Like all law-abiding citizens, you’re willing to pay your income taxes.
But like all rational people, you don’t want to pay any more than you have to. If you do any research on how to pay less tax, you’ll come across the topic of deductions.
From there, it’s a short trip down the rabbit hole to reach itemized deductions, which probably leaves you wondering: what are itemized deductions? Should I itemize?
The answer, as in most tax matters, is that it depends. It depends on certain IRS rules and, to a larger extent, on math. In today’s article, we’ll delve into the world of itemized deductions.
We’ll start with an explanation of what they are. Then, we’ll help you figure out if they make sense for you. Finally, we’ll give an overview of the different itemized deductions possible, including ones that people often overlook.
By the end of it, you’ll be better informed on how (and whether or not) itemizing your deductions can save you money on your income tax.
Let’s get started!
Understanding Itemized Deductions
Before we cover itemized deductions, we need to clarify some basic terminology. To start with, we need to clear up what a tax deduction is. As we covered in our explanation of adjusted gross income, a deduction reduces your total taxable income. It doesn’t reduce the amount you owe in taxes directly. Rather, it decreases the amount of your income subject to taxes.
For example, let’s say your salary was $40,000 in 2017. By 2017 tax laws, that would place you in the tax bracket of $37,950 to $91,900. This would result in a total tax bill of $5,226.25 plus 25% of the excess over $37,950:
Total tax bill = $5,226.25+$512.50 = $5,738.75
But let’s say you were able to claim $4,000 in deductions so that your total taxable salary is $36,000. That would drop you into the tax bracket just below, where your tax bill would be only $932.50 plus 15% of the excess over $9,325 (which is $4001,25).
Post-deduction total tax bill = $4001.25+$932.50 = $4,933.75
This is the power of deductions.
The other common way to save money on your taxes is a tax credit. Unlike a deduction, a tax credit lowers your final tax bill by a given amount. For example, if you owed $5,000 in taxes but were able to claim a tax credit of $500, your total tax bill would come down to $4,500. Some tax credits, such as the purchase of electric vehicles, can be large enough to very significantly reduce your final tax bill.
Now that we understand what tax deductions are, we can explain itemized deductions. Itemized deductions are tax deductions that you can take for particular kinds of expenditures. In some circumstances, they can dramatically reduce your taxable income when compared to the more common option: the standard deduction.
As the IRS explains, “The standard deduction is a dollar amount that reduces the amount of income on which you are taxed and varies according to your filing status”.
So which should you choose? Standard or itemized? As we’ll see in the next section, it depends on your situation.
Should You Itemize or Take the Standard Deduction?
For most people, taking the standard deduction is the best option. It will result in higher tax savings and less time spent preparing your taxes than itemized deductions. This will become clear once we delve into the various itemized deductions in the next section.
What we can tell you with certainty is that in certain situations the IRS does not allow you to take the standard deduction. You can’t take the standard deduction if you’re one of the following:
- “A married individual filing as married filing separately whose spouse itemizes deductions.
- An individual who files a tax return for a period of fewer than 12 months because of a change in his or her annual accounting period.
- An individual who was a nonresident alien or a dual-status alien during the year. However, nonresident aliens who are married to a U.S. citizen or resident alien at the end of the year and who choose to be treated as U.S. residents for tax purposes can take the standard deduction. For additional information, refer to Publication 519, U.S. Tax Guide for Aliens.
- An estate or trust, common trust fund, or partnership; see Code Section 63(c)(6)(D).”
All of the above situations require that you itemize your deductions. In addition, the IRS also recommends you itemize if you:
- “Had large uninsured medical and dental expenses
- Paid interest or taxes on your home
- Had large unreimbursed employee business expenses or other miscellaneous deductions
- Had large uninsured casualty or theft losses, or
- Made large contributions to qualified charities”
The above list is the perfect segue into the next section, in which we dive deeper into the sort of expenses that qualify for each of the above categories.
Itemized Deductions: An Overview
Explaining every single itemized deduction in one article would result in thousands and thousands of words. The IRS has already created such a document, known as Instructions for Schedule A.
Rather than attempting to reproduce every part of that publication here, we’ll provide an overview and explanation of each type of expenses, along with links to further information. This way, if you do decide to itemize you’ll know which deductions to be on the lookout for.
We’ve structured our list based on the IRS Instructions for Schedule A. Schedule A is the form you use to report your itemized deductions, and it divides itemized deductions into the following seven categories:
1. Medical and Dental Expenses
This category covers everything from prescription medicines or insulin to hospital care to programs to help you quit smoking. This is a category that’s easy to overlook since it also includes things such as eyeglasses, laser eye surgery, and even pregnancy tests (administered by a doctor).
Note that you must actually have paid these expenses out of pocket in order to deduct them (expenses covered by insurance are not deductible). For more information on qualified medical and dental expenses, consult Publication 502, Medical and Dental Expenses.
2. Taxes You Paid
Next up, we have the most meta of deductions: deductions for taxes you paid. That’s not a typo–the IRS allows you to deduct five different kinds of taxes:
1. State and Local Income Taxes
These are fairly self-explanatory. If you use tax preparation software and choose to itemize, the software will automatically figure this calculation for you based on the info you input from your Form W-2.
2. State and Local General Sales Taxes
This category can get a bit trickier. The most important thing to understand is that if you plan to claim this deduction, you must have very scrupulous records to back it up. Save every receipt that records the tax you paid, as you may need them in case of an audit.
Note also that you can’t deduct both your state and local income taxes and your state and local general sales taxes. You need to pick one or the other. To help you figure out which would save you more money, use the IRS Sales Tax Deduction Calculator.
3. State, Local, and Foreign Real Estate Taxes
The IRS allows you to deduct “any state, local, or foreign taxes on real property levied for the general public welfare.” “Real property” is just a legal term for property that is attached to land and can’t be moved (hence the term “real estate”).
This category does not include the following taxes and fees:
- Taxes levied for the purpose of improvements to public property such as sidewalks or sewer lines.
- Service charges for water, sewage, or trash collection.
- Homeowners association fees.
- Transfer taxes on the sale of property.
- Estate and inheritance taxes.
See “Line 6: Real Estate Taxes” in Instructions for Schedule A for more info.
4. Personal Property Taxes
This category covers taxes on other kinds of personal property not included in real-estate. The most common will be taxed on your motor vehicle such as a yearly registration fee, but it could also include a boat or recreational vehicle.
Note that these taxes must be based on the property’s value to qualify as deductible. The example the IRS gives is a vehicle tax based in part on the vehicle’s value and in part on its weight. In such a case, only the amount of tax based on the vehicle’s value is deductible.
5. Other Taxes
As in all things, there’s an “other” category. These are any other deductible taxes not included in the categories above. The most common such tax is income tax paid in a foreign country or U.S. possession.
For more information on taxes, you can deduct, consult IRS Topic Number 503 – Deductible Taxes.
3. Interest You Paid
Next up: interest. You can deduct certain kinds of interest provided they meet the IRS qualifications. These types of interest fall into three categories:
1. Home Mortgage Interest
You can deduct any “qualified mortgage interest” paid on your main or second home. The IRS definition of “home” is “where you live most of the time, such as a house, cooperative apartment, condominium, mobile home, house trailer, or houseboat. It must have sleeping, cooking, and toilet facilities.
For a detailed explanation of what qualifies as a home and what mortgage interest you can deduct, consult Publication 936, Home Mortgage Interest Deduction.
2. Mortgage Insurance Premiums
You can deduct the premiums you pay on qualified mortgage insurance. This includes mortgage insurance from any of the following providers:
- Department of Veterans Affairs
- Federal Housing Administration
- Rural Housing Service (or their successor organizations)
- Private mortgage insurance
You can’t deduct mortgage insurance premiums if your combined income when married filing jointly is greater than $109,000 ($54,500 if married filing separately). For more info, see “Line 13: Mortgage Insurance Premiums” in Instructions for Schedule A.
3. Investment Interest
If you borrow money in order to engage in income-producing activities, then you may be able to deduct the interest paid towards that debt. The most common example would be borrowing money to invest in property. For more info, see Topic Number: 505 – Interest Expense.
4. Gifts to Charity
Of all the itemized deductions, charitable gifts are the ones people are most familiar with. The government wants to incentivize donations to charity and allows you to deduct contributions to any qualified charitable organization.
To see if the organization to which you are donating qualifies as a charity, type its name into the IRS Exempt Organizations Select Check tool.
Charitable gifts fall into two categories, and each has different rules for documenting/reporting them.
1. Gifts by Cash or Check
This is the most common type of deductible charitable contribution, and it’s fairly straightforward.
You’ll need to keep a written record of the donation in the form of either a bank/credit card statement or a written record from the charity that includes the name of the charity, the date, and the amount of the contribution. You don’t need to include this record when you file, but you should retain it in case you get audited.
Also be aware that if you receive some kind of benefit from the contribution such as merchandise, a meal, or admission to an event, you can only deduct the amount that exceeds the “fair market value” of the benefit. For example, if you give $100 and receive admission to a charity banquet valued at $40 in exchange, you can only deduct $60. If you need help determining the benefit’s fair market value, consult the charitable organization that provided it.
Note also that in this case “cash” doesn’t just mean paper currency. It includes any monetary contributions made with a debit card or credit card as well.
2. Gifts Other Than by Cash or Check
This category covers any kind of donation. The most common would be donating your clothes or other used items to Goodwill or another similar organization. But it can also include larger gifts such as the donation of a vehicle. Whatever the item might be, you can deduct its fair market value from your taxes.
How do you determine fair market value? The IRS defines “fair market value” as “the price that property would sell for on the open market.” This is still quite broad, so consult Publication 561, Determining the Value of Donated Property for further information on how to determine fair market value.
Finally, note that the total amount you can deduct for charitable contributions cannot exceed 50% of your adjusted gross income.
5. Casualty and Theft Losses
No one wants to experience an act of crime or an adverse event, but the good news is that it may get you a break on your taxes. You can deduct casualty and theft losses that resulted from the following causes:
- Theft, vandalism, fire, storm, or similar causes
- Car, boat, and other accidents
- Corrosive drywall
- The insolvency or bankruptcy of a bank or financial institution
To be deductible, each loss must be at least $100 and the total amount of all losses during the year is more than 10% of your adjusted gross income. You’ll need to report casualty and theft losses on Form 4684.
6. Job Expenses and Certain Miscellaneous Deductions
This category and the next one cover a lot of different kinds of expenses not covered in the other categories.
1. Unreimbursed Employee Expenses
Even if you don’t run your own business, you may be able to deduct expenses you incur when performing your job. For these expenses to qualify, they need to meet the following three criteria:
- Necessary for your job. The IRS defines necessary expenses as “one that is helpful and appropriate for your business.”
- Ordinary in your job. An ordinary expense is one that is “common and accepted in your field of trade, business, or profession.”
- Unreimbursed. You can’t deduct expenses for which your employer reimbursed you.
Record your deductions for unreimbursed employee expenses on Form 2106.
2. Tax Preparation Fees
Any money that you paid for the preparation of your taxes is deductible. This includes money you paid for tax software, the services of an accountant, and any other fees you had to pay for filing your return electronically.
3. Other Expenses
This subcategory covers money “paid to produce or collect taxable income and manage or protect property held for earning income.” If you don’t own a business, service fees for paying your taxes using a credit or debit card will be the most likely claimable deduction in this sub-category. Consult Instructions for Schedule A for further information.
7. Other Miscellaneous Deductions
In the final category, we have other miscellaneous deductions you may be able to claim. These deductions are less common than the ones we’ve already discussed and applied only in special tax, investment, or income situations.
The other miscellaneous deductions are as follows:
- Gambling losses. However, you can only deduct an amount that is less than your total gambling winnings, which the IRS requires you to report under “Other Income” on Schedule A. This also assumes that you gamble for recreation, not as your profession. See Topic Number 419 – Gambling Income and Losses for more information on this deduction.
- Casualty and theft losses of income-producing property. This deduction is separate from the casualty and theft losses discussed above, which apply to property that does not produce income.
- Loss from other activities from Schedule K-1, which is used to report income, deductions, and credits from a partnership.
- Federal estate tax on income you received as a result of someone’s death.
- A deduction for amortizable bond premium. Bond premium is the face value of the bond minus the amount you paid for it. The IRS allows you to deduct this amount, though there are special rules for determining this. Tax preparation software or a financial adviser can help you navigate these rules.
- An ordinary loss attributable to a contingent payment debt instrument or an inflation-indexed debt instrument. In this case and the above, you may want to speak to your investment broker or financial adviser for more advice, as a full explanation is beyond the scope of this article.
- Deduction for repayment of amounts under a claim of right if over $3,000. Claim of right repayment is a complicated issue, but basically, it refers to situations in which you incorrectly claimed that income you received was not actually income and therefore not subject to tax in the past. Now, you must pay that tax.
- Certain unrecovered investment in a pension. Consult Publication 939, General Rule for Pensions and Annuities for more information.
- Impairment-related work expenses of a disabled person. These are any expenses that are necessary for you to work if you’re disabled. See Publication 907 – Tax Highlights for Persons with Disabilities for further information on what expenses qualify.
For more information on what qualifies as miscellaneous deductions and how to calculate them, consult Publication 529, Miscellaneous Deductions.
Claim and Receive the Itemized Deductions You Deserve
The jungle of itemized deductions is thick and vast, but now that you’ve read this article you should feel more confident in navigating it (and deciding whether you should navigate it at all). In the correct circumstances, the navigation is worth it, since itemizing your deductions can result in greater tax savings than taking the standard deduction.
Figuring out whether or not to itemize can be tough on your own, so in addition to the guidance from our website and weekly email newsletter, we also recommend using tax preparation software to save time, avoid frustration, and maximize your tax savings. We’ve put together reviews of all the top tax software on the market to help you choose the best product for your situation.
We wish you a low tax bill and speedy tax preparation!