Have you gone to your tax pro with a fistful of receipts you’ve been collecting over the past year only to find out you cannot take the deductions because you don’t have enough to itemize? You may wonder exactly what that means.
Here’s how that scenario goes:
First of all, the IRS does not tax your total income; it allows a number of subtractions from that income before taxes are levied. On page one of Form 1040 in section one, you report all of the income that is subject to taxation. Then in section two, you subtract out adjustments to income (see last week’s column) to arrive at your adjusted gross income.
When you flip over to page 2 of Form 1040, you find a choice of taking either the standard deduction or itemized deductions; both methods again reduce your income. The standard deduction is a set dollar amount based on your filing status and your age. The standard deduction is higher if you are age 65 or older, are blind, or have a net disaster loss in 2010 because of a disaster that occurred before 2010 and was declared a federal disaster after 2007.
The standard deduction for 2010 is $5,700 if single or married filing separately, $11,400 if married filing joint or qualifying widow(er) with a dependent, and $8,400 if head of household. If you can be claimed as a dependent on someone else’s tax return, you must complete a worksheet to determine the amount of standard deduction you may claim. If you are using the filing status of married filing separately and your spouse itemizes deductions, you are required to itemize deductions. This could be disadvantageous if the amount of itemized deductions you can claim is lower than the standard deduction.
If the receipts you bring to your tax preparer total less than the standard deduction for your filing status, you don’t have enough to itemize.
If your total deductions are in excess of the standard deduction, you may wish to itemize deductions. The list of deductions that qualify for itemizing generally include:
1. Medical expenses in excess of 7.5% of your adjusted gross income,
2. State income taxes, property taxes, vehicle license fee, local taxes,
3. Mortgage interest
4. Causality and theft losses
5. Charitable contributions
6. Unreimbursed job expenses and job search expenses
7. Other miscellaneous deductions such as investment expenses and tax preparation fees subject a reduction of 2% or your adjusted gross income
Check out the instructions for Schedule A at www.irs.gov for a complete listing of itemized deductions. Those who generally have the ability to itemize include: homeowners with mortgages, higher earners who pay large amounts of state income taxes, and wage earners such as sales reps, that have a large amount of unreimbursed employee business expenses.
There’s a bit of unfairness in this particular system of taxation. Tax law is created to motivate certain behaviors. To encourage charitable giving, donations are allowed as a deduction, and to inspire home ownership, the IRS provides the mortgage interest and property tax deduction. Because home loans are interest heavy in the early years of a mortgage, a taxpayer is able to write off almost all of his housing cost. A renter on the other hand, has no such opportunity: A single individual who rents with an income of $50,000 and paying $1,000 per month for housing will pay taxes on $50,000 less the standard deduction and his exemption allowance. If a homeowner pays $1,000 per month for mortgage interest, he will be able to itemize deductions as well as include other deductions the renter cannot claim. To his $12,000 of mortgage interest, let’s say he adds property taxes - $2,000, state income taxes - $2,000, vehicle registration - $200, tax preparation fees - $200, charitable contributions - $600, and other miscellaneous deductions - $1,000 for a total of $18,000. The homeowner’s income is reduced to $28,350 – a difference of $12,300 in taxable income from what the renter declares.
The renter pays $2,500 more in taxes, simply because he hasn’t had the means or opportunity or inclination to purchase his own home. But here’s the dilemma: Every tax deduction costs money. The homeowner receives a tax benefit but he can’t call the landlord when things break, when carpet needs to be replaced or walls painted.
The current administration is studying this phenomena and part of the tax reform being considered is the elimination of itemized deductions paired with a substantial increase of the standard deduction – up to $30,000. Interesting concept, but will it back fire? Will the majority of people reduce or eliminate charitable contributions forcing much-needed nonprofit organizations to close? Without the tax incentive of home ownership, will the already ailing real estate market slump further by a deluge of inventory? After all, why bother owning the home if there is no write off? Broken pipes? Backed up plumbing? Call the landlord.
Even if a flat tax were introduced, itemized deductions and incentives would disappear, but the problem would remain.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.