Updated August 2020 (originally posted Feb 2016)
A conversation I have frequently during tax season:
- 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. One of the things the government does is encourage homeownership. Homeownership 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 house can create tax deductions, thus providing a way to pay lower taxes. This provides a financial incentive for people to buy houses.
But what about the people who aren't in the right place in their lives to buy a house? Can't they get a deduction? 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 2020 the standard deduction amounts are as follows:
|Filing Status||2020 Standard Deduction|
|Married Filing Jointly||$24,800|
|Married Filing Separately||$12,400|
|Head of Household||$18,650|
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 understand 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. 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 refers to the taxes paid on 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.
Since 2018 the total amount of state and local income taxes, real estate taxes, and property taxes that can be deducted from the federal tax return is limited to $10,000. If your state and local, real estate and personal property taxes add up to more than $10,000, then you simply deduct $10,000. Taxpayers are encouraged to put the actual values into their tax software even if the amount will be limited to $10,000. Many stater are not following the federal rules on itemizing and you may get full credit for taxes paid on your state income tax return.
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 may deductible to taxpayers with an AGI below $110,000. The law allowing this must be voted on by Congress each year, so it could go away at any time.
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 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
The unreimbursed job expenses of an employee are no longer deductible. This category of deductions was removed by the Tax Cuts and Jobs Act. However, the provisions of the TCJA are set to expire in 2025, so they may be back one day!
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). Congress moves this number often. Some years it is 7.5%, some years it is 10%. Make sure you are using the latest and greatest numbers if you're itemizing medical expenses.
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 typically ask the taxpayer if they own their home or rent. Without the deductions for mortgage interest or real estate taxes, it is unusual that itemizing makes financial sense. 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.
It is rare for military families who do not pay state income taxes to itemize their federal deductions. It happens, but it is rare.
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.