When tax season comes around people love to talk about deductions. Tax deductions, put in the simplest way, are items that lower your taxable income and therefore lower your tax liability. Contrary to what some people mistakenly think a deduction is not a direct reduction of the taxes owed. A tax credit is an item that directly lowers the tax owed.
Before going into detail about when deductions are used and what qualifies as a deduction here is an illustration of how they work. Let’s say a taxpayer made $100 this tax year and the taxpayer is in a 10% income tax bracket. That would mean that the taxpayer would have to pay $10 in income tax ($100 X 10%). Now let’s say this taxpayer had a deduction of $20. In this case the $20 deduction is deducted from the taxpayer’s taxable income before the tax rate is applied. So with the deduction their taxable income is $80 ($100 -$20). Now when the 10% tax rate is applied the $80 of taxable income the amount of the total tax drops to $8 ($80 X 10%). This example demonstrates how a $20 deduction lowered the tax $2, not the full deduction amount. Keep in mind that this is a very simplistic and unrealistic scenario used just to show how the deduction works.
Deductions get reported on tax forms in a few different places. For the sake of this article we’re only going to talk about a few of the common ones. We’ll start with deductions that are applicable to everyone, Standard and Itemized deductions. Then we’ll go into deductions related to business income and rental property income.
Standard and itemized deductions. To start with, these work just like the model I outlined above. They lower taxable income so your tax liability is lowered as well. The standard deduction and the itemized deduction are available to all taxpayers (usually) but each taxpayer can only take one each year. Meaning the taxpayer has to choose whether they want to itemize their deductions or take the standard, in almost all cases people take them most beneficial one.
The standard deduction is meant to be a simplistic umbrella type deduction. Everyone has it as an option so using it makes preparing your taxes easier. It’s easy because you don’t have to do any record keeping or gather information, it’s automatic. The IRS allows this so if they have to audit a taxpayer they don’t have to verify small dollar deductions. In tax year 2022 the standard deduction for a single taxpayer is $12,950 and $25,900 for married filing jointly.
The itemized deduction works the same way as the standard deduction except it’s a cumulative list of all of the taxpayer’s deductible items. Unlike the standard deduction if you get audited you will likely have to prove the values of the deduction. Generally you only take the itemized deduction if the cumulative amount of all of your deductions is larger than the standard deduction available for your filing status.
So the next part of the itemized deduction to discuss is what factors into it. The itemized deduction includes medical costs, state income taxes, property taxes, mortgage interest, charitable contributions, job-related expenses, union dues, tax preparation fees, and many more. There are many more than what are mentioned in that list and if you have questions about specifics talk to an accountant for more detail. Some of these items have minimum amount thresholds that have to be met in order to be used, some have maximum limits, and some have phase out windows based on income. Again for specific detail talk to a professional.
The next type of deduction that should be mentioned are deductions from specific types of income. For the purposes of this explanation rental property and small business income will be grouped together. However they are not always the same and are not grouped together on your tax return. Also for this topic the definition of a small business will be a sole-proprietorship reported on the taxpayer’s Schedule C. Going into specifics about all businesses and deductions would require a book not a short informative blog.
The way deductions work with rental income and small businesses are slightly different than the standard and itemized deductions. These types of deductions are in addition to the taxpayer’s standard or itemized deduction. The deductions still lower taxable income but they do it directly to the income they are related to. Only in some scenarios where there are net losses are the losses applied to adjusted gross income.
Generally rental property deductions and small business’s deductions are anything a taxpayer spent to earn the income. For a rental property this would include real estate taxes, mortgage interest, advertising, home owners insurance, landscaping, repairs, and depreciation on the house. For small business’s this could be office supplies, travel, advertising, home office expenses, professional services, and materials. All types of expenses that are incurred trying to earn income are deductions against that income.
This article goes into some detail about what deductions are and how they work. This is just the tip of the iceberg. There are many more types of deductions than the ones discussed here. Even more abundant are the limits, thresholds, and phase outs that these deductions are subject to. This article was meant to provide a fundamental understanding of how deductions work without going into specific tax strategy and advice. Since everyone’s income level, deductions, and tax situation differ so greatly it would be impossible to provide a one size fits all informational essay. With that in mind, please talk to an accountant with any specific questions regarding deductions available to you.