Though the majority of tax filers claim the standard deduction on their returns, a good 30% of households choose to itemize instead. Itemizing deductions allows you to lower your tax bill by exempting a portion of your income from taxes. The value of your deductions is tied to your effective tax rate.
Say you're eligible for $20,000 in deductions and your effective tax rate is 25%. By excluding $20,000 of income from taxes, you'll save yourself $5,000.
That said, certain deductions lend themselves to taxpayer abuse more easily than others, so the IRS tends to scrutinize them more heavily. Here are three deductions you need to be careful about claiming.
1. The home office deduction
If you're self-employed and work from home, you may be inclined to take a home office deduction, which, depending on your expenses, could put a fair chunk of money back in your pocket. But what many tax filers don't realize is that the IRS has strict criteria for claiming the home office deduction. To be eligible, you must have a dedicated space in your home used solely for business purposes, and your home office must constitute your primary location for conducting business.
In other words, if you perform the majority of your work at your kitchen table, you can't claim the home office deduction, nor can you set up shop in your kids' playroom and call it an office. However, if you have an actual separate office at home, you can claim it even if you regularly travel to client sites and do some work there. Another thing to keep in mind is that your home office doesn't need to be a walled-off room per se; it just needs to be a defined, dedicated space within your home.
2. Business meals and entertainment
If you're self-employed, you're allowed to deduct 50% of the cost of business meals and entertainment. So if you're a writer and take an industry expert out to lunch to pick his or her brain, you can deduct half of the cost of your meal.
Now, many people look at this deduction and think, "What's to stop me from dining out with a friend and writing it off as a business expense?"
While the IRS isn't necessarily going to follow you around town with a spy camera to ensure that each expense you claim is legitimate, you'll still need to be careful. For each meal or event you write off, you should document who you meet with and the business purpose behind it.
Furthermore, make certain the size of your deduction aligns with your profession. If you're a writer who makes money interviewing various artists, it stands to reason that you'd have numerous meals and events to deduct. But if you're a math tutor, a large deduction for meals and entertainment probably won't make sense in the eyes of the IRS.
3. Hobby loss deductions
If you earn money from a hobby, you must report it as income on your tax return. On the flipside, if you lose money from an income-producing hobby, you can claim a deduction for that loss. But proceed with caution because not all hobbies qualify.
To take a hobby loss deduction, the IRS requires proof that your hobby has previously produced income, and that your intention in pursuing that hobby is to make money. As a general rule, if your hobby hasn't made a profit in at least three of the previous five tax years, you probably shouldn't claim a deduction for it.
None of this should be taken to mean that you shouldn't claim the above deductions if they're absolutely legitimate. If the IRS does choose to examine your return more closely and you have evidence supporting your claims, the most you'll lose is the time it takes to provide that added documentation. But don't make the mistake of exaggerating your deductions just to save a few bucks. That's a move that could come back to haunt you in more ways than one.