The purpose of this article is to discuss tax deductions. The discussion will describe common itemized deductions, provide a comparison of itemized deductions and the standard deduction, and explain how to determine when it is best to take the standard deduction versus itemized deductions.
Itemized tax deductions fall under three categories: expenses incurred in a trade or business; expenses incurred for the production of income (an investment activity) or for tax advice; and certain specified personal expenses. Once it is determined that an expense fits under one of these categories and can be used as a deduction, it must be determined if the deduction is classified as for AGI (adjusted gross income) or from AGI. Itemized deductions fall under the classification from AGI.
Specific Itemized Deductions
Medical and Dental Expenses – Medical expenses may be deducted only when the following conditions are met: the expense “must be incurred for the medical care of a qualified individual” (Pope et al.); the medical expense must not be reimbursed by insurance or other means; and medical expenses may be deducted “only to the extent the expenses exceed 7.5% of the taxpayer’s AGI” (Pope et al.).
Taxes – “Section 164 provides taxpayers with a deduction for specifically listed taxes paid or accrued during the taxable year” (Pope et al.). Taxes listed as deductible include: state and local income taxes; state and local sales taxes in lieu of state and local income taxes; personal property taxes based on value; real estate taxes; and 1/2 of self-employment tax paid.
Interest – Interest is the cost of borrowing money, such as “finance charges, loan discounts, premiums, loan origination fees, and points” (Pope et al.). It does not include other charges such as appraisal fees and title searches. Certain types of interest are deductible, including all interest incurred in connection with active trade or business, interest incurred on debt to acquire a personal residence when the principal or second residence is used to secure the debt, and student loan interest. “Individuals may take a for AGI deduction for interest paid on qualified educational loans” (Pope et al.) with a maximum annual deduction of $2,500, which is phased out as modified AGI reaches $50,000 to $65,000 for individual returns and $105,000 to $135,000 for joint returns. Interest that is not deductible is personal interest, including interest incurred for credit cards, car loans, and consumer debt.
Charitable contributions – “Individuals who itemize their deductions can deduct charitable contributions to qualified organizations” (Pope et al.). Qualified organizations include:
1) The United States, the District of Columbia, a state or possession of the United States, or a political subdivision of a state or possession.
2) A corporation, trust, community chest, fund or foundation created or organized under the laws of the United States, a state, possession, or the District of Columbia.
3) A post or organization of war veterans.
4) A domestic fraternal society, order, or association.
5) Certain cemetery companies.
Cash contributions are deducted in the amount of cash contributed. When non-cash property is donated, the deduction amount is based on “(1) the type of property donated and (2) the type of qualifying organization (public charity or private non-operating foundation) to whom the property is given” (Pope et al.).
Gambling Losses – Gambling losses are deductible only when the following criteria are met: 1) deductible to the extent that gambling earnings are declared and 2) the individual must have receipts.
Casualty Losses on Personal-Use Property – “The tax law provides non-corporate taxpayers a limited deduction for losses on personal-use property that is either stolen or damaged in a casualty” (Pope et al.). Non-business casualty or theft losses may be deducted to the extent that: 1) the amount of each separate casualty or theft loss must be more than $100 and 2) the total amount of annual losses (minus the $100 limit) must be more than 10% of the amount on Form 1040, line 38.
Miscellaneous Itemized Deductions
Miscellaneous itemized deductions are subject to a 2% nondeductible floor. Section 67 imposes a nondeductible floor of 2% of AGI to the following types of itemized deductions: 1) unreimbursed employee business expenses, 2) investment expenses, and 3) other miscellaneous itemized deductions.
Employee Business Expenses – Reimbursed employee expenses may be deducted for AGI when the reimbursement is included in the employee’s gross income. Unreimbursed employee business expenses are deductible from AGI. Items that may be included in unreimbursed employee business expenses include the cost of purchasing or cleaning uniforms, job related travel not including the daily commute to the office, union dues, job-hunting expenses for seeking employment in the same trade or business (e.g., employment agency fees), and the cost of small tools and supplies.
Investment Expenses – These “include expenses connected with the earning of investment income, such as publications and safe deposit box rentals” (Pope et al.).
Other Miscellaneous Itemized Deductions – These “include items such as fees for tax return preparation and appraisal fees for charitable contributions” (Pope et al.).
Comparison of Itemized and Standard Deductions
As previously discussed, itemized deductions are expenses that are deductible from gross income, such as medical and dental expenses, state and local taxes, mortgage interest, and charitable contributions. The standard deduction is an amount set by the IRS that all taxpayers may deduct from gross income. According to Internal Revenue Service, the standard deduction for 2006 is as follows:
$5,150 for a single
$5,150 for married filing separately
$7,550 for head of household
$10,300 for a married filing jointly
When to Take the Standard Deduction
In order to decide whether to take the standard deduction or itemized deductions, a taxpayer must first determine the total of all itemized deductions. Once this is calculated, the taxpayer will take the greater of the total itemized deductions or the standard deduction. For example, if an individual filing a single tax return has a total of $6,570 in itemized deductions, that individual would take the itemized deductions, because they is greater than the $5,150 standard deduction. However, a couple married filing jointly with $6,570 in itemized deductions would take the standard deduction on the tax return, because the standard $10,300 deduction is greater than the itemized deductions.
Internal Revenue Service. “2006 Standard Deduction Tables”. IRS website. URL: http://www.irs.gov/publications/p17/ch20.html
Pope, T. R., Anderson, K. E., & Kramer, J. L. (2006). Federal taxation 2006. Upper Saddle River, NJ: Pearson Prentice Hall.