The federal tax code allows you to subtract many major expenses from your taxable income, which in turn reduces the tax you owe. No one -- not even the Internal Revenue Service -- has drawn up a "master list" of every single thing that could be deducted and the circumstances under which you could deduct it, but tax deductions fall into several distinct categories. Some deductions are available to anyone who files a tax return; to claim others, you must itemize your deductions.
Standard vs. Itemized Deductions
Every taxpayer must decide whether to itemize deductions. When you itemize, you list your deductible expenses, add them up and then reduce your taxable income by the total. People who don't want to go through the hassle -- or who don't have very many qualifying deductions -- may take the "standard deduction." This is an amount set by the government. It's based on your filing status and represents a kind of "ballpark figure" for the amount of deductions a typical person in your situation might have. For the 2011 tax year, for example, the standard deduction for single taxpayers and married people filing taxes on separate returns was $5,800. For a married couple filing jointly, it was $11,600. The standard deduction rises with inflation.
People who itemize may be able to deduct a portion of their medical and dental expenses. This deduction is limited to the amount in excess of 7.5 percent of a taxpayer's adjusted gross income, or AGI. Say you had an AGI of $50,000 and $4,000 in medical and dental expenses. Since 7.5 percent of your AGI is $3,750, you would be able to take a medical deduction of $250. Internal Revenue Service Publication 502 provides an extensive list of which medical and dental expenses that you may and may not deduct.
Itemizers may also deduct many taxes they pay to state, local and foreign governments. Taxpayers may choose to deduct non-federal income taxes or general state and local sales taxes, but they may not deduct both. Other deductible taxes include real estate taxes and "personal property taxes," such as taxes on vehicle registrations. Taxes that qualify for the deduction are often fully deductible, but they must have been paid during the year for which they are claimed. If a tax is assessed in one year but you don't pay it until the next, you may only claim the deduction for the second year.
People who itemize may deduct the interest on a home mortgage, often including "points" of prepaid interest charged when the loan closes. Mortgage insurance premiums, which lenders often require of borrowers they consider risky, are considered deductible insurance. Investment interest -- that is, interest paid on money borrowed for investment purposes -- is also deductible.
Other Itemized Deductions
When you itemize, you may also deduct gifts to charities and other tax-exempt organizations, as well as uninsured losses caused by disasters or theft. One catch-all category, "Miscellaneous Deductions," allows you to claim a wide range of deductions, including work expenses you paid out of pocket, tax-preparation fees, certain legal and accounting fees, and gambling losses up to the amount of your taxable gambling winnings. Some of these deductions must be added together, and you may then deduct only the portion that exceeds 2 percent of your AGI. Others are fully deductible. IRS Publication 529 lists these deductions and identifies whether the 2 percent limit applies to each.
The tax code identifies about a dozen deductions that anyone who is eligible may claim, regardless of whether they itemize. Though the IRS refers to them as "adjustments to income," rather than deductions, they have the same effect as deductions. These adjustments are commonly called "above-the-line deductions," since you claim them on your tax return right above the line where you add up your federal AGI. Among the above-the-line deductions are teachers' out-of-pocket expenses for classroom supplies; contributions to individual retirement accounts, certain other retirement accounts and health savings accounts; alimony payments; tuition and fees paid by college students; student loan interest; some job-related moving expenses; and certain expenses for self-employed people. The instructions for IRS Form 1040 go over the eligibility rules for these deductions.
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