Today we’re talking tax write-offs. Have you ever heard someone talk about tax-write offs like they were getting something for free, as if the government was handing them a big bag of money? It might go like:
- “Well, we get to write off the interest on our mortgage interest, so it’s basically free money.”
Or maybe it sounds like this:
- “Oh I never have to worry about paying for supplies, they’re a tax write off for my side business.”
I just smile and nod, smile and nod, but what they’re saying does not make sense to me.
Regarding the mortgage interest, about 90% of people do not itemize (they take the “standard deduction”) so they get $0 government subsidy on their mortgage loan (I wrote about this here). Or, if we are talking about someone who itemizes (likely a high-income homeowner), they are probably paying about $100 in interest for every $25 in tax savings (if their tax rate is 25%).
Regarding the business expenses, there could be a couple things going on there. This person could be purchasing something that is not actually a business expense, but pretending it is a business expense. Mmm, I do not endorse cheating on taxes. Or it could be that this person correctly understands that each dollar of business expense shelters a dollar of business revenue from taxes. That’s because a business only has to pay tax on their profits (revenues minus expenses equals profits). You want an example? Math time!
- A freelancer has $1000 of revenue during the year (aka “sales,” aka “gross income”). They pulled together all their receipts to do their taxes and added up $600 of expenses from that year. They have to pay income tax on $400 of profits (=$1,000 – $600). If their tax rate is, say, 20%, they owe $80 in tax (= $400 * 20%). After-tax profits are $320 (=$400-$80).
- Oh, but they just realized that they forgot to include one receipt for $100! Their expenses were actually $700. This means their profits were only $300 (=$1,000 – $700), so they only owe tax of $60 (=$300 * 20%). Woohoo, that’s $20 less in taxes! After-tax profits are $240 (=$300-$60).
- But here I am, boring Stephanie, reminding them that they spent $100 in order to save $20. I’d rather save $20 than not save $20, but it’s not free.
It’s not about miniziming taxes per se, but maximizing what stays in your pocket (after-tax profits in this example).
So tax-write offs are not free. If you understand how this works, you can spend if that’s right for you, and correctly understand any tax consequences.