Note: A new tax law signed into law on December 22, 2017 will create several changes for itemized deductions. These changes will generally take effect for tax year 2018. They will last until tax year 2025 unless Congress acts to extend them. See How Will The New Tax Law Impact Individual Taxpayers for more information.
When the conversation turns to income taxes, and specifically tax deductions, the term “itemized deductions” often comes up. In order to better clarify things, below is an overview of the topic.
The government gives all individuals a “standard deduction” to help reduce taxable income. This deduction is intended to allow taxpayers to receive a minimum deduction amount for personal, nonbusiness expenses an average individual or household would incur throughout the year. You do not have to list or “itemize” your actual expenses on your tax return when you claim the standard deduction. Your actual expenses may be more or less.
The tax law indexes the standard deduction for inflation on an annual basis. Filing status determines the amount of the standard deduction you can claim on your tax return. For example, married filing jointly (MFJ) taxpayers can claim a higher amount than someone who files as single. For 2017, the standard deduction is $6,350 for single filers, and $12,700 for MFJ.
However, if your total actual deductible personal expenses exceed the standard deduction, you use the higher actual amount (and you are said to be “itemizing” your deductions). The most common expenses which allow you to “itemize deductions” are real property taxes, mortgage interest, state income taxes, and charitable contributions.
Medical expenses and miscellaneous itemized deductions are also allowed, but they are subject to limitations. These limitations make it more difficult to claim a deduction for these expenses. Itemized deductions are claimed on your tax return by filling out IRS Schedule A (Itemized Deductions).
Choosing Between The Standard Deduction and Itemized Deductions May Not Be Automatic
You may be one of the few out there who still prepares tax returns on paper forms by hand (manually). If this is the case, you must do the optimization yourself. You must compare the standard deduction for which you are eligible to the total of your actual deductible expenses. This way you can claim the higher of the two amounts on your tax return.
Alternatively, you may have joined the masses and prepare your tax return electronically using tax software. Many tax programs lead you through a questionnaire. This questionnaire will usually ask you about home ownership and related mortgage interest and property tax expenses, for example.
It may also automatically take state taxes from your Form W-2 input and pull them to Schedule A (itemized deductions). However, some more basic software programs may not have these features. As such, it may be up to you to enter all deductible expenses in determining your tax liability.
Finally, if you pay a professional to prepare your taxes, he or she will likely ask you about any deductible expenses. This way they can do the optimization on their software program. If they do not ask about a specific expense and you do not provide all the required information, you may stand to miss out on some valuable tax deductions.
Following is a discussion of some of the most common expenses which allow taxpayers to itemize deductions. We will also discuss some other tax saving strategies.
Real Property Taxes
You can deduct property taxes on as many homes that you own and use personally (not rented or used exclusively for business). For example, you can deduct the property taxes on your main residence and a vacation home. Taxes paid on a rental property are not part of your itemized deductions. Such taxes should instead be reported on Schedule E.
If you live in a multi-family unit which you also rent, you can split the tax deduction between the personal portion (Schedule A) and the rental portion (Schedule E). For example, you may own a duplex where you live in one unit, and rent out the other. Alternatively, you may use a room in your home or apartment as a home office. In such a case, you may allocate a proportional amount of the property taxes to IRS Form 8829 (Home Office Deduction).
Sometimes you may use the same residential unit personally, and also rent it out to others. This may be the case with a vacation home, for example. In such a situation, special rules may apply.
Mortgage interest is only deductible on up to two homes which you own. This generally includes your main home and a second home. Also, there is a limitation on the amount which you can deduct. You can only deduct interest on up to $1,000,000 of total “mortgage acquisition indebtedness”. This includes debt you incur to purchase, construct, or otherwise improve your home.
You can also deduct interest on an additional $100,000 of “home equity” indebtedness. Taxpayers can use this $100,000 for any purpose. Some use home equity debt to improve their home, to finance other projects or financial needs, or to consolidate high credit card debt.
These limitations are not on a per home basis. Rather, they are limitations on the overall total debt on up to two homes.
Similar to real property taxes, if you use part of your home or property for business or rent it out, you may need to split the tax deduction among different forms. You report the personal use portion on Schedule A (itemized deductions). Note that the deduction limitations noted above for mortgage interest only apply to personal use (Schedule A).
For example, if you own five rental properties, you can deduct the mortgage interest for each one of them. And there is no dollar limitation on the amount of debt for which you can deduct interest. However, any rental loss you generate may be limited by other tax rules such as the passive activity or vacation rental rules.
State Income Taxes
If you have a job where you receive a W-2 form, the state taxes withheld from your wages can be deducted on Schedule A (itemized deductions). The same holds true for any quarterly state income tax estimated tax payments which you make. Such payments may be necessary, for example, if you are self-employed, or if your wage withholding is not sufficient. State income taxes paid with extension or as a balance due on a state tax return are also deductible as itemized deductions.
Keep in mind, however, that federal income taxes are not deductible. Neither are social security or medicare taxes withheld from your paycheck, or otherwise paid if you are self employed. Also, any interest and penalties paid along with your state income tax are also not deductible.
You can only deduct state taxes for the year in which you pay them. So, for example, if you make a state extension payment for the 2017 tax year in April of 2018, this payment will be deductible on your 2018 tax return.
Making excessive state estimated tax payments in order to claim a greater itemized tax deduction is not a wise tax strategy. Any state tax refund created by excessive state tax payments will be taxable in the following year to the extent that you received a tax benefit from the related deduction. Further, you will lose use of the money until you file your tax return and receive the refund.
Sales Tax Deduction
Many taxpayers live in states such as Florida or Texas, which do not have a personal income tax. Or for whatever other reason, their state tax payments may be very low. In such a case, you may want to look into deducting sales taxes. You can deduct the higher of your state income tax or sales tax that you paid.
Since most individuals do not keep track of the sales tax they paid throughout the year, you are allowed to deduct an amount based on your income and the state and county in which you live. Also, you may deduct the sales tax on big-ticket items such as a new car. But remember, it’s one or the other. You can’t deduct both state income taxes and sales taxes.
Only contributions to qualified charities are tax deductible. Churches, synagogues, temples, mosques, government agencies, and 501(c)(3) organizations (charities registered as nonprofit with the IRS) all qualify. Charitable donations to nonprofit hospitals and educational organizations also qualify. Political contributions and the value of your time or services are not tax deductible. You deduct donations in the year you make them (date check mailed, credit card charged, items donated, etc.).
Further, the tax law generally limits charitable contribution deductions to 50% of your adjusted gross income. However, 30% and 20% of AGI limitations may apply in certain cases. This is usually not an issue for most individuals who itemize their deductions. You can carry forward any excess for up to five subsequent years.
You can only deduct donations of clothing or household items if they are in good used condition or better. This standard does not apply for any item for which you claim a deduction of over $500 and includes a qualified appraisal of the item with the tax return.
You must get a written acknowledgement from the charity for each gift worth $250 or more. For noncash donations under $250, you should still obtain a receipt from the charity if possible to support the deduction. If you make a donation at a charity’s unattended drop site, make your own written record which includes the date of the gift, name of the charity, and a description of the property you donated.
Charitable donations of a car, boat, or airplane are usually limited to the gross proceeds from the sale of the property. This applies only if the claimed value is more than $500. Form 1098-C or a similar statement must be provided to the donor by the charity and attached to the donor’s tax return.
You must have some type of bank record or written statement from the charity in order to deduct ANY monetary donation, regardless of amount. Bank records include canceled checks and bank and credit card statements. Record information should include the name of the charity, date of the donation, and the amount.
As with noncash donations, you must support any monetary donation of $250 or more with a written acknowledgement from the charity.
It is relatively difficult for many individuals to get the benefit of a tax deduction for medical expenses. The reason being that there is a 10% income threshold limitation which you must meet.
So let’s say your adjusted gross income (AGI) is $50,000. If your total out of pocket (unreimbursed) medical expenses are $5,000 or less, you are not allowed a tax deduction. However, if these expenses are $6,000 for the year, you would be allowed a deduction of $1,000 on Schedule A. So you are only allowed a tax deduction for medical expenses to the extent they exceed 10% of your AGI.
What Qualifies as a Deductible Medical Expense?
Among the more common deductible medical expenses are health insurance premiums, long term care insurance premiums (subject to limits based on age), prescription medicines, hospital care (including meals and lodging), qualified long-term care services, and Medicare Parts B and D.
Also deductible are medical examinations, laboratory services, diagnostic tests, and the cost of visits to doctors. Doctors may include medical doctors, dentists, eye doctors, chiropractors, and psychiatrists, among others.
Medical aids such as eyeglasses, contact lenses, hearing aids, braces, wheelchairs, and crutches also qualify as deductible medical expenses.
The cost of medical treatment for alcohol or drug addiction, or to stop smoking is also deductible. A weight loss program is only deductible as a treatment for a specific disease such as obesity, diagnosed by a doctor.
Travel to a doctor, hospital, or other facility where you receive medical treatment is also deductible. This can include the cost of public transportation, ambulance, tolls, and parking fees. If you drive, you can deduct either the actual costs or the standard mileage rate. For 2017, the standard mileage rate for medical transportation is 17 cents per mile.
Among expenses which are not deductible are those for cosmetic surgery, the cost of diet food, illegal drugs, imported drugs not approved by the FDA, and nonprescription medicines.
Keep in mind that you can only deduct these expenses to the extent that your insurance or employer does not reimburse you. Also, do not deduct payments made from a tax advantaged account such as a Health Savings Account (see below).
Can You Deduct Medical Expenses Paid for Others?
You can generally deduct the medical expenses incurred for yourself and your spouse. If you are no longer married, the medical expenses of your spouse must have been incurred or paid while you were still married.
Medical expenses paid for your dependents are also deductible. The person must have been your dependent while the medical expense was incurred or paid. Further, you can deduct medical expenses for anyone who would otherwise be your dependent if not for the failure to meet the gross income and joint return tests.
For example, if you cannot claim your child as a dependent solely because they earned more than the minimum threshold in income ($4,050 in 2017) during the year, you can still deduct medical expenses paid on their behalf.
For purposes of the medical expense deduction, a child of divorced or separated parents can be treated as a dependent of both parents. However, the child must receive over half of his or her support during the year from his or her parents.
Further, the child must be in the custody of one or both parents for more than half the year. Otherwise, it does not matter which parent claims the actual dependency exemption on their tax return for the child in determining if they can deduct medical expenses.
Automatic Tax Deduction for Premiums Paid Under An Employer Group Plan
This is one of several good reasons why it’s beneficial to have medical insurance through an employer group plan. Any portion of the health insurance premiums withheld from your pay reduces your taxable wages, effectively giving you a tax deduction from the first dollar expended. This way, you do not have to worry about meeting the aforementioned 10% threshold.
Self-Employed Health Insurance Premiums Deduction
You can also deduct premiums without regard to this threshold limitation if you are considered self-employed. However, you can only claim the deduction to the extent you have a self-employment profit.
For example, you may have a sole proprietorship consulting or other small business which you report on IRS Schedule C. Any health insurance premiums of the proprietor (and their family if a family plan) can be deducted on page 1 of IRS form 1040, line 29 as long as you have sufficient profit on Schedule C.
Section 105 Medical Reimbursement Plan For Your Sole Proprietorship Business
However, being part of an employer group plan or self-employed only addresses deductions for health insurance premiums. What about other out of pocket expenses such as copays, deductibles, supplies, etc. Well, if you are a self-employed sole proprietor, you can hire your spouse as an employee. Then you can set up an Internal Revenue Code Section 105 medical reimbursement plan for your business.
With such a plan, you can deduct all unreimbursed medical expenses for your spouse as an “employee benefit” directly on Schedule C. This can include premiums for her family health plan, as well as other out of pocket medical costs. If your employee spouse’s compensation is comprised only of the medical reimbursement, then you don’t have to file a Form W-2 for your spouse.
However, this strategy will only hold up under IRS scrutiny if your spouse actually performs legitimate work for your company, and the reimbursed expenses represent reasonable compensation for such work. Click here for a sample Section 105 reimbursement plan document. If you decide to employ this strategy, it may be best to consult a professional to go over any applicable details.
Health Savings Accounts
Another strategy for deducting other out of pocket medical expenses without having to meet the 10% threshold is to open and fund a Health Savings Account (HSA). You can contribute to such an account directly or through your employer via your paycheck. You can deduct contributions, and then use the money contributed to pay for qualified medical expenses.
However, keep in mind that in order to contribute to an HSA account, you must have coverage under a high deductible insurance plan. Also, the tax law limits the amount that you can contribute each year. For more information on HSA accounts, click here.
Other Miscellaneous Expenses
Most types of “other miscellaneous expenses” are subject to an AGI threshhold of 2%. This means that you can only get a tax deduction to the extent that the total of all such expenses for the year exceeds 2% of your AGI.
Examples of these expenses include unreimbursed employee expenses such as job travel, union dues, and job education. Tax preparation fees, the cost of a safe deposit box, and investment expenses such as advisory fees are also deductible. Keep in mind that investment expenses related to tax-free income such as that from tax-exempt bonds, are not tax deductible.
The Tax Law Limits Itemized Deductions for Higher Income Taxpayers
Your total deduction for itemized expenses may be reduced if you are a high income taxpayer. However, in 2017 this limitation only applied to individuals who had income of $287,650 ($313,800 for married couples filing jointly) or more.
Also, certain itemized deductions are not allowed in calculating the Alternative Minimum Tax (AMT). Congress intended to apply the AMT to higher income taxpayers. However, it is possible for more moderate income taxpayers to be hit with the tax. The AMT is calculated on IRS form 6251.
State income taxes and real property taxes are among the most common disallowed expenses for individuals subject to the AMT. Miscellaneous itemized deductions subject to the 2% limitation are also not allowed in computing the AMT.
Having a basic knowledge of the tax laws can save you money. This may be the case whether you use a professional or prepare your own tax returns.
Some software programs may not ask you for all the required information. Or you may not be familiar enough with the software program and/or the tax law to get the benefit of all deductions available in your situation. So if you don’t know what you are doing, you may miss out.
The same holds true when working with a tax professional. Being informed can help you have more productive discussions about tax planning issues in general. Not to mention that you can contribute deductible expense information if your tax preparer doesn’t request it.