One of the most frequently asked questions I hear is, “what can I deduct?”. It makes sense, since deductions reduce taxable income, thereby reducing tax. And who doesn’t want to reduce tax?
So, let’s talk about deductions. Deductions reduce your income before you calculate tax. Credits, on the other hand, can directly reduce the amount of tax you owe or increase your tax refund. Some credits even generate a refund when no tax is owed. But I digress. I can cover credits in a future newsletter.
For most individuals, the standard deduction is the largest deduction on their tax return. Currently the standard deduction for single individuals, or those who are married and filing separate from their spouse is $12,550. Married couples filing together get a $25,100 deduction and individuals filing as Head of Household get $18,800. The standard deduction was not always so generous. The amounts almost doubled in 2018 and since then, the amounts have increased steadily due to inflation adjustments.
The standard deduction appears on line 12a of the 2021 Form 1040 U.S. Individual Income Tax Return. It reduces adjusted gross income. If the standard deduction exceeds itemized deductions, you get to take the greater of the two. As an added bonus, individuals who take the standard deduction in 2021 can also receive the benefit of a deduction for cash contributions to qualified charities. Single individuals can claim $300, while married couples can claim $600.
Itemized deductions can be taken if they exceed the standard deduction. Itemized deductions are not what they once were. You used to be able to include things like unreimbursed employee expenses but sadly, these went away in 2018. The deduction still exists for qualified employees or eligible educators, but for most employees, the mileage deductions and home office deductions are a thing of the past. Another unfavorable change was the $10,000 cap on property and state tax deductions.
The itemized deductions that remain can be separated into four main categories.
- Medical expenses
- Taxes paid (up to $10,000)
- Interest paid
- Gifts to charity
There are still deductions for casualty and theft losses, gambling losses to the extent of winnings, and other miscellaneous deductions but these are rarer than the four listed above.
Like the cap on taxes paid, medical expenses are limited on the federal tax return. To be deductible, medical expenses must exceed 7.5% of your adjusted gross income. As an example, if your adjusted gross income was $100,000, you would only be able to deduct medical expenses that exceeded $7,500. Thankfully, medical expenses are 100% deductible on your Arizona tax return. So, if you itemize, it may still make sense to provide your medical expenses to your tax preparer.
The tax deduction includes your state and local income taxes or general sales tax. If you make a large purchase subject to sales tax, it might be more beneficial to take the general sales tax deduction rather than the state and local income tax. Another deduction is real estate tax. If you own multiple properties, you can deduct the real estate tax on each of your properties, including RVs and mobile homes. Next is personal property tax. Personal property tax includes the tax paid when registering your vehicle. The entire registration fee is not deductible, only the vehicle license tax.
The interest deduction includes home mortgage interest and points, mortgage insurance premiums (if you qualify) and investment interest. The mortgage interest on your primary home is fully deductible subject to the $750,000 limitation. If your mortgage exceeds $750,000, you only get to deduct the interest on the first $750,000. You can also only deduct the interest on home acquisition debt. Home acquisition debt is a mortgage to buy, build, or substantially improve a qualified home. This applies to your main home and your second home. If you own more than two homes, your deduction is limited to the interest expense on your main home and one other. Keep in mind, for the mortgage interest to be deductible, it must be secured by that home. As an example, if you take a second mortgage out on your main home to buy a second home, the interest on the second mortgage is not deductible. To be deductible, the mortgage should be secured by the second home.
Gifts to charity can be either cash or noncash contributions. There are limitations on deductions based on the type of charity. In 2020 and 2021, the cash contributions to qualifying organizations may be 100% deductible. Normally contributions are limited to 60% of adjusted gross income. If you donate $250 or more to a charity, be sure to keep a record of the donation. Most charities will issue acknowledgment letters to prove the amount of the donation and specify whether any goods or services were provided in exchange for the donation. If goods or services were provided, their value must be subtracted from the donation to arrive at the tax-deductible amount. If you make noncash donations, be sure to keep the receipt. Any noncash donations exceeding $500 must be reported on a separate tax form.
Section 162 of the tax code allows a deduction for all the “ordinary and necessary” expenses of carrying on a trade or business. This means that any expense that is considered normal for your business, is generally deductible. However, the tax code is full of exceptions. One such exception is Section 262 that disallows the deduction of personal, living, or family expenses. For example, if you have a vehicle you use for business, the commute between your home and your place of business is considered “personal” and is nondeductible. Another exception is the disallowance of entertainment expenses and 50% of business meals. However, in 2021 and 2022, there is a temporary 100% deduction of business meals purchased from a restaurant. It is an exception to the exception.
If you ever have a question about what deductions are available for your business, you can always consult your tax return. Whether you file on Schedule C, Schedule E, Form 1065, Form 1120, or Form 1120-S, there are expense categories listed right on the tax return. Examples include advertising, vehicle expense, wages or contract labor, depreciation, insurance, interest expense, legal and professional fees, repairs and maintenance, supplies, taxes and licenses, travel, utilities, and if none of these categories aptly describe your business expense, you can always list the expense under “Other expenses”.
I hope that answered some of your questions about deductions. There is not enough space within this newsletter to cover all the deductions available to you or your business. That is why you should hire a tax professional to help you navigate the tax code and find all the deductions that will reduce your taxable income and reduce your tax. If you need the help of a CPA who understands real estate taxation, you can call me at (480) 626-5557 or email me at email@example.com.
by David J. Hawks, CPA, EA