After you read through this guide, you will be able to understand tax deductions and how they can affect your refund or tax bill at the end of the year.
What is a tax deduction?
A tax deduction is an amount of money that the government allows you to subtract from your income from the year. You are not taxed on this amount.
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Most tax deductions fall into three categories:
- Expenses that the government recognizes as a burden on the taxpayer. Examples of this are unreimbursed medical and dental expenses, or casualty and theft losses.
- Deductions for behavior the government wants to incentivize. Examples of this are charitable donation deductions and the mortgage loan interest deduction.
- Deductions to avoid double taxation. The government allows you to deduct state and local taxes paid from your federal income. This means that you won’t be taxed twice on the same income.
You can see how this could get complicated. All of these are common expenses that most Americans will have in their lifetimes, and most people don’t want to take the time and effort to record this information every year. That’s why the IRS created the standard deduction.
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What is the standard deduction?
The standard deduction is a “blanket” amount that you can deduct from your income. It’s intended to be large enough to cover, and be a bit more than, the average American’s deductible expenses every year.
Because the standard deduction is generally more than the amount of individual deductions in a year, most people just use the standard deduction instead of calculating out individual deductible amounts.
If you do calculate your individual deductions (called itemizing) you can choose between standard or itemized to see which gives you the bigger deduction.
Are tax deductions legal?
Allowed tax deductions are perfectly legal and encouraged.
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People are not allowed to create their own tax deductions: claiming a pet as a child, for instance.
What can I deduct on my taxes?
If you do want to itemize deductions on your tax return, these are some common deductions you can take:
- Unreimbursed medical and dental expenses and health insurance premiums
- State and local sales, excise, and property taxes
- Home mortgage interest paid
- Charitable donations
- Casualty or theft losses
Most of these have a “cap” or limit of how much you can deduct in each category.
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You should have proof of the expense for any deduction that you take.
The 6 P’s of tax deductions
OK, so I have an expense that falls into one of the deductible categories. But how do I know if the expense is deductible? The 6 P’s can help you tell.
Suppose you bought a home last year, and you want to know what expenses from the purchase you can deduct.
The purchase amount of the home is not deductible, nor is the total mortgage payment itself, but the interest on the mortgage payment is deductible.
Place
If the home is in the United States, it’s in the right place.
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Proper Time
You have to deduct interest paid last year on your last year’s tax return. Interest paid in other years would have to be deducted on a tax return for those other years.
Purchase Amount
The purchase price of your home, and how much of a mortgage you have, will have an effect on how much deductible interest you have.
Proper Documentation
You need to have a document from the mortgage company that shows how much you paid in interest for the year.
If your return is audited, you will need to provide proof of each deductible expense you have.
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Person
To deduct the interest, either you or your spouse (if you are filing jointly) must have the mortgage.
If the mortgage belongs to someone else, in or out of your household, you cannot claim the interest as a deduction.
Purpose
The home must be your primary residence. If you purchase a home to use as a vacation home, the mortgage interest will not be tax deductible.
(Rental real estate and Airbnbs have their own rules about deductible expenses that are outside the scope of this article.)
How to keep your tax receipts organized
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The best way to keep your tax receipts organized throughout the year (in my opinion) is a series of envelopes or folders, labeled.
As soon as you receive any tax documents or receipts to show deductions throughout the year, put them in the correct envelope right away.
Many people think tax preparation is a great mystery. Understanding how tax deductions work is key knowledge when you are thinking strategically about your money.
Plan well throughout the year, and keep more of your money in your pocket at tax season!
