension for free. Unfortunately, the IRS does not offer e-filing of extensions directly, and instead relies on private companies to supply this service. As a result, there are too many e-filing options for any rational person to sift through, so paper-filing is generally much simpler and easier (and free except for the stamp). The only drawback is you’ll have to mail a check if you’re making a payment.

With that caveat, here’s how to file an extension in 10 very simple steps: (OK, one or two aren’t “very simple,” but we promise they’re not bad.)

  1. First, print out Form 4868 with instructions.
  2. Cut off the Form 4868 at the bottom of page 1.
  3. Fill in Lines 1-3 with your name, address, and Social Security Number(s).
  4. Estimate your tax liability in Line 4. OK, this one can be tricky. We recommend TaxCaster from TurboTax as a pretty user-friendly tool for doing this. Alternately, you can base your estimate on last year’s tax return. When all else fails, there’s no penalty for making a wild guess and being way wrong. (Although there is a very small penalty for underpayment, so guess high.)
  5. Enter your 2013 payment in Line 5. For most people, this means add up the amount in Box 2 of all W2′s you received. This may underestimate your payments, but it’s a reasonable start.
  6. Subtract Line 4 from Line 5 and enter it in Line 6…just like it says on the form :-)
  7. Enter any amount you’re paying on Line 7. This is optional. You don’t have to include a payment.
  8. Check the boxes on lines 8 & 9 if they apply to you. (Line 9 only applies to non-US citizens.)
  9. Put the form, along with a check if you’re making a payment, in an envelope.
  10. Use the table on the back page of the 4868 instructions to determine which address to use (based on your state of residence and whether you’re making a payment).Put a stamp on that envelope, seal it, and drop it in the mail. You’re done.

You now have until mid-October to file your return without any late filing penalties.


Self-Employed People Might Want to Avoid Getting Subsidies for Their Health Insurance

March 28, 2014

We’re just about at another deadline for people to sign up for qualifying health insurance, or face a penalty for being uninsured when they file their tax return for 2014. So hopefully this doesn’t come too late for you, but I’ve been thinking about a particular aspect of the law that applies to self-employed people.

Self-employed people are able to deduct the cost they pay for health insurance and reduce their Adjusted Gross Income (AGI). To determine if people qualify for subsidized health insurance (aka “premium assistance”) based on their income level, the government uses Modified Adjusted Gross Income (MAGI), which in this case is defined as Adjusted Gross Income, plus excluded foreign income, non-taxable Social Security benefits, and tax exempt interest. So we run into circular logic here, because the amount you pay for health insurance depends on your MAGI, but your MAGI in turn depends on how much you pay for health insurance.

I’ve seen a few discussions of this problem, some of which propose rather complicated iterative mathematical solutions, but I think the solution is fairly simple and presents a clear planning opportunity for self-employed individuals who potentially qualify for health insurance subsidies under the Affordable Care Act. And depending on your household size, you could potentially qualify with a MAGI of well over $100,000. For example, a family of 5 qualifies for subsidies with a MAGI of $110,280 or less.

Based on a plain reading of IRC 162(l) (“allowed as a deduction (…) the amount paid during the taxable year for insurance (…)”), it appears that if you choose to pay full-price for your health insurance then you can deduct the full cost you pay during the taxable year, thus reducing your MAGI as low as possible. When you file your tax return at the end of the year, you’ll fill out whatever form the IRS provides to determine what amount of subsidy you’re actually eligible for based on 2014 MAGI, and claim the subsidy as a tax credit on your return. Using this method, you could potentially qualify for a significantly larger amount of premium assistance than if you applied for the subsidized premium amount up front and paid less for insurance during the year (thus increasing your MAGI).

Of course, it’s not a totally free lunch. Under the principle that if you deduct something that’s later refunded/reimbursed, then you simply claim the subsidy as income on the following year’s taxes. This is actually quite common when it comes to medical expenses. We sometimes see in the tax world that somebody will have to pay for major medical expenses out of pocket, and then they take a tax deduction for those expenses. Later, when they finally get the insurance company to reimburse them for their costs, they have to include the reimbursement as taxable income. So getting reimbursed for part of your health care costs after year end really isn’t even a new concept.

Here’s a simple example of how this might benefit you: In 2014, imagine I’m married no kids and make $65k/yr. If I don’t take the advance subsidy, we’ll say my insurance costs are $5k/year, making my MAGI $60k/yr. So I claim a credit for (let’s say) $3k. Since that’s a refund of premiums I deducted, I report the $3k as income in 2015.

If I do take the subsidy, we’ll say I pay only $2k/year for insurance. (The cut-off for the subsidy for 2 people is ~$62k/yr.) By paying only $2k/yr, my MAGI is $63k/yr and I no longer qualify for the subsidy…so now I have to PAY BACK the $3k/yr advance subsidy that I don’t actually qualify for.

In the first scenario, I paid $5000, got $3000 refunded, but have to pay tax on that $3000. At that income level for a married filing joint taxpayer, I’m probably paying 15% on that $3k, so overall I’m out about $2500.

In the second scenario, I pay $2000 during the year and another $3000 at year-end, so I’m out $5000. Overall, I’m $2500 better off paying full price up front and then taking the subsidy at year-end when I file my taxes!

Moral of the story: If you’re self-employed and potentially eligible for a subsidy, do not take the subsidy during the year.

Disclaimer: The above advice is based on a plain reading of the Internal Revenue Code and the application of logic and common tax principles. This does not mean the IRS will necessarily use logic, common tax principles, or a plain reading of the Internal Revenue Code when they create the forms and instructions to handle the premium subsidies/tax credit. (Though to be fair, as popular as it is to knock the IRS, I find that the vast majority of the time the IRS’ interpretation of the tax code is consistent with how most intelligent tax practitioners — not to mention most of the legal community — interpret it.) I’ve heard other theories of how the IRS may interpret this law, but to be honest none of the other interpretations I’ve read seem consistent. Regardless, I’m in no way guaranteeing the IRS will interpret the law this way. But the worst that can happen if you reject the subsidy now is that through some convoluted interpretation of the law the IRS determines you still don’t qualify even though you paid premiums that put your MAGI in the qualifying range. And of course you wouldn’t have qualified anyway, so you have nothing to lose by trying.


Avoiding Penalties on Retirement Account Distributions

March 20, 2014

If you had to take money out of a retirement account last year, the IRS provides some tips and general info on retirement account distributions that I’ve included below.

However, if you’re under age 59 1/2* and had to take a pension or IRA distribution last year, make sure to look carefully for all the possible exceptions to the early distribution penalty. There are several ways to get money out of an IRA or pension without penalty even if you’re under age 59. I’ll give you a few of the more common exceptions, but to find a complete list, start with page 3 of the Form 5329 instructions or consult with a well-qualified professional.

[*If you have an employer-based plan and you're separated from service, you can start taking distributions penalty-free at age 55 instead of 59 1/2.]

First, make sure you have a taxable withdrawal. If you’ve contributed to a Roth IRA, or made non-deductible contributions to a Traditional IRA (or the equivalent employer-based plans), then part or all of your contribution might be tax-free. With Roth IRA distributions, all of your distributions are tax- and penalty-free until you’ve distributed an amount equal to your contributions to the plan. (If you’ve converted Traditional IRA money to a Roth, you’ll have to wait five years before withdrawing these funds without a penalty.) With Traditional IRAs, the formula is more complicated…basically a portion of your distribution is non-taxable based on the portion of your IRA value that comes from non-deductible contributions. See Form 8606 for the details of that calculation. The amount of your distribution that is tax-free will also be penalty-free.

Once you’ve determined some or all of your distribution is taxable, you’ll want to start looking for exceptions to the early withdrawal penalty. Some of the most common ways we find to avoid these penalties relate to education and medical expenses. Unemployed individuals are generally able to avoid the penalty for amounts equal to what they pay for health insurance. And if you had major medical expenses (greater than 7.5% of your income), you may be able to exclude part of these costs from penalty as well.

Students are able to avoid the penalty for amounts equal to what they pay for qualified education expenses. And here’s a little known twist on education…if you’re at least a half-time student, you can include an allowance for room and board in your “qualified education expenses”–even though room and board is usually not considered an education expense for most purposes. Your school’s financial aid department should be able to help you determine the official room and board allowance for your school. (Note that these apply whether the student is you, your spouse, or a dependent.)

If you’re considering a withdrawal, and considering a home purchase, be aware that there’s a $10,000 exception for qualified “first-time home buyers” (which includes taxpayers who haven’t owned their home in the last two years). This exception can be used by both spouses, so it can be used to exclude $20,000 from penalty on a joint return. This exception can be used once in your lifetime. Of you might be able to take advantage of an exception that applies to a series of substantially equal payments made over a series of years. The payments must last at least 5 years or until you reach age 59 1/2, whichever is later, so this requires careful planning.

Be aware that some of these exceptions apply to individual retirement accounts like IRAs, some to employer plans like 401k’s, and some apply to both types of plans. Before applying any of these exceptions, or taking any action based on the intent of applying any of these exceptions, make sure you do your homework or consult a professional.

And without further ado, here’s what the IRS had to say on the topic:

Some taxpayers may have needed to take an early distribution from their retirement plan last year. The IRS wants individuals who took an early distribution to know that there can be a tax impact to tapping your retirement fund.  Here are ten facts about early distributions.

  1. Payments you receive from your Individual Retirement Arrangement before you reach age 59 ½ are generally considered early or premature distributions.
  2. Early distributions are usually subject to an additional 10 percent tax.
  3. Early distributions must also be reported to the IRS.
  4. Distributions you rollover to another IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.
  5. The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.
  6. If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.
  7. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.
  8. If you received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.
  9. There are several exceptions to the additional 10 percent early distribution tax, such as when the distributions are used for the purchase of a first home, for certain medical or educational expenses, or if you are disabled.
  10. For more information about early distributions from retirement plans, the additional 10 percent tax and all the exceptions see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements (IRAs). Both publications are available at IRS.gov or by calling  800-TAX-FORM (800-829-3676).

Is the “simplified” home office deduction right for you?

March 6, 2014

One of the more complicated pieces of the tax code that people commonly encounter is the home office deduction.

But last year the IRS announced it will offer a very simplified option for taking the home office deduction. As I’ll explain, this option will be very beneficial for most home-owners, especially in low cost areas. On the other hand, most renters, especially renters in expensive areas, will want to pass on this option. (Fortunately, the simplified option is just that, an option. You can still calculate your home office deduction under the old rules if you prefer.)

First, a quick background. The home office deduction is available to anybody who uses a portion of their home regularly and exclusively for business purposes. This part hasn’t changed.

Under the old method, the amount of the deduction was calculated by finding the ratio of the square footage of the home office to the entire square footage of the home. This ratio was then multiplied by various expenses related to maintaining a home such as utilities, insurance, mortgage interest, rent, etc. In addition, there are various instructions related to which expenses are always deductible, which expenses are only deductible to the extent of business profits, and so forth.

Under the new method, any area that meets the definition of a home office is eligible for a deduction of $5 per square foot, up to a maximum of 300 square feet (or $1500). So, for example, if you use a 200 square foot room as a home office during the tax year, you can deduct $1000 as a home office expense. This rule takes effect for tax year 2013.

Homeowners can still deduct the full amount they pay for mortgage interest and real estate taxes on Schedule A. Homeowners no longer deduct depreciation, which means no longer having to track depreciation over time and add that depreciation to income when the home is later sold. For these reasons, many homeowners will likely benefit from using this simplified method. In addition to fewer record-keeping hassles, many homeowners will actually get a larger deduction overall when considering that mortgage interest and real estate taxes will still be fully deductible. This won’t be true in every case, particularly if you pay a lot for utilities, home insurance, or other expenses that aren’t otherwise deductible. But as a general rule, if you own your home, you might want to consider using the simplified method.

For renters, on the other hand, you’ll probably want to continue tracking what you pay in rent and other costs so you can keep using the standard method. The reason for this is simple — you usually can’t deduct rent unless it’s a home office expense. So, let’s say you rent in even a low-cost area where you pay only 50 cents per square foot in monthly rent (this works out to $750 per month for a 1500 square foot home, just to give you an idea). Even at this rate, you’re paying $6 per square foot each year in rent alone. Plus you’re probably paying utilities on top of that, and maybe even insurance and some other costs as well. So being able to deduct $5 per square foot isn’t a particularly good deal for you. And if you’re in a high-rent area, like the SF Bay Area, you’re probably paying at least $1 per square foot each month, or $12 per year, so taking a deduction of only $5 per square foot doesn’t make much sense.

It’s a common trade-off in the tax world. Everybody claims to want simplification. But the downside to simplification is some people pay more and some pay less. And not many people like simplification if it means they pay more in tax. Fortunately in this case, every taxpayer has the choice. If taking the simplified option will mean a much smaller deduction for you, then keep doing things under the old method. But if you can save money, or even come out close to even, then your tax return will be getting a little simpler in 2013.


Filing 1040EZ may be costing you money.

February 27, 2014

I recently had somebody come to me for help with their taxes. This person came to me because he knew he’d be making decisions in the next few years that could have significant tax implications.

In the previous few years, he’d had a very simple tax situation, so he’d chosen to use the Form 1040-EZ…a very simple tax form intended for people with very simple situations. Unfortunately, while this form is simple, it can prove quite costly.

While reviewing his prior returns, I noticed he’d missed a very simple credit that would have saved him a couple hundred dollars each year. (Fortunately I was able to amend his returns and get this money back for him.) Why did he miss this credit? Simple. The Form 1040-EZ doesn’t mention this credit, or many other credits and deductions.

The problem with 1040-EZ is it only mentions the very common items. Many other items are not terribly unusual — and most people will have at least one of them — but they aren’t mentioned on Form 1040-EZ or its instructions. As a result, people who have simple situations might completely miss an opportunity to save on their taxes.

Of course, most people want to keep their lives as simple as possible, so it’s easy to understand the appeal of filing with the simplest form possible. But think about the payoff. By spending an hour or two skimming the instructions of Form 1040, there’s a good chance you’ll find a deduction or credit that will save you hundreds, if not thousands, of dollars. That’s a pretty good return on an investment of a couple hours.

Don’t want to do all that reading? Or just afraid you won’t understand and wind up missing something anyway? Then shell out a little cash for a basic version of reputable tax software like TurboTax that will walk you through a whole slew of questions that should turn up any deduction or credit that you might have missed. Still sounds like too much trouble? Then spend a little more cash to have a professional at least review your return. If you do the legwork of preparing your return initially, many professionals will review it for a fairly nominal fee just to make sure you’re not missing any common credits or deductions like the one that was missed by the person who contacted me.

Everybody knows the tax code is riddled with loopholes and special exceptions. Don’t make the mistake of filing Form 1040-EZ and assuming there’s no benefits available to you. Spend a little time or a little money, and chances are your investment will pay off many times over with a significant tax savings.


Tax Consequences of the Sharing Economy – Part 3

February 20, 2014

The last two weeks, we’ve looked at the tax consequences of participating in the sharing economy. Specifically, we looked at renting out a room for the night, and getting paid to give somebody a lift.

Finally, we’re going to do a quick overview of providing services (through a site like Taskrabbit) or renting out our personal property (though a site like Snapgoods). As we’ll see, both of these are pretty straightforward from a tax perspective.

If you’re offering to provide services for pay, then you’re generally going to be considered self-employed. This means a couple things, some good and some not so good.

First, the not so good. As a self-employed individual, you’re subject to Self-Employment Tax of 15.3% on all of your net earnings. This is in lieu of the FICA tax you would pay on wages if you were paid as an employee. This might come as a surprise if you don’t have a lot of income and aren’t expecting to have a tax liability…for example, if you have only $10,000 of income, you normally wouldn’t have any income tax liability after applying the standard deduction and your personal exemption. But, if the $10,000 is all self-employment income, then you might be surprised to find you owe over $1500 in tax!

However, there is good news. If you incur any expenses related to earning this income, you can deduct those directly against the income to reduce your net self-employment income. If you have a dedicated space in your home that you use exclusively for setting appointments, performing administrative tasks, or possibly doing the actual work you’re getting paid for, you probably have a home office that generates some deductions. Also, if you work from a home office, you can deduct mileage or transit expenses to get to client locations when you work from there. So be sure to keep track of your travel and other expenses…if in doubt, keep track of it, and ask a professional at the end of the year when you do your taxes.

Now, if you’re renting out personal items (lawn-mower, bike, etc.), this might be the easiest item of all to report. If you only occasionally rent out personal items, then you simply report these as “Other Income” (line 21 of Form 1040, if you’re filling out the forms directly). There usually aren’t many expenses to deduct for this kind of rental, but if you do have expenses, these would be deducted as an “Other Adjustment” that reduces your income (line 36 of Form 1040 with “PPR” written in, if you’re filling out the forms directly).

You have to be careful with this activity, however. If you rent out personal property on a regular and on-going basis, you might deemed to be “in the business” of renting personal property. There’s no bright-line test here, but if you find that every weekend you’re bringing in money from renting out personal items, you might be “in business.” And if you’re in business, then you’ll be subject to the self-employment tax. In that case, see the discussion above for deducting expenses to reduce your net earnings subject to self-employment tax.

So there you have it. There’s many advantages to the sharing economy, and it’s a great way to make some extra cash from items that would otherwise sit unused. And hopefully from these tips here, you can reduce the bite at tax-time.

UPDATE: I received a question from a reader about how to treat renting out a car that you don’t actually drive. If you’re not doing the driving (a situation discuss in the last article), then this is actually no different than the situation above where you rent out personal items like a bike or a power tool. And in this case, I see no reason that you couldn’t use the standard mileage deduction to calculate your expenses for the use of the vehicle. (Although one caveat…if the user fills the gas tank for you, then you’d technically need to include the cost of the fill-up in your income too, because deducting standard mileage means you’ve already deducted the value of the gas they used.) As with other rentals of personal property, if you do this on a regular, on-going basis, then you might be deemed “in business” doing this; i.e. you’re treated as a rental car company for tax purposes.


Tax Consequences of the Sharing Economy, Part 2

February 13, 2014

Last week I begin explaining some of the tax consequences of the “sharing economy”, i.e. providing goods and services for money through services like AirBnb, Lyft, TaskRabbit, etc.

Last week I provided a (fairly exhaustive…and exhausting) overview of the correct ways to treat property rented through sites like AirBnb. This time, I’ll take a look at ride-share services like Lyft and Uber. If you made it through last week’s edition (because you’re some kind of masochist), this time it should be a lot easier.

Let’s start with the basics again. Unlike with renting out your home, where you don’t have to report income if you rent your main home out for fewer than 15 days, there is no equivalent “de minimis” amount of miles you can drive or rides you can provide before it’s considered income. Any money you receive for driving people around is going to be considered income to you.

“But wait!” (I can already hear some people saying…) “The ride-share service I’m driving for only accepts donations! We aren’t charging them anything!” Um…yeah…so the way I’ve heard that arrangement described by representatives of one of these companies is that you don’t have to pay, but…if you don’t pay, it will go on your account and any potential driver will see that, and so nobody will pick you up anymore. So if you’re giving people rides in expectation of a “donation”, and you’re not picking up the people who aren’t providing this “donation”…I can tell you right now the IRS is going to call that income. Nice try, though.

So now that we know it’s income, let’s get to the next step. What can be deducted against this income? This is where there’s good news.

Let’s assume you do this on a reasonably regular basis. Maybe not 5 days a week…maybe not even two days every week…but at least a day or two each month on average with an expectation of doing this continuously and the intention of making a profit by doing so. In this case, you’re pretty clearly operating a business. And as a self-employed individual, you’ll be filing Schedule C with your tax return, and deducting all of the ordinary and necessary expenses of this business.

This big expense is obviously the costs of driving around the car. And there’s good news here. The IRS has a “standard mileage rate” that allows you to deduct a fixed amount (currently 56 cents) for each and every business mile you drive…as long as you document it! This standard rate can come in very handy if you drive an efficient car with low costs to operate. And it saves you the hassle of saving every fuel and maintenance receipt, and then dividing all those expenses up based on how much personal use of the car you have. And only in the last few years has the IRS allowed drivers “for hire” to use this method; they used to be required to keep track of all actual expenses, plus a record of mileage which was required to determine the business portion.

But, as I mentioned, make sure you document your mileage. That means keeping a logbook or some other method where you regularly (i.e. every time you drive for hire) document the date, the miles driven, and the business destination. (You don’t necessarily have to record your entire route, but entering as many destinations as you can remember each time is a good habit. The company you drive for may even provide a report for you with this info.) Without that, the IRS may not allow a deduction for the costs of operating your vehicle.

Of course, you might not want to use the standard mileage method. If your car is expensive to operate, or you bought an expensive new vehicle primarily for providing rides for hire and want to take advantage of accelerated depreciation*, then it might make sense to use the actual expense method. But in my experience, the standard mileage rate usually results in a comparable or larger deduction than the actual expenses, and it’s less hassle.

Beyond the cost of operating the vehicle, you’re also able to deduct other necessary expenses required to provide your services. This may include tolls, fees you have to pay to operate, marketing expenses like business cards you give to riders, and other necessary expenses to acquire and retain business. However, you can not deduct personal expenses.

If you have to eat meals on the go, unfortunately that’s still considered a personal expense. Meals are only deductible in two situations. One is when you’re required to be away from home for a period that requires sleeping a full night (or day) away from home. I’m trying to choose my language carefully here because working the night shift doesn’t mean you’re away from home for a period that allows you to deduct meals, nor does taking a nap during a break. The concept is you’re away from home long enough that a sustained sleeping period (i.e. the amount of sleep you’d get in a typical 24 hour period) is required. The other time meals are deductible is if you’re having a meal with a client, or potential client, and having a business discussion.

Other nondeductible personal expenses would be things like getting a massage after a long day at the wheel, or headphones to listen to music while you drive. On the other hand, if you buy music that you play for customers in hopes of improving their experience and making them want to request you for next time…that might fly. There’s clearly some grey area here. But if an item is for the direct benefit of your customers and you can make a reasonable case that it helps you increase or maintain business, then it’s probably something you can deduct.

Hopefully by keeping track of your mileage, and the money you spent on items required to provide your “for hire” driving service, you can limit the income you have to pay tax on to just what you actually keep at the end of the day (and maybe even less than that if you have an efficient car and use the standard mileage method).

The one pitfall to avoid here is to have this activity classified as a “not for profit” or “hobby” activity by the IRS. Unlike with renting out part of your home, where you actually get a nice tax break if you try it a few times but decide not to continue, driving your car for hire is something you should plan on sticking with for awhile once you start. If you try it out a few times, but don’t do it on a fairly regular basis, the IRS might decide it’s just a hobby. The downside of that is you often lose the ability to deduct any of your expenses. There’s technically a way to deduct hobby expenses, but it’s on a part of the tax return that doesn’t do most people a lot of good.

So if you’re going to sign up with Lyft or Uber or any similar service, make a plan to stick with it for awhile and keep good records. This will help make the tax bite on your earnings as painless as possible. Good luck!

*”accelerated depreciation” basically means you get to deduct a big portion of the car’s total cost in the first few years of its life. Depreciation means deducting part of the cost of an item each year so that over a period of time (often 5-7 years) you wind up deducting the entire cost. Depreciation is “built in” to the standard mileage rate, but under the actual expenses method you have to calculate your allowable depreciation every year.


Follow

Get every new post delivered to your Inbox.

Join 1,673 other followers