Taxes are inevitable. But some people pay very little in taxes, despite earning a lot of money. How do they do it? And how can you get tax deductions yourself? Many take tax deductions through their business, like the famous Hummer tax loop hole which allows deduction of the cost of certain vehicles. But you don’t have to own your own business to qualify for tax deductions.
The purpose of this article is to highlight some of the major tax deductions available to people who don’t own businesses and how you might qualify for them.
Tax Deductions and Tax Credits Are Different
Before we get started, I want to define our terms.
Tax credits mean that the entire tax amount will be given back to you, or credited to you. This is the more favorable kind of tax benefit.
Tax deductions reduce the total income upon which you will be taxed. These are helpful, but less so than tax credits.
The government provides these tax incentives as a way to accomplish their policy goals – for example, there’s an effective subsidy on the purchase of homes in the form of the mortgage interest tax deduction.
Let’s look at an example.
Jane and Charles earn a combined income of $100,000. When they file taxes, they choose married, filing jointly.
In 2022, if they had no deductions, credits, or adjustments, they would owe $13,234 in taxes for the year.
What if they got a tax credit for $5,000? Then they’d owe $8,234 and receive a tax refund of $5,000.
What if they got a tax deduction for $5,000? Then their taxable income would be $95,000 and they would owe $12,134 in taxes. They would still receive a refund, but only for $1,134.
I hope I’ve convinced you that tax credits are much more desirable than tax deductions. Before we move on, we should talk about the Standard Deduction.
What is the standard deduction?
In 2017, the Tax Cuts and Jobs Acts significantly changed the federal tax code. One of the changes was to increase the standard deduction.
All tax filers, whether we make $10,000 a year or $10 million per year, are eligible for the standard deduction.
In 2022, if you’re married and filing jointly, IRS has announced the standard deduction is $29,500 for married filing jointly and $12,950 for single filers. For heads of household, the standard deduction will be $19,400. These deduction amounts have been increased by $800, $400, and $600, respectively, compared to 2021.
What does it mean to take the standard deduction?
Tax filers can choose whether or not to take the standard deduction. If you take the standard deduction, you accept that you will not itemize deductions which include your mortgage interest and property taxes. Not everyone should take the standard deduction to optimize taxes, as we will discuss later.
Let me show you a sample Form 1040, which is the tax form completed by you, Turbotax, or your accountant when you file taxes annually.
In summary, the federal government has created a deduction that we can all use that reduces the total income on which we are taxed.
If you choose to take the standard deduction, you will not itemize taxes. That’s what we’ll talk about next.
What does it mean to itemize deductions?
Some tax payers itemize deductions, which means they (or their software or accountant) must complete Schedule A. The Schedule A form is a worksheet on which deductions for specific categories are listed.
The major categories are medical and dental expenses, taxes you’ve paid, interest you’ve paid, charitable contribution, and theft losses.
Deducting medical and dental expenses
Not everyone can deduct medical or dental expenses. It’s important to know a ballpark of your total medical expenses and your adjusted gross income (sum of wages, interest, dividends, business income, less estimated taxes) to know whether your expenses qualify.
If you’re not sure, you can always input your total expenses into your software or provide them to your accountant.
You can deduct any of the following items as medical and dental expenses, so long as they have not already been reimbursed by insurance, according to IRS:
- Prescription medicines or insulin
- Physician visits or other health care workers including acupuncture, occupational and physical therapy, psychology.
- Imaging such as x-ray and MRI, blood work
- Tests such as pregnancy tests, blood sugar
- Nursing wages, including employment taxes
- Hospital costs
- Long-term care costs
- Medicare part D premiums
- Weight loss programs as treatment for disease (including obesity). Smoking cessation programs.
- Glasses, contact lenses, wheelchairs.
- Surgery to improve vision
- Lodging expenses but not meals while away from home for medical care.
- Breast pumps for lactation
- Ambulance services.
It’s a long list, and for some people, medical expenses can be substantial. However, unless the sum of your medical and dental expenses (line 1, Schedule A) exceeds 7.5% of your adjusted gross income (line 11, Form 1040), you won’t be able to deduct any of those expenses.
In Schedule A, if you complete the worksheet, you’ll write the sum of all medical and dental expenses in line 1.
Then you’ll write your adjusted gross income, taken from Form 1040, on line 2.
You’ll calculate 7.5% of your adjusted gross income and write it on line 3.
And you’ll be told to subtract 7.5% of your income from the sum of your medical expenses. If your income was too high, you might not be able to deduct your medical expenses. That’s because 7.5% of your income may be far more than your total medical expenses.
Most high income earners can’t take this deduction unless they have significant medical expenses. A two-physician household earning $500,000 would need to exceed $37,500 in medical expenses to take the deduction. Jane and Charles, earning $100,000, would need $7,500 in medical expenses to qualify.
Even when your income or expenses meet the threshold, you’re only going to deduct the expenses that exceed 7.5% of your income.
Deducting state and local taxes, deducting property taxes
State and local income taxes as well as property taxes can be deducted, up to a certain limit. This was a change in the Tax Cuts and Jobs Act, where previously there was no significant cap.
If you have paid state income taxes for the year, or have had state income taxes withheld from your income, here’s where you list them, line 5a. You could also opt to add the sales taxes on food, clothing, and cars.
It’s commonly known that property taxes can be deducted. If you’re not sure where to find how much you paid, look on the Form 1098 issued by the bank, if you have a mortgage. If you don’t have a mortgage, you can verify through your property tax bill. Include real estate property taxes on line 5b.
Did you know you can deduct the taxes paid for your car annually when you pay for its registration? You can only deduct the portion of the registration fees that are based on the car’s values. Record this on line 5c.
You’re limited in this section to taking $10,000 in state and property taxes. If the sum of all these taxes (lines 5a-5c) exceeds $10,000, you won’t be able to deduct the amount over $10,000. That’s what lines 5d-e calculate.
Finally, you can deduct taxes you’ve paid to another country. If you paid income taxes to a foreign country, include this amount on line 6.
Let’s look now at interest deductions
Mortgage Interest Deduction and Others
One of the most famous deductions is the mortgage interest deduction. This was also modified in 2017 by the new law. You can only deduct mortgage interest on loans up to $750,000 if married filing jointly or $375,000 if single. Note this applies only to mortgages engaged after December 15, 2017.
On Form 1098, the lending bank reports to IRS (and to you) the amount of interest paid and points paid on your personal residence. This is the same form used earlier to show property taxes paid.
Interestingly, If you have a home equity line of credit (HELOC), the interest will also be reported on 1098 and gets listed on line 8a. However, you can only deduct the interest from a HELOC that you use to buy, build, or improve your home. If you used your HELOC to buy a car, you can’t use the interest paid for that purpose in this calculation.
If you have mortgage insurance, you can deduct these premiums on line 8d.
Finally, if you borrowed money to invest, you can deduct the interest for that in line 9. For example, if you borrowed money for the purchase of a stock, the interest from that debt is deductible. IRS specifically uses stock in its information sheet about the investment interest deduction.
There’s no cap to how much interest you can deduct. That doesn’t mean you should avoid paying off your home. Tax deductions only save you a fraction of the amount of interest you’re paying. As my accountant says, you shouldn’t spend a dollar to save a quarter.
Gifts to Charity are Tax Deductible
Finally, the last section of Schedule A allows tax deductions to be made for gifts to charity, so long as the taxpayer isn’t getting a special benefit from that amount.
For example, if you donated $100 to a charitable organization and became eligible for a free dinner. The free dinner is not tax deductible but the remaining portion of your gift is deductible.
Tax deductions start in January
These are only some of the ways that can be used to legally lower your tax bill. People don’t take these deductions by accident. Those who have substantial deductions often plan what they will do to optimize taxes. Hence, tax deductions start in January. Note that it only makes sense to itemize your taxes if the itemized deductions exceed the standard deduction.
And there you have it. I’ve listed all the common tax deductions available to workers with W2 income including home mortgage interest, property , and income.
Thanks for reading. Please let me know your thoughts below.
(I’m not an accountant or tax professional!)
