What Is a Tax Deduction and How Does It Work?

What is a tax write-off?

A tax write-off — also known as a tax deduction — is an expense you can subtract from your taxable income.

A lower taxable income means a smaller tax bill. That's why tax deductions are such a powerful financial tool for self-employed people, whose tax bills can be uncomfortably high without them.

Who can write off expenses?

There are actually two kinds of tax write-offs: deductible business expenses and personal itemized deductions. Only self-employed people are eligible to deduct business expenses, while all taxpayers can claim personal itemized deductions.

Here's how the two types of write-offs work.

Deductible business expenses

Self-employed people, like independent contractors and business owners, can deduct most of their business expenses from their gross income to lower their tax bills.

This is true whether you have a sole proprietorship or an LLC — you don't need to have a particular type of business entity to deduct expenses. (W-2 employees, however, can't write off what they spend on work, even if they’re paying out of pocket. They'll have to get reimbursed by their employers.)

Simply put, deductible business expenses are the day-to-day costs associated with doing your work. You deduct them by filling out your Schedule C.

Common write-offs in this category include:

• 💻 Your computer
• 📱 Your phone
• 📦 Supplies you use for work
• 🤝 Fees paid to contractors
• 🏠 The home office deduction, which can include your rent, utilities, and even home insurance
  🚗 Car-related expenses, if you drive for work (outside of your commute)‍
• 🍽️ Meals, if you use them to meet with clients or to talk shop‍
• 🧳 Travel expenses, if you go on business trips
  

At Keeper, we've built a deduction tracker that finds these qualifying business expenses for you. Sign up for the app, and you'll be paired with a tax assistant who uses our software to scan your purchases for write-offs like these.

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One important thing to keep in mind about these business expenses: you can write them off even if you take the standard deduction. More on that later!

How to find deductible business expenses

Depending on what you do for work, lots of other purchases might be tax-deductible.

For example, an Uber driver can write off freebies for passengers like water bottles, gum, and even barf bags. Meanwhile, an actor can deduct the occasional movie or show ticket. But if an Uber driver tried to deduct movie tickets? That would be a problem.

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Capitalizing and depreciating business expenses

If you have business assets costing more than $2,500 — think office furniture, equipment, or even buildings — they won't be recorded in the app. Instead, if you file taxes with us, we'll capitalize and depreciate them: that is, spread their cost over multiple tax years, in accordance with IRS guidelines.

Why $2,500? That's the maximum the IRS has stipulated for deducting "tangible property" used for your business.

There’s a couple of caveats here. One: This is only true of items with a "useful life" of one year or more. Things like contractor payments don't count, since their useful life is less than a year. You can write off a contractor payment of $3,000, for example, just like any other business expense, rather than capitalizing or depreciating it.

Also, Section 179 deductions and bonus depreciation will actually allow a lot of small business owners to deduct the full cost of a business asset in the year it’s purchased — even if it costs more than $2,500. (For an example, check out our post on how this works for car depreciation.) We can handle these special cases when you file.

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Personal itemized deductions

Only self-employed people can write off business deductions. But there are other, personal deductions that all individual taxpayers can take. You'll fill these out on your Schedule A, with a few exceptions including deductions for investment losses and IRA contributions. If you have a 401(k) with your W-2 job, tax contributions are reflected in your paycheck, so you don’t have to worry about them for your personal taxes.

Common itemized deductions include:

• 😇 Charitable donations
• 😷 Medical expenses
• 🏘️ Mortgage interest
• 🏫 Student loan interest
• 🏡 Mortgage points on your home loan
  

Keep in mind: Unlike business expenses, you have a choice to itemize personal deductions or go with the standard deduction, a set dollar-amount that all American taxpayers can choose to write off. 

That dollar  amount depends on your filing status. In 2024, it's $14,600 for single filers, $29,200 if you're married filing jointly, and $21,900 if you're a head of household. There are additional deductions for those over 65 or blind; you can find more detail here. 

Note that itemizing only makes sense if the amount you spent on charitable contributions, medical bills, and the like ends up exceeding the standard deduction.

If you file your taxes through Keeper, we can help you make these personal deductions on your tax return.

How much are tax write-offs worth?

The actual value of the write-offs you claim can be confusing. A 100% tax deduction, after all, doesn't mean that the purchase was free.

The actual dollar value of your write-off depends on your tax rate. If you use the Keeper app, you can find your tax rate on the ⓘ icon by "Estimated Tax Savings" on the app's main page. You can also estimate it using our free self-employment tax rate calculator.

To calculate how much you're saving from a write-off, just take the amount of the expense and multiply it by your tax rate.

Here's an example. Say your tax rate is 25%, and you just bought $100 in work supplies, which are fully tax deductible. $100 x 25% = $25, so that's the amount you're saving on your taxes.

How tax deductions compare to tax credits

It's easy to confuse tax deductions with tax credits. Instead of lowering your taxable income, tax credits directly reduce the amount you're paying in tax. 

For example, the American Opportunity Tax Credit is a credit for certain education expenses, worth up to $2,500. So if you had a tax bill of $5,500 but then qualified for the maximum amount of the credit, your tax liability would fall to $3,000.

What if your write-offs result in a net loss?

Reduce your taxable income with write-offs, and you'll end up with a lower tax bill. But what if you incur so many business expenses that your profit falls down to nothing?

When your expenses exceed your income, that's called a net operating loss (NOL). In general, it's nothing to worry about — especially if you're just starting out. It’s normal for new freelancers not to make a lot of money in their first few years. Even experienced freelancers may find themselves with extremely limited net income from time to time.

Let's talk about when these losses can save you money, and when too many losses can hurt you.

When losses can help

Sometimes, losses can help you reduce your tax bill without any negative impact on you.

For people who freelance as a side hustle

People who freelance alongside a W-2 job might find themselves losing money on their side gig initially. You can take this loss and use it to reduce your income from your W-2 job.

For example, let's say you work a full-time job, where you make $50,000 a year. You also drive for Uber on weekends. But your rideshare side gig cost you more money than you got paid. After deducting all your expenses, you ended up with a loss of $1,000.

On your tax return, you can take this $1,000 NOL and subtract it from your W-2 salary. Now, your taxable income for the year is $49,000.

For people who freelance full-time

What if your only income is from freelancing? In that case, you may not be able to benefit from your loss the year you incur it. But if you include it  on your tax return, you can carry it forward to future years.

Say you had a NOL of $1,000 the first year you went freelance. Then the following year, you start to hit your stride: your income, after expenses, is $10,000.

You can carry your loss from the previous year forward, reducing your taxable income to $9,000 for the year.

When losses might hurt

The IRS does expect self-employed people to earn a profit eventually. If you fail to make more than you spend in at least three of the last five years, the agency may decide to treat your business as a hobby.

Why does it matter? Unfortunately, if your business is classified as a hobby, you can't deduct your business expenses anymore. Your “hobby” income, though, will still be taxed – the worst of both worlds.

At the end of the day, losses are no big deal when you first start working for yourself. Don't let the fear of taking a hit  stop you from taking legitimate business deductions. After all, you're investing in your ability to work smarter in the future.

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FAQ

Does a tax deduction mean it’s free?

No, a tax deduction does not mean it’s free. (Sorry.) Instead, a deduction lowers the amount of income you’re taxed on. For example, let’s say you make $5,000 from selling clothes on Depop but spent $1,000 on postage and inventory in order to operate your shop. You can deduct that $1,000 — postage and inventory are ordinary and necessary expenses! That means the amount you’ll actually pay taxes on is (5,000 - 1,000), or $4,000.

What is the difference between a tax credit and a tax deduction?

A tax deduction lowers your taxable income, or the total amount of money you pay taxes on. This has the effect of reducing how much tax you’ll owe, but it doesn’t reduce that number directly. A tax credit, however, directly reduces the amount you owe — your tax liability — rather than the amount you’re taxed on.

How do I know if something is a business expense?

Deductible business expenses must be “ordinary and necessary” for your business. According to the IRS, this means that the expense must be both common for your industry and helpful for your business’s function.

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