Individual taxpayers in the United States
are allowed a choice when preparing their Federal income tax returns
. After computing their Adjusted gross income
(AGI), taxpayers can itemize
their deductions (from a list of allowable items) and subtract those itemized deductions (and any applicable personal exemption deductions
) from their AGI amount to arrive at their taxable income
amount. Alternately, they can elect to subtract the standard deduction
for their filing status (and any applicable personal exemption deduction) to arrive at their taxable income. In other words, the taxpayer may generally deduct the total itemized deduction amount, or the standard deduction amount, whichever is greater.
The choice between the standard deduction and itemizing involves a number of factors:
- A comparison between the available standard deduction and allowable itemized deductions - the larger number is generally advantageous
- Whether or not the taxpayer has or is willing to maintain the records required to substantiate the itemized deductions
- If the total itemized deductions and the standard deduction are very close in value, whether the taxpayer would prefer to take the standard deduction to reduce the risk of change upon examination by the Internal Revenue Service (IRS). (The standard deduction amount cannot be changed upon audit unless the taxpayer's filing status changes.)
- Whether the taxpayer is otherwise eligible to file a shorter tax form (like the 1040EZ or 1040A) and would prefer not to prepare (or pay to have prepared) the more complicated 1040 form and the associated Schedule A for itemized deductions.
- If the taxpayer is filing as "Married, Filing Separately", and his or her spouse itemizes, then the taxpayer must itemize as well.
Examples of Allowable Itemized Deductions
There are a number of allowable deductions:
- Medical expenses, to the extent that the expenses exceed 7.5% of the taxpayer's AGI. (e.g., a taxpayer with an AGI of $20,000 and medical expenses of $5,000 would be eligible to deduct $3500 of their medical expenses (20,000 X .075 = 1500; 5000 - 1500 = 3500 ).) The 7.5% floor means that most taxpayers are unable to take advantage of the medical expense deduction. Allowable medical expenses include:
- Payments to doctors, dentists, surgeons, chiropractors, psychologists, counselors, physical therapists, osteopaths, podiatrists, home health care nurses
- Premiums for medical insurance (but not if paid by another, or with pre-tax money)
- Premiums for qualifying long-term-care insurance, depending on the taxpayer's age
- Payments for prescription drugs and insulin
- Payments for devices needed to treat or compensate for a medical condition (crutches, wheelchairs, prescription eyeglasses, hearing aids)
- Mileage for travel to and from doctors and medical treatment
- Necessary travel expenses
- Non-deductible medical expenses include:
- Over-the-counter medications
- Health club memberships (to improve general health & fitness)
- Cosmetic surgery (except to restore normal appearance after an injury or to treat a genetic deformity)
- State and local taxes paid, including:
- Income taxes (or, alternatively, state and local general sales taxes)
- Property taxes (assessed by reference to the value of the property)
- but not including:
- Mortgage interest expense on debt incurred in connection with up to two homes, subject to limits (up to $1,000,000 in purchase debt, or $100,000 in home equity loans)
- also, points paid to discount the interest rate on up to two homes; points paid upon acquisition are immediately deductible, but points paid on a refinance must be amortized (deducted in equal parts over the lifetime of the loan)
- Investment interest, up to the amount of income reported from investments (the balance is deferred until more investment income is declared)
- Charitable contributions to allowable recipients; this deduction is limited to either 30% or 50% of AGI, depending on the characterization of the recipient. Donations can be made as money, or in the form of goods. The value of donated services cannot be deducted as a contribution. Reasonable expenses necessary to provide donated services can, however, be deducted (such as mileage, special uniforms, or meals). Non-cash donations valued at more than $500 require special substantiation on a separate form. Non-cash donations are deductible at the lesser of the donor's cost or the current fair market value. Eligible recipients for charitable contributions include:
- Churches, synagogues, mosques, other houses of worship
- Federal, state, or local government entities
- Fraternal or veterans' organizations
- Non-eligible recipients include:
- Casualty and theft losses, to the extent that they exceed 10% of the taxpayer's AGI (in aggregate), and $100 (per event)
- Gambling losses, but only to the extent of gambling income (For example, a person who wins $1,000 in various gambling activities during the tax year and loses $800 in other gambling activities can deduct the $800 in losses, resulting in net gambling income of $200. By contrast, a person who wins $3,000 in various gambling activities during the year and loses $3,500 in other gambling activities in that year can deduct only $3,000 of the losses against the $3,000 in income, resulting in a break-even gambling activity for tax purposes for that year -- with no deduction for the remaining $500 excess loss.)
Miscellaneous Itemized Deductions
It is important to distinguish miscellaneous itemized deductions from other “normal” itemized deductions. The reason for this is because miscellaneous itemized deductions are subject to a 2% floor. A taxpayer can only deduct the amount of miscellaneous itemized deductions that exceed 2% of their adjusted gross income. For example, if a taxpayer has adjusted gross income of $50,000 with $2,000 in miscellaneous itemized deductions, the taxpayer can only deduct $1,000.
There are 12 deductions listed in 26 U.S.C. § 67(b). These are NOT miscellaneous itemized deductions, and thus not subject to the 2% floor (although they may have their own rules). Any deduction not found in section 67(b) is a miscellaneous itemized deduction. Examples include:
- Job-related clothing or equipment, such as steel-toed boots, hardhats, uniforms (if they are not suited for social wear: suits and tuxedoes are not deductible, even if the taxpayer does not like to wear them, but nurses' and police uniforms are), tools and equipment required for work
- Unreimbursed work-related expenses, such as travel or education (so long as the education does not qualify the taxpayer for a new line of work; law school, for example, is not deductible.)
- Fees paid to tax preparers, or to purchase books or software used to determine and calculate taxes owed
- Subscriptions to newspapers or other periodicals
Limitations on Itemized Deductions
If the taxpayer's adjusted gross income is above a threshold (or "applicable amount"), then the total allowable itemized deductions is reduced by the lesser of
- 3% of the excess of adjusted gross income over $156,400; or
- 80% of the total itemized deductions otherwise allowable
In 2007, the applicable amount was $156,400 ($78,200 if married filing separately).
So, for example, if your adjusted gross income is $300,000 and you have $20,000 in itemized deductions, first figure out 3% of the excess above $156,400:
Then figure out 80% of the total deductions
Finally, determine which value is lesser. In this instance, the lesser value is $4,308 so the taxpayer's total itemized deductions shall be reduced by $4,308. This leaves a total amount of itemized deductions of $15,692
Even though the Internal Revenue Code sets the applicable amount at $100,000, that amount is subject to inflation. Therefore, you must double check the Consumer Price Index for the applicable amount for the current year.
In addition, this limitation on itemized deductions is applied after any other limitation. This means that you first need to figure out the total allowable miscellaneous itemized deductions, etc., before determining any limits on the total amount of deductions.
Phaseout of the Limitation
This limitation of itemized deductions is being "phased out. In other words, the total reduction is itself subject to a reduction. For taxable years beginning in 2006 and 2007, the amount is reduced to 2/3 of the reduction, and for taxable years beginning in 2008 and 2009, the amount is reduced to only 1/3 of the reduction. So, in the example above, the total itemized deductions were reduced by $4,308. If the year is 2007 then the taxpayer needs only subtract $2,843, leaving $17,157 in itemized deductions. If the year is 2008, however, then the total only needs to be reduced by $1,422, leaving $18,578 in itemized deductions. This "phase out" only applies until January 1, 2010.