When was the last time you heard a friend or business associate say, "I'll just write this expense off as a deduction?" Did you scratch your head and ask yourself, "Write what off against what?" or "What's a deduction?"
Tax deductions come in many shapes and forms, both for personal and business purposes. As a rule, you are entitled to take deductions only where specifically authorized by the Internal Revenue Code. Therefore, because deductions are a matter of "legislative grace," courts closely scrutinize your deductions and claims, and reject those that do not clearly satisfy the letter of the law. This is generally done through an audit examination -- you've heard of them, I'm sure. Each taxpayer bears the burden of proving his or her entitlement to a deduction, and ambiguities are often resolved in favor of the government.
Where do deductions come from and how are they applied in your personal tax return? Virtually anything you can use to reduce your taxable income can be considered some form of a deduction. Thinking about how your individual income tax return is computed is the best way to understand this concept.
The starting point of an individual's income tax is "gross income," which is broadly defined to include income from any source, except items specifically excluded by the code. Gross income would include all of your income -- wages, interest, dividends, business income, rental income, and on and on. Once you determine your gross income, you can then subtract certain "deductions" to determine your "adjusted gross income" (AGI).
Deductions from gross income to determine AGI might include:
There are even more deductions you can use to arrive at your "adjusted gross income," but they are more commonly referred to as "adjustments to income." Call them what you wish, they are still deductions used to reduce your taxable income and, therefore, your income tax. They include:
- Certain contributions to qualified pension plans and individual retirement accounts (IRAs)
- Alimony payments that are included in the taxable income of the recipient
- Moving expenses
- Deductions for self-employed insurance paid and self-employment taxes paid
- Deductions for student loan interest and medical savings accounts
Once you have determined your AGI, you then get to play with even more deductions. To determine your taxable income, you take your AGI and reduce it further by subtracting:
- Personal exemptions (more deductions), and
- The greater of either your "standard deduction" or your "itemized deductions"
Your total tax liability is then calculated based on your "taxable income."
If you do not elect to "itemize" your deductions (and this is an election), you are allowed a "standard" deduction instead. The standard deduction is a simplification device that avoids the necessity of accounting for modest amounts of itemized deductions. As an alternative to the standard deduction, taxpayers can elect to "itemize" their deductions. Some examples of itemized deductions include:
- Medical expenses (IRS Publication 502)
- Taxes (IRS Publications 530 and 535)
- Interest (IRS Publications 936, 535, and 550)
- Charitable contributions (IRS Publication 526)
- Casualty and theft losses (IRS Publication 547), and
- Miscellaneous itemized deductions (IRS Publications 529, 463, 508, and 550)
Many of the deduction rules are complex and require informed judgment to avoid surprises. For example, medical expenses and "miscellaneous itemized deductions" such as education expenses and unreimbursed employment-related expenses must exceed a certain percentage of your AGI before they can be deducted. Other items, such as hobby expenses, are only deductible up to the amount of income produced from the activity. So, deductions can be tricky and very complicated. You want to make sure you are on solid ground before you decide to "write off" that liposuction procedure for your poodle.
Now you know a little bit more about deductions, how they work, and how they are molded into your individual income tax return. In this case, let's hope that a little knowledge is not a dangerous thing.
