Personal Deductions - Module 3 of 5

Module Three: Personal Deductions

Tax deductions reduce the amount of income that is subject to income tax and that is paid by a person, business, estate or trust. In this module, we’ll look at income tax deductions that are mainly relevant to individuals. In the next module, we’ll focus on deductions that are mainly relevant to businesses and business activities. Each tax deduction is listed in the Code.  If there is no specific provision in the Code that allows for the deduction, then the expense is not deductible.

The first important point is that not all deductions are created equal. We must distinguish between “above the line” deductions and “below the line” deductions. Those “above-the-line” are deducted from income before determining the taxpayer’s “adjusted gross income.” The “AGI” is very important as it is used for many income-testing purposes, including the extent to which other deductions can be applied. Above-the-line deductions include qualifying contributions to retirement accounts, certain deductible contributions to health savings accounts, certain educator expenses and many business-related expenses.

“Below-the-line” deductions, which include the standard and itemized deductions on Schedule A that we are going to focus on shortly, are deductions that are taken from adjusted gross income to calculate net income, and eventually tax due. While valuable, they are subject to various limitations and are not as valuable as above-the-line deductions.

Standard and Itemized Deductions

The Internal Revenue Code allows individual taxpayers to choose between taking “standard” deductions, which allow the taxpayer to take a deduction of a specific amount irrespective of the taxpayer’s income or expenses, and “itemized” deductions, which are deductions on Schedule A of the Form 1040.[1]

Taxpayers choose whether to take standard or itemized deductions each year and can switch from year-to-year. Naturally, taxpayers should take whichever deduction is larger in a given year.

The Tax Cuts and Jobs Act of 2017 greatly increased the allowable standard deduction and limited certain itemized “Schedule A” deductions, partially in an effort to simplify the tax preparation process by encouraging more people to take the simple standard deduction rather than to itemize. According to one projection, the new standard deduction was projected to decrease the percentage of taxpayers who itemize from about 25% of taxpayers to just over 10%.[2] Note that the Tax Cuts and Jobs Act of 2017 is currently scheduled to “sunset” in 2025, but for our purposes, we will ignore this limitation.

For tax year 2019, an individual is entitled to a $12,200 standard deduction, while couples filing jointly are entitled to a $24,400 standard deduction. As of this writing, in late-2019, the standard deduction is scheduled to increase annually until 2025, when much of the Act “sunsets.” So, there is much uncertainty in the amount of the standard deduction year-to-year. As such, the decision whether to itemize or take a standard deduction must be revisited on an annual basis. The enlarged standard deduction replaced the more complex personal exemptions and child tax credits, though a more streamlined version of the child tax credit was maintained, which we will cover in Module Five. Some groups of people are provided with even greater standard deductions. People aged 65 and blind taxpayers, for example, are given additional standard deductions.[3] 

For those choosing to itemize deductions, there are many types of deductions available. However, there are limitations on many of these deductions and income limitations on the effectiveness of itemized deductions overall.

For example, for people whose adjusted gross income exceeds the “applicable amount” ($300,000 for married filing jointly, $250,000 for individual taxpayers and other amounts for other situations), their standard deductions are reduced by the lesser of 3% of their excess adjusted gross incomes or 80% of the amount of their itemized deductions. This has the effect of phasing out itemized deductions for high income taxpayers.[4]  

Let’s look at an example. A married couple has a 2019 adjusted gross income of $380,000 and allowable itemized deductions of $40,000. They, therefore, have $80,000 excess income over the applicable amount.  Their reduction in allowable itemized deduction is the lesser of 3% of their excess adjusted gross income ($80,000 x 3% = $2,400) or the 80% value of their itemized deductions ($40,000 x 80% = $32,000). Because the $2,400 is the lesser amount, their allowable itemized deductions will be reduced by $2,400.

Deductions for Paid Interest

            Section 163 of the Code allows for the deduction of many types of interest paid on business ventures and investments that is paid or accumulated during the tax year. Deductible interest includes interest paid or accumulated in the taxpayer’s trade or business, investment interest paid for the purchase of property that generates income and interest paid in a trade or business in which the taxpayer is not involved in the day-to-day operations.[5] For interest paid on a loan to finance the purchase of an investment property, the interest is deductible only up to the net investment income earned that year.[6]

            Personal interest, such as that paid on personal loans and credit cards, is not deductible. However, there are exceptions for interest paid on personal residence mortgages and for interest paid on certain loans to finance education.       

Interest paid on home purchase money mortgages is deductible, but only up to a mortgage amount of $1 million. Under the Tax Cuts and Jobs Act of 2017, the mortgage amount is limited to $750,000 for purchases in 2018 and later. The mortgages themselves may be for more than that, but the deductible interest is only the interest that corresponds to the debt up to these limits. So, for example, in a $2 million mortgage taken on 2017, with a 5% interest rate, the maximum deductible interest would be 5% of 1 million ($50,000) rather than 5% of 2 million.[7]

To qualify, the loan must be to acquire, construct or substantially improve the taxpayer’s qualified residence, and the residence must be pledged as collateral and secured by a mortgage.  A qualified residence can include a principal residence and one other residence, provided the taxpayer does not rent out the second residence during the tax year. Therefore, the deduction can apply to one vacation home, provided that the vacation home is not rented out.[8]

Interest on home equity lines of credit, while previously allowable, is excluded from the interest deduction under the Tax Cuts and Jobs Act.[9]

For interest paid on a qualified education loan, the amount is deductible up to $2,500 annually.[10]  However, when modified adjusted gross income exceeds $50,000 for individual taxpayers or $100,000 for married taxpayers, the deductible interest amount is reduced.  For example, if married taxpayers take out a loan in 2019 to pay for their daughter’s college education and their 2019 modified adjusted gross income is $125,000, the excess $25,000 over the $100,000 limit is divided by $30,000 ($25,000/$30,000 = 83.33%) and results in the $2,500 qualified education loan deduction being adjusted down by $2,083 to $417. Of course, for those with more than $130,000 of AGI, the deduction phases out completely.

To be a qualified education loan, the loan must be paid to a qualified educational organization and must be incurred on behalf of the taxpayer, the taxpayer’s spouse or any dependent of the taxpayer at the time the loan was incurred. The recipient must be an eligible student. 

State and Local Taxes

Taxes paid to state and local governments, including state income tax and property tax, are also deductible.[11] Taxes paid to foreign governments are deductible under the same provisions.

From 2018 onwards, under the Tax Cuts and Jobs Act, there is a $10,000 cap on deductions for state and local (and foreign) taxes for individuals and for married couples (the cap is $5,000 each for married people filing separate tax returns) [12].  However, there is no cap on deductions for taxes paid or accrued on real property or personal property when incurred in carrying on a trade or business activity, as those are considered expenses for the production of income.[13]

As an alternative to deducting state and local income taxes, taxpayers may instead choose to deduct state sales tax (though they may not deduct both). For this purpose, sales tax includes “general” retail sales tax and/or “compensating use” tax, which is assessed on the use, storage or consumption of an item and which is treated as a general sales tax.[14]   For example, if a taxpayer buys a lawn mower and pays sales tax for it, and also rents a storage shed in which to keep it and pays taxes on the rental, both qualify as sales taxes.  

In determining sales tax paid in a given year, the taxpayer can keep her receipts and thus demonstrate the sales tax paid over a given year. However, the IRS also recognizes that most people don’t keep their ordinary retail sales receipts. Thus, the IRS has put together a table, wherein the taxpayer can input her income level, family size, location of residence and one or two other factors to generate an estimated sales tax paid. This estimate can be used in lieu of state and local income tax.[15]

State taxes assessed on provided local benefits – like streets, sidewalks, water mains, sewer lines and public parking facilities – that increase the value of the property on which these local benefits taxes are assessed, are not deductible.[16]  However, taxpayers can claim them as deductible maintenance expenses or deductible interest charges or they can increase the cost basis of the property by its increased assessed value due to these local benefits, which decreases capital gains tax when the property is later sold. 

For property taxes assessed in a year during which real property is sold, the property taxes are divided between the buyer and seller based on the number of days in the year of sale that the buyer owned the property and the number of days that the seller owned the property.[17]

For state taxes assessed on a shareholder’s interest in a corporation, if the corporation pays these taxes and the shareholder does not reimburse the corporation, the corporation is allowed the deduction and the shareholder may not claim the deduction.[18]

Deductions are also allowed for federal taxes, in some cases. For example, self-employed people who must pay both the employer’s and employee’s component of payroll taxes (which are taxes for social security and Medicare) may deduct one half of this amount, as an above-the-line deduction.[19] 

Losses

Individual taxpayers may deduct losses that are not compensated for by insurance if they are business losses incurred in a transaction entered into for profit or if they arise from fire, storm, shipwreck, casualty or theft.[20] However, in the latter case (non-business losses), the losses are only deductible to the extent that they exceed 10% of the taxpayers adjusted gross income.[21] Moreover, under the Tax Cuts and Jobs Act, losses in 2018 and forward are deductible only if the loss is attributable to a federally declared disaster,[22] meaning a disaster determined by the President to warrant assistance from the federal government.[23]   

For property losses, the deduction amount is the property cost, reduced by depreciation already taken, if any.[24]  Paradoxically, because depreciation rules allow for deductions based on assumed decreases in value of property that may not be mirrored in real life, it is possible for an insurance reimbursement after a disaster to comprise more than the cost basis of the property. For example, assume an investment property was purchased for $500,000 and, pursuant to applicable depreciation rules, the taxpayer took $200,000 in allowable depreciation deductions over the course of several years. The cost basis of the property is now $300,000. When the property was destroyed by fire, the insurance company paid out $400,000, because that is what it would cost to rebuild the property. This phenomenon is known as a casualty gain.[25]  

            When personal casualty gains exceed personal casualty losses, the gains are taxed as capital gains.[26] The duration of time that the property was held before being destroyed determines whether it’s a short-term or long-term capital gain. If the property was held for more than a year, is considered a long-term capital gain just as if it were sold at the time of the disaster. Casualty gains can also be used to offset other casualty losses in the same year.[27]

Other limitations also apply to various types of losses. First, gambling and wagering losses are deductible only to the extent that they offset any income derived from those activities.[28] So, if a person wins $20,000 and loses $19,000 at blackjack, the $19,000 of losses may be used to offset most of the $20,000 in gains, leaving a net income of $1,000. However, if the taxpayer lost $21,000 at the game, while he would not need to report a gambling gain, he also would not benefit from any additional deduction.

While capital losses (which occur when capital assets are sold for less than their adjusted cost bases) are deductible to offset other capital gains in the same year, when capital losses are greater than capital gains in a given year, they may be deducted from other income only up to $3,000 annually (or $1,500 for a married individual filing separately).[29] Capital losses beyond $3,000 per year can be carried over to future years and taken at the rate of $3,000 per year until the loss has been completely deducted.

For example, if one sustains a capital gain of $4,000 and a capital loss of $6,000, one can deduct $2,000 in that tax year.  However, if one sustains a capital gain of $4,000 and a capital loss of $8,000, then one can deduct a capital loss of $3,000 in this tax year and carry over the $1,000 excess for the next year.[30] If the capital loss was $10,000 in the capital gain was $4,000, she may carry that over and deduct $3,000 each of the next two years. Assume the same taxpayer realizes a $5,000 capital gain the next year. She can deduct $3,000 that year to realize a total gain of $2,000 and still have $3,000 to write off the following year.

Charitable Deductions

Charitable deductions,[31] which are below-the-line Schedule A deductions, are allowed for contributions to tax-exempt organizations.[32]

 Individual taxpayers must make the donation during the taxable year to get the deduction for that tax year.[33]  Corporations that report income on the accrual basis may deduct charitable contributions declared during the tax year and made on or before April 15 of the following tax year.[34]  The total contribution a corporation may claim in a tax year cannot exceed 10% of the corporation’s taxable income.[35]  The excess can be carried forward as deductions for up to five successive tax years.

There are contribution percentage limitations for individual taxpayers, as well.  Under the Tax Cuts and Jobs Act, individual taxpayers may annually deduct contributions up to 60% of adjusted gross income.  This is referred to as the “60% Contribution Base Deduction” to qualified exempt organizations, termed “Type A” organizations.  If the taxpayer’s annual contribution exceeds the 60% limit, the excess can be carried forward as deductions for up to five successive tax years.[36]

Type A organizations include churches, private foundations, non-profit educational organizations, organizations that maintain hospitals or medical research facilities and organizations created under state or federal law and operated exclusively for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals.

Charitable contributions to organizations that are not Type A organizations – like veteran organizations, fraternal societies and cemetery organizations – are deductible up to a prescribed percentage of the taxpayer’s adjusted gross income.  The amount the taxpayer may deduct is the lesser of 30% of adjusted gross income or the excess of 50% of the adjusted gross income minus the contributions they made to Type A organizations. 

For example, if the taxpayer has an AGI of $100,000, she may deduct up $60,000 in contributions to Type A organizations under the Tax Cuts and Jobs Act (the previous limit was 50%). She may, alternatively, deduct up to $30,000 in contributions to organizations that are not Type A. If she contributes $30,000 to Type A organizations and $20,000 to non-Type A organizations, it’s all deductible. However, if she donates $40,000 to non-Type A organizations, only $30,000 is deductible because of the 30% limit on non-Type A contributions. If she donates $30,000 to Type A organizations and $30,000 to non-Type A organizations, only $50,000 total is deductible, as there is a 50% cap on combinations of donations to Type A and non-Type A organizations (the increase to 60% under the Tax Cuts and Jobs Act applies only to donations entirely to Type A organizations). Any amount that is not deductible can be carried over to the next year in accordance with the applicable rules.[37]

The rules get still more complex for donations of appreciated assets (such as stocks that are worth more than what the taxpayer paid for them). When appreciated assets are donated, the deduction amount is limited to 30% of the taxpayer’s adjusted gross income if donated to a Type A organization[38] or to 20% of adjusted gross income if donated to a non-Type A organization.[39] Contributions that exceed these deduction limits may be carried forward as deductions for up to five successive tax years. Contributions to both types of organizations are treated similarly to the limits for other contributions that we discussed a bit earlier.

Another type of charitable contribution that may be deducted is the “Qualified Conservation Contribution,” which is a contribution of a qualified real property to a qualified organization exclusively for conservation purposes.[40] The interest can be the donor’s entire interest in the real property, a remainder interest or a restriction in perpetuity on the use of the real property.  Qualified organizations are Type A organizations[41] and charities that receive at least one-third of their financial support from public contributions.[42]  Conservation purposes include the protection of ecosystems and natural habitats of fish, wildlife or plants, preservation for the general public of lands for outdoor recreation or education, of open spaces for scenic enjoyment and of historically important land areas.[43] 

When a taxpayer donates a qualified real property interest that consists of the exterior of a building, but continues to own the interior of the building, the taxpayer may only deduct the contribution as a qualified conservation contribution if the entire building exterior is preserved or any change to the exterior is consistent with the historical character of the building. The donor and recipient must sign a written agreement that the recipient is a qualified organization whose purpose is environmental protection, land conservation or historic preservation and that the recipient has the resources to manage and maintain the property.[44]

            In our next module, we’ll focus on income tax deductions that are mainly applicable to businesses and the business activities of individual taxpayers.