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Free tax file 11. Free tax file   Employer-Provided Educational Assistance Table of Contents Introduction Working condition fringe benefit. Free tax file Introduction If you receive educational assistance benefits from your employer under an educational assistance program, you can exclude up to $5,250 of those benefits each year. Free tax file This means your employer should not include those benefits with your wages, tips, and other compensation shown in box 1 of your Form W-2. Free tax file This also means that you do not have to include the benefits on your income tax return. Free tax file You cannot use any of the tax-free education expenses paid for by your employer as the basis for any other deduction or credit, including the American opportunity credit and lifetime learning credit. Free tax file Educational assistance program. Free tax file   To qualify as an educational assistance program, the plan must be written and must meet certain other requirements. Free tax file Your employer can tell you whether there is a qualified program where you work. Free tax file Educational assistance benefits. Free tax file   Tax-free educational assistance benefits include payments for tuition, fees and similar expenses, books, supplies, and equipment. Free tax file Education generally includes any form of instruction or training that improves or develops your capabilities. Free tax file The payments do not have to be for work-related courses or courses that are part of a degree program. Free tax file   Educational assistance benefits do not include payments for the following items. Free tax file Meals, lodging, or transportation. Free tax file Tools or supplies (other than textbooks) that you can keep after completing the course of instruction. Free tax file Courses involving sports, games, or hobbies unless they: Have a reasonable relationship to the business of your employer, or Are required as part of a degree program. Free tax file Benefits over $5,250. Free tax file   If your employer pays more than $5,250 in educational assistance benefits for you during the year, you must generally pay tax on the amount over $5,250. Free tax file Your employer should include in your wages (Form W-2, box 1) the amount that you must include in income. Free tax file Working condition fringe benefit. Free tax file    However, if the benefits over $5,250 also qualify as a working condition fringe benefit, your employer does not have to include them in your wages. Free tax file A working condition fringe benefit is a benefit which, had you paid for it, you could deduct as an employee business expense. Free tax file For more information on working condition fringe benefits, see Working Condition Benefits in chapter 2 of Publication 15-B, Employer's Tax Guide to Fringe Benefits. Free tax file Prev  Up  Next   Home   More Online Publications
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Free tax file 1. Free tax file   Deducting Business Expenses Table of Contents What's New Introduction Topics - This chapter discusses: Useful Items - You may want to see: What Can I Deduct?Cost of Goods Sold Capital Expenses Capital versus Deductible Expenses Personal versus Business Expenses How Much Can I Deduct?Not-for-profit limits. Free tax file At-risk limits. Free tax file Passive activities. Free tax file Net operating loss. Free tax file When Can I Deduct an Expense?Economic performance. Free tax file Not-for-Profit ActivitiesGross Income Limit on Deductions What's New Optional safe harbor method to determine the business use of a home deduction. Free tax file  Beginning in 2013, you can use the optional safe harbor method to determine the deduction for the business use of your home. Free tax file See Optional safe harbor method under Business use of your home , later. Free tax file Introduction This chapter covers the general rules for deducting business expenses. Free tax file Business expenses are the costs of carrying on a trade or business, and they are usually deductible if the business is operated to make a profit. Free tax file Topics - This chapter discusses: What you can deduct How much you can deduct When you can deduct Not-for-profit activities Useful Items - You may want to see: Publication 334 Tax Guide for Small Business 463 Travel, Entertainment, Gift, and Car Expenses 525 Taxable and Nontaxable Income 529 Miscellaneous Deductions 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts 538 Accounting Periods and Methods 542 Corporations 547 Casualties, Disasters, and Thefts 587 Business Use of Your Home 925 Passive Activity and At-Risk Rules 936 Home Mortgage Interest Deduction 946 How To Depreciate Property Form (and Instructions) Sch A (Form 1040) Itemized Deductions 5213 Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit See chapter 12 for information about getting publications and forms. Free tax file What Can I Deduct? To be deductible, a business expense must be both ordinary and necessary. Free tax file An ordinary expense is one that is common and accepted in your industry. Free tax file A necessary expense is one that is helpful and appropriate for your trade or business. Free tax file An expense does not have to be indispensable to be considered necessary. Free tax file Even though an expense may be ordinary and necessary, you may not be allowed to deduct the expense in the year you paid or incurred it. Free tax file In some cases you may not be allowed to deduct the expense at all. Free tax file Therefore, it is important to distinguish usual business expenses from expenses that include the following. Free tax file The expenses used to figure cost of goods sold, Capital expenses, and Personal expenses. Free tax file Cost of Goods Sold If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Free tax file Some of your business expenses may be included in figuring cost of goods sold. Free tax file Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. Free tax file If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense. Free tax file The following are types of expenses that go into figuring cost of goods sold. Free tax file The cost of products or raw materials, including freight. Free tax file Storage. Free tax file Direct labor (including contributions to pension or annuity plans) for workers who produce the products. Free tax file Factory overhead. Free tax file Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Free tax file Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. Free tax file This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million. Free tax file For more information, see the following sources. Free tax file Cost of goods sold—chapter 6 of Publication 334. Free tax file Inventories—Publication 538. Free tax file Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations. Free tax file Capital Expenses You must capitalize, rather than deduct, some costs. Free tax file These costs are a part of your investment in your business and are called “capital expenses. Free tax file ” Capital expenses are considered assets in your business. Free tax file In general, you capitalize three types of costs. Free tax file Business start-up costs (See Tip below). Free tax file Business assets. Free tax file Improvements. Free tax file You can elect to deduct or amortize certain business start-up costs. Free tax file See chapters 7 and 8. Free tax file Cost recovery. Free tax file   Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. Free tax file These recovery methods allow you to deduct part of your cost each year. Free tax file In this way, you are able to recover your capital expense. Free tax file See Amortization (chapter 8) and Depletion (chapter 9) in this publication. Free tax file A taxpayer can elect to deduct a portion of the costs of certain depreciable property as a section 179 deduction. Free tax file A greater portion of these costs can be deducted if the property is qualified disaster assistance property. Free tax file See Publication 946 for details. Free tax file Going Into Business The costs of getting started in business, before you actually begin business operations, are capital expenses. Free tax file These costs may include expenses for advertising, travel, or wages for training employees. Free tax file If you go into business. Free tax file   When you go into business, treat all costs you had to get your business started as capital expenses. Free tax file   Usually you recover costs for a particular asset through depreciation. Free tax file Generally, you cannot recover other costs until you sell the business or otherwise go out of business. Free tax file However, you can choose to amortize certain costs for setting up your business. Free tax file See Starting a Business in chapter 8 for more information on business start-up costs. Free tax file If your attempt to go into business is unsuccessful. Free tax file   If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories. Free tax file The costs you had before making a decision to acquire or begin a specific business. Free tax file These costs are personal and nondeductible. Free tax file They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility. Free tax file The costs you had in your attempt to acquire or begin a specific business. Free tax file These costs are capital expenses and you can deduct them as a capital loss. Free tax file   If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss. Free tax file   The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. Free tax file You cannot take a deduction for these costs. Free tax file You will recover the costs of these assets when you dispose of them. Free tax file Business Assets There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. Free tax file You must fully capitalize the cost of these assets, including freight and installation charges. Free tax file Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. Free tax file See Regulations section 1. Free tax file 263A-2 for information on these rules. Free tax file Improvements Improvements are generally major expenditures. Free tax file Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements. Free tax file The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. Free tax file Beginning in 2014, you must capitalize as improvements costs that are for the betterment of a unit of property, restore the unit of property, or adapt the unit of property to a new or different use. Free tax file Temporary regulations allow you to capitalize costs meeting the above criteria for tax years beginning after 2011. Free tax file However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. Free tax file Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition. Free tax file Restoration plan. Free tax file   Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. Free tax file This applies even if some of the work would by itself be classified as repairs. Free tax file Capital versus Deductible Expenses To help you distinguish between capital and deductible expenses, different examples are given below. Free tax file Motor vehicles. Free tax file   You usually capitalize the cost of a motor vehicle you use in your business. Free tax file You can recover its cost through annual deductions for depreciation. Free tax file   There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. Free tax file See Publication 463. Free tax file   Generally, repairs you make to your business vehicle are currently deductible. Free tax file However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation. Free tax file Roads and driveways. Free tax file    The cost of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. Free tax file The cost of maintaining a private road on your business property is a deductible expense. Free tax file Tools. Free tax file   Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor. Free tax file Machinery parts. Free tax file   Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense. Free tax file Heating equipment. Free tax file   The cost of changing from one heating system to another is a capital expense. Free tax file Personal versus Business Expenses Generally, you cannot deduct personal, living, or family expenses. Free tax file However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. Free tax file You can deduct the business part. Free tax file For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. Free tax file The remaining 30% is personal interest and generally is not deductible. Free tax file See chapter 4 for information on deducting interest and the allocation rules. Free tax file Business use of your home. Free tax file   If you use part of your home for business, you may be able to deduct expenses for the business use of your home. Free tax file These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Free tax file   To qualify to claim expenses for the business use of your home, you must meet both of the following tests. Free tax file The business part of your home must be used exclusively and regularly for your trade or business. Free tax file The business part of your home must be: Your principal place of business, or A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or A separate structure (not attached to your home) used in connection with your trade or business. Free tax file   You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility. Free tax file   Your home office qualifies as your principal place of business if you meet the following requirements. Free tax file You use the office exclusively and regularly for administrative or management activities of your trade or business. Free tax file You have no other fixed location where you conduct substantial administrative or management activities of your trade or business. Free tax file   If you have more than one business location, determine your principal place of business based on the following factors. Free tax file The relative importance of the activities performed at each location. Free tax file If the relative importance factor does not determine your principal place of business, consider the time spent at each location. Free tax file Optional safe harbor method. Free tax file   Beginning in 2013, individual taxpayers can use the optional safe harbor method to determine the amount of deductible expenses attributable to certain business use of a residence during the tax year. Free tax file This method is an alternative to the calculation, allocation, and substantiation of actual expenses. Free tax file   The deduction under the optional method is limited to $1,500 per year based on $5 a square foot for up to 300 square feet. Free tax file Under this method, you claim your allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A (Form 1040). Free tax file You are not required to allocate these deductions between personal and business use, as is required under the regular method. Free tax file If you use the optional method, you cannot depreciate the portion of your home used in a trade or business. Free tax file   Business expenses unrelated to the home, such as advertising, supplies, and wages paid to employees, are still fully deductible. Free tax file All of the requirements discussed earlier under Business use of your home still apply. Free tax file   For more information on the deduction for business use of your home, including the optional safe harbor method, see Publication 587. Free tax file    If you were entitled to deduct depreciation on the part of your home used for business, you cannot exclude the part of the gain from the sale of your home that equals any depreciation you deducted (or could have deducted) for periods after May 6, 1997. Free tax file Business use of your car. Free tax file   If you use your car exclusively in your business, you can deduct car expenses. Free tax file If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Free tax file Generally, commuting expenses between your home and your business location, within the area of your tax home, are not deductible. Free tax file   You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Free tax file Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. Free tax file Beginning in 2013, the standard mileage rate is 56. Free tax file 5 cents per mile. Free tax file   If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate. Free tax file   For more information on car expenses and the rules for using the standard mileage rate, see Publication 463. Free tax file How Much Can I Deduct? Generally, you can deduct the full amount of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense. Free tax file Recovery of amount deducted (tax benefit rule). Free tax file   If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. Free tax file If you have a recovery in a later year, include the recovered amount in income in that year. Free tax file However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income. Free tax file   For more information on recoveries and the tax benefit rule, see Publication 525. Free tax file Payments in kind. Free tax file   If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. Free tax file You cannot deduct the cost of your own labor. Free tax file   Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. Free tax file If these costs are included in the cost of goods sold, do not deduct them again as a business expense. Free tax file Limits on losses. Free tax file   If your deductions for an investment or business activity are more than the income it brings in, you have a loss. Free tax file There may be limits on how much of the loss you can deduct. Free tax file Not-for-profit limits. Free tax file   If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. Free tax file See Not-for-Profit Activities , later. Free tax file At-risk limits. Free tax file   Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. Free tax file You are at risk in any activity for the following. Free tax file The money and adjusted basis of property you contribute to the activity. Free tax file Amounts you borrow for use in the activity if: You are personally liable for repayment, or You pledge property (other than property used in the activity) as security for the loan. Free tax file For more information, see Publication 925. Free tax file Passive activities. Free tax file   Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. Free tax file In general, deductions for losses from passive activities only offset income from passive activities. Free tax file You cannot use any excess deductions to offset other income. Free tax file In addition, passive activity credits can only offset the tax on net passive income. Free tax file Any excess loss or credits are carried over to later years. Free tax file Suspended passive losses are fully deductible in the year you completely dispose of the activity. Free tax file For more information, see Publication 925. Free tax file Net operating loss. Free tax file   If your deductions are more than your income for the year, you may have a “net operating loss. Free tax file ” You can use a net operating loss to lower your taxes in other years. Free tax file See Publication 536 for more information. Free tax file   See Publication 542 for information about net operating losses of corporations. Free tax file When Can I Deduct an Expense? When you can deduct an expense depends on your accounting method. Free tax file An accounting method is a set of rules used to determine when and how income and expenses are reported. Free tax file The two basic methods are the cash method and the accrual method. Free tax file Whichever method you choose must clearly reflect income. Free tax file For more information on accounting methods, see Publication 538. Free tax file Cash method. Free tax file   Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them. Free tax file Accrual method. Free tax file   Under an accrual method of accounting, you generally deduct business expenses when both of the following apply. Free tax file The all-events test has been met. Free tax file The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. Free tax file Economic performance has occurred. Free tax file Economic performance. Free tax file   You generally cannot deduct or capitalize a business expense until economic performance occurs. Free tax file If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. Free tax file If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. Free tax file Example. Free tax file Your tax year is the calendar year. Free tax file In December 2013, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. Free tax file You paid it by check in January 2014. Free tax file If you use the accrual method of accounting, deduct the $600 on your tax return for 2013 because all events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic performance occurred in that year. Free tax file If you use the cash method of accounting, deduct the expense on your 2014 return. Free tax file Prepayment. Free tax file   You generally cannot deduct expenses in advance, even if you pay them in advance. Free tax file This rule applies to both the cash and accrual methods. Free tax file It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. Free tax file Example. Free tax file In 2013, you sign a 10-year lease and immediately pay your rent for the first 3 years. Free tax file Even though you paid the rent for 2013, 2014, and 2015, you can only deduct the rent for 2013 on your 2013 tax return. Free tax file You can deduct the rent for 2014 and 2015 on your tax returns for those years. Free tax file Contested liability. Free tax file   Under the cash method, you can deduct a contested liability only in the year you pay the liability. Free tax file Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U. Free tax file S. Free tax file possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. Free tax file However, to take the deduction in the year of payment or transfer, you must meet certain conditions. Free tax file See Regulations section 1. Free tax file 461-2. Free tax file Related person. Free tax file   Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. Free tax file However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. Free tax file Your deduction is allowed when the amount is includible in income by the related cash method payee. Free tax file See Related Persons in Publication 538. Free tax file Not-for-Profit Activities If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Free tax file Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit. Free tax file The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. Free tax file It does not apply to corporations other than S corporations. Free tax file In determining whether you are carrying on an activity for profit, several factors are taken into account. Free tax file No one factor alone is decisive. Free tax file Among the factors to consider are whether: You carry on the activity in a businesslike manner, The time and effort you put into the activity indicate you intend to make it profitable, You depend on the income for your livelihood, Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business), You change your methods of operation in an attempt to improve profitability, You (or your advisors) have the knowledge needed to carry on the activity as a successful business, You were successful in making a profit in similar activities in the past, The activity makes a profit in some years, and You can expect to make a future profit from the appreciation of the assets used in the activity. Free tax file Presumption of profit. Free tax file   An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Free tax file Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. Free tax file The activity must be substantially the same for each year within this period. Free tax file You have a profit when the gross income from an activity exceeds the deductions. Free tax file   If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death. Free tax file   If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. Free tax file This means the limits discussed here will not apply. Free tax file You can take all your business deductions from the activity, even for the years that you have a loss. Free tax file You can rely on this presumption unless the IRS later shows it to be invalid. Free tax file Using the presumption later. Free tax file   If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test. Free tax file   You can elect to do this by filing Form 5213. Free tax file Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity. Free tax file   The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Free tax file Accordingly, it will not restrict your deductions. Free tax file Rather, you will gain time to earn a profit in the required number of years. Free tax file If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. Free tax file If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period. Free tax file   Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. Free tax file The period is extended only for deductions of the activity and any related deductions that might be affected. Free tax file    You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity. Free tax file Gross Income Gross income from a not-for-profit activity includes the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from the activity. Free tax file Gross income from the activity also includes capital gains and rents received for the use of property which is held in connection with the activity. Free tax file You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. Free tax file However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting. Free tax file Limit on Deductions If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. Free tax file If you are an individual, these deductions may be taken only if you itemize. Free tax file These deductions may be taken on Schedule A (Form 1040). Free tax file Category 1. Free tax file   Deductions you can take for personal as well as for business activities are allowed in full. Free tax file For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Free tax file Deduct them on the appropriate lines of Schedule A (Form 1040). Free tax file For tax years beginning after December 31, 2008, you can deduct a casualty loss on property you own for personal use only to the extent it is more than $500 and exceeds 10% of your adjusted gross income (AGI). Free tax file The 10% AGI limitation does not apply to net disaster losses resulting from federally declared disasters in 2008 and 2009, and individuals are allowed to claim the net disaster losses even if they do not itemize their deductions. Free tax file The reduction amount returns to $100 for tax years beginning after December 31, 2009. Free tax file See Publication 547 for more information on casualty losses. Free tax file For the limits that apply to home mortgage interest, see Publication 936. Free tax file Category 2. Free tax file   Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Free tax file Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category. Free tax file Category 3. Free tax file   Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Free tax file Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Free tax file Where more than one asset is involved, allocate depreciation and these other deductions proportionally. Free tax file    Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). Free tax file They are subject to the 2%-of-adjusted-gross-income limit. Free tax file See Publication 529 for information on this limit. Free tax file Example. Free tax file Adriana is engaged in a not-for-profit activity. Free tax file The income and expenses of the activity are as follows. Free tax file Gross income $3,200 Subtract:     Real estate taxes $700   Home mortgage interest 900   Insurance 400   Utilities 700   Maintenance 200   Depreciation on an automobile 600   Depreciation on a machine 200 3,700 Loss $(500)   Adriana must limit her deductions to $3,200, the gross income she earned from the activity. Free tax file The limit is reached in category (3), as follows. Free tax file Limit on deduction $3,200 Category 1: Taxes and interest $1,600   Category 2: Insurance, utilities, and maintenance 1,300 2,900 Available for Category 3 $ 300   The $800 of depreciation is allocated between the automobile and machine as follows. Free tax file $600 $800 x $300 = $225 depreciation for the automobile             $200 $800 x $300 = $75 depreciation for the machine The basis of each asset is reduced accordingly. Free tax file Adriana includes the $3,200 of gross income on line 21 (other income) of Form 1040. Free tax file The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Free tax file Adriana deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit. Free tax file Partnerships and S corporations. Free tax file   If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. Free tax file They are reflected in the individual shareholder's or partner's distributive shares. Free tax file More than one activity. Free tax file   If you have several undertakings, each may be a separate activity or several undertakings may be combined. Free tax file The following are the most significant facts and circumstances in making this determination. Free tax file The degree of organizational and economic interrelationship of various undertakings. Free tax file The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting. Free tax file The similarity of the undertakings. Free tax file   The IRS will generally accept your characterization if it is supported by facts and circumstances. Free tax file    If you are carrying on two or more different activities, keep the deductions and income from each one separate. Free tax file Figure separately whether each is a not-for-profit activity. Free tax file Then figure the limit on deductions and losses separately for each activity that is not for profit. Free tax file Prev  Up  Next   Home   More Online Publications