23 February 2016
Readers should be aware the tax law signed by the President on 22 December 2017 dramatically changed the applicability of this article. Most of these rules have changed or are obsolete. I have decided to leave it here for consistency and posterity.
This article is going to explain the difference between the standard deduction and itemized deductions because this is a conversation I have frequently this time of the year:
- Taxpayer: How much do you charge?
- Paul: Do you use the standard deduction or itemize?
- Taxpayer: What's that mean?
I am about to tell you what that means.
In addition to raising revenue the federal government also uses the tax code to influence our behavior. For example, home ownership is good for the economy. When people buy homes it creates jobs for home builders, landscapers, real estate agents, bankers, etc. The government wants to encourage Americans to buy homes, so they allow money spent on things like mortgage interest and real estate taxes to be deducted from a taxpayer's income before the tax is calculated. Buying a home provides a way to pay taxes on a lower amount of income. This provides a financial incentive for people to buy houses.
But what about the people who can't afford to buy a house? Can't they get a decuction? Are they stuck paying taxes on all of their income? The government has determined that would not be fair, so they created the standard deduction. The standard deduction is an amount anyone can remove from their income before they calculate the tax owed. The amount of a taxpayer's standard deduction is based on their filing status: married filing jointly, single, head of household, married filing separately, or qualified widow(er). For 2015 the standard deduction amounts are as follows:
Any taxpayer can use the standard deduction, or they can calculate the amount of each individual deduction for which they qualify, total them, and use the total of the individual deduction items instead. As always, we are interested in the result that is LAMA (legal and most advantageous) to the taxpayer. This will almost always be whichever provides the larger deduction. To know if you itemize or take the standard deduction you need to have a sense for the things that qualify for deductions.
Typical Deductions on an Individual Return
Other taxes you pay. The state and local income taxes you pay can be deducted from your federal tax return. That's nice as it prevents you from getting taxed twice on the same money. If you are a resident of a state with no income taxes you can deduct your sales taxes instead. Local taxes refer to the income taxes some cities place on their residents. (See my article on Alternative Minimum Tax for a big exception to Uncle Sam's generosity regarding not getting double-taxed.)
You can also deduct the real estate taxes you pay. For most taxpayers this is their residence. If you pay real estate taxes on a property you rent to someone else you don't itemize those on Schedule A. You deduct those when you figure out your rental property's operating expense on Schedule E.
Personal property taxes paid can also be deducted. In Virginia Beach that's the lovely little blue sheet that comes from the city every year telling you how much you owe because of your vehicle (or boat or trailer). People sometimes get real estate taxes and personal property taxes confused. For federal tax purposes, real estate is land and buildings. Personal property is everything else you own.
After taxes the largest deduction for which many people get a good benefit is loan interest. Specifically because mortgage interest is usually a big number and it's deductible.
Points paid on a mortgage are deductible, but you usually can't take them all in the year they are paid. Points paid must be amortized (spread out) over the life of the loan. If you paid $3,000 in points for a 30-year loan, then you can essentially take $100/year in your deduction for points.
Mortgage insurance premiums are deductible to taxpayers with an AGI below $110,000.
Donations to charity are generally deductible if you itemize your taxes. There are a lot of rules about this, but the one most taxpayers should remember is SAVE YOUR RECEIPTS. There is a common misperception that the IRS doesn't require receipts below a certain level. Not true. If you are audited you have to account for every dollar.
Side Note: It's common for people to hand me a receipt from GoodWill or Habitat for Humanity that lists a few items and the date of the donation. Then I ask the person what was the value of the items donated and they have trouble recollecting. When you get the receipt write down the value of the items donated while it is still fresh in your mind. (Not the value of the items when they were new - the amount they can reasonably be expected to sell for as used items.)
Unreimbursed Job Expenses
I frequently disappoint people trying to claim this deduction. The government standard for claiming it is higher than most people realize.There is also a minimum threshold before your expenses count. It gets complicated, so if you think you can deduct something do some research or ask your tax professional.
People bring me medical receipts all the time because for many years medical expenses were a good deduction. But, I think in the last 2 years I have only had one client whose medical expenses reached the deductible threshold. As part of the Affordable Care Act (a.k.a. Obamacare) the threshold for claiming medical expenses was raised to 10% of adjusted gross income (AGI). That means if your AGI is $50,000 your medical bills are not deductible until they total over $5,000 (10% of $50,000). (The threshold is 7.5% of AGI for taxpayers age 65 and older.)
Standard Deduction or Itemize? The House is Usually the Key.
When trying to determine if a taxpayer is going to take the standard deduction or itemize their deductions I will typcally ask the taxpayer if they own their home or rent. The vast majority of homeowners use the itemized deduction because owning a home usually qualifies for mortgage interest and real estate tax deductions. Often just those two deductions will come to more than the standard deduction. If you don't own a house (and a mortgage) you will have to give a lot of money to charity to make itemizing more beneficial than just the standard deduction.
Deductions are a great thing to have if you are trying to minimize your tax bill. Getting the largest deduction possible might be something I can help you with. If you have any questions, please contact me.