Over the years the tax code has incorporated social as well as financial goals. Deductions are the lawmakers' invitations to you to let Uncle Sam help you buy a house or give to charity. If you spend money for specifically sanctioned expenses, the IRS will ignore that part of your income. Every $1,000 of deductions knocks $1,000 off your taxable income. shaving $280 off your tax bill if you're in the 28% bracket. That effectively reduces your $1,000 out-of-pocket cost to $720.
A few years back, Congress decided that higher-income taxpayers shouldn't use this method to avoid all their taxes. The change was supposed to be temporary, but the lawmakers made it permanent. Then, as part of the big tax cut in 2001, the lawmakers had another change of heart and decided to phase out the crackdown in 2006. For 2006, the phase out affects you if your adjusted gross income (AGI) exceeds $150,500. That threshold applies whether you file a joint, single or head-of-household return. If you're married and file separately, the threshold is cut in half, to$75,250. (The trigger points will rise in the future with inflation. If your AGI is over this level, your itemized deductions are reduced ("phased out".) You lose deductions equal to 3% of the amount by which your AGI exceeds the threshold. For 2006, however, the maximum amount by which these amounts can be reduced is only 2/3rds of the amount that would otherwise apply. (Don’t worry, TaxCut will handle the necessary calculations automatically.)
The deduction phased out amounts to a tax hike for taxpayers whose AGI is over the threshold.
This phase out does not hit all deductions. It spares write-offs for medical expenses, casualty and theft losses, gambling losses and investment interest. You get the full power of those deductions, notwithstanding your AGI. (Medical expenses and casualty and theft losses are already subject to tough restrictions.)
This deduction is designed as a safety net for taxpayers with extremely larege medical expenses. So while the list of medical costs that can be deducted is long, few taxpayers get any tax benefit. To deduct any medical expenses, your total outlay for qualifying costs during the year must exceed 7.5% of your adjusted gross income. (AGI is basically all your taxable income minus certain items, the most common of which are IRA and Keogh contributions, alimony you paid, moving expenses and the student loan interest deduction.)
To see the impact of this rule, consider a taxpayer with AGI of $50,000. The 7.5% test blocks the deduction of the first $3,750 of medical expenses. If you had $4,000 in unreimbursed medical expenses, for example, the deductible amount would be only $250.
The tougher Congress makes it to get any medical deductions, the more important it is to know what can qualify for this tax saver. The basic definition of medical care is extremely broad. Qualifying expenses include what you pay for the diagnosis, treatment or prevention of disease or for treatment affecting any structure or function of the body. You also count the cost of transportation to and from the place you receive the care and the premiums you pay for medical insurance.
In addition to what you pay for your own medical care, include what you pay for your spouse and anyone you claim as a dependent. If you were divorced during the year but paid medical bills incurred by your spouse while you were married, you can deduct those costs even though you file a separate return. Also count medical expenses you pay for someone who would qualify as your dependent (either individually or under a multiple-support agreement) except that he or she earned more than the personal exemption amount ($3,300 in 2006) or filed a joint return.
If you are divorced, you can include in your deductible medical expenses any qualifying bills you pay for your child, even if he or she is claimed as a dependent by your ex-spouse.
Now, what's deductible?
Qualifying costs include premiums you pay for policies that either pay directly or reimburse you for:
You may also deduct what you pay for Medicare B supplemental insurance and, if you're not covered by Social Security but choose to enroll in the program, your Medicare A premiums as well.
Except for the rule that allows a deduction for the cost of long-term care policies that offer per-diem benefits, you can't deduct premiums you pay for any policy that promises to pay you a set amount – $100 a day, say – for time you're in the hospital, insurance that pays you for lost earnings, or a policy that pays a flat amount for the loss of a limb, for example, or sight. To be deductible, the insurance benefits must be tied to the actual cost of medical care. (On the bright side, benefits you receive under a nondeductible policy are tax-free.)
The cost of getting where you have to go for medical care is deductible, too. While trips to a local doctor won't help much toward the 7.5% threshold (if you drove your own car in2006, for example, you can deduct 18 cents a mile, plus parking and tolls. Out-of-town travel counts, too, and those costs can mount up quickly.
Here's a handful of less-than-obvious situations in which travel expenses have been permitted as medical deductions:
Here's a rundown of some of the other expenses you may be able to include when figuring your medical-expense deduction:
Contributions you make to a Health Savings Account (HSA) — a new tax-saving option first available in 2004 — are not treated as medical expenses. Instead, you can deduct 100% of your qualifying contributions to an HSA, even if you don't itemize deductions. HSAs work something like individual retirement accounts, in that contributions are deductible and earnings accumulate tax free. Withdrawals from the accounts — of both contributions and earnings — are tax free (at any age) if used to pay qualifying medical bills. To qualify for an HSA, you must also have a high-deductible medical insurance policy. (In this case, "deductible" has nothing to do with taxes; it's the amount of medical bills you must pay out of pocket before the insurance kicks in.)
Residents of five states – California, New Jersey, New York, Rhode Island, and Washington – can include in their state tax deduction required contributions to state disability-benefit funds. TaxCut handles these entries in the interview for Form W-2.
If you don't own a home and don't deduct mortgage interest, your state income-tax bill is likely to be your largest single itemized deduction. It's fairly easy to keep track of this deduction. Amounts withheld from your paychecks will show up on your W-2 form; any income tax you pay via estimated payments will be recorded on your copies of estimated tax forms; and if you pay an additional amount when you file your state return, that amount will be on the return.
As with other expenses, you deduct state and local income taxes on the return for the year in which you made the payment, which may be a different year than that for which you owe the tax. Say, for example, that when you completed your 2005 state return in the spring of 2006 you had to pay an additional $500 balance due. Although the tax was assessed against your 2005 income, the fact that you paid it in 2006 means it should be deducted on your 2006 federal return. It won't show up on your W-2 form, but be sure to include it when we ask about additional state tax payments.
If you owe estimated taxes on self-employment or investment income, the state tax bill offers some planning opportunities. In most states, the final estimated tax payment is due in January of the following year. If you make your final 2006 payment in January 2007, it would be deductible on your 2007 federal return. Make that payment by December 31, 2006, however, and you can include the amount in your 2006 deductions. (The payment is considered to have been made in 2006 as long as your check is in the mail by the end of the year, even if it's not cashed until the following year.)
For the deduction of such a payment to withstand IRS scrutiny, it must be a reasonable estimate of the tax you owe for the year involved. You may not, for example, make a huge fourth-quarter estimated payment to beef up your federal deductions if the outlay is actually a deliberate overpayment of your state taxes that you'll soon get back in the form of a state tax refund.
In some cases, it's better not to accelerate the tax payment. If you are not itemizing deductions – because your total expenses won't pass the standard deduction amount – holding off the fourth-quarter payment until January has a double benefit. It lets you hold on to your money a little longer and preserves the possibility that you'll get to write off the payment the next year. Also, if you expect to be in a higher tax bracket the following year, the value of the deduction would escalate. Finally, if you are subject to the alternative minimum tax, don't prepay your taxes. State income taxes aren't deductible at all under the AMT.
In 2004, Congress decided to revive a deduction that had been killed back in the 1980s: The choice to deduct either state local sales or state and local income taxes (You can't deduct them both).
The choice is a no-brainer for taxpayers who live in the seven states with sales taxes but no income tax— Alaska , Florida , Nevada , South Dakota , Texas , Washington and Wyoming . The sales tax deduction is sure to be a money- saver. And, you don’t have to save up all your receipts to benefit. The IRS publishes a table of standard amounts you can deduct, based on your income, your state, and your family size. The table, of course, is built into TaxCut. If you bought certain big ticket items – such as a car, boat or airplane, for example – you can add the actual tax paid on that purchase to the table amount.
Most people who live in a state with an income tax probably paid more in income tax than sales tax, so they’ll be better off claiming the income tax deduction. But, if you bought a big ticket item during 2006, for example, or if your income is exempt from state tax (like social security or most state pensions), then perhaps the sales tax deduction would be better for you.
Check out the standard amount for your sales tax situation and compare it with your state income tax paid for the year. Then, claim the bigger deduction.
As the law stands now, the sales tax option will not be available on 2006 returns. (It was created as a two-year only break covering 2004 and 2005.) But we expect Congress to revive the write-off again.
State and local real estate taxes you pay on your home or other property are deductible.
If you pay your property taxes through an escrow account funded by part of your monthly mortgage payments, you don't actually earn the deduction until funds are transferred out of the account to pay the tax bill. Your lender will probably send you a statement showing how much real estate tax was paid for you during the year – an amount that may differ from the total of the installments you paid into the escrow account during the calendar year. If you don't receive such a statement from the lender, ask for one.
If you are a renter, you may not claim a deduction for the part of your rent you figure goes to cover the landlord's property taxes. Even if a rent increase is specifically tied to a property-tax increase, you don't get a deduction. The law allows a write-off only for the person on whom the tax is directly imposed – your landlord in this case.
What about special municipal assessments imposed on homeowners for widening roads or adding sidewalks or street lights? Such levies generally are not deductible but rather are added to the tax basis of your home. The distinction between deductible real estate taxes and nondeductible assessments is that the tax-favored levies are for the general public welfare and assessments primarily benefit and add to the value of the specific properties involved.
When general revenues pay for such services as trash and garbage pickup, the cost is part of your deductible real estate taxes. However, if your community imposes a separate fee for such services, that charge is nondeductible.
If you buy or sell property during the year, your real estate tax deduction may be more or less than you actually paid the taxing authority. The deduction is allocated between buyer and seller, based on the part of the property-tax year (which may not be the same as the calendar year) each owned the property. The settlement sheet should show the allocation. If you can deduct more or less property tax than you actually paid, the selling price of the house is adjusted – in the eyes of the IRS – to reflect the difference.
State and local personal property taxes are deductible if the tax is imposed annually and based on the value of the property being taxed. Although only a few states and municipalities have a levy that's specifically called a personal property tax, in many states at least part of what you pay annually to register or license your car fits the definition and can be deducted.
The key to deductibility is that the annual license fee be based – at least in part – on the value of your car. Any part of the charge based on the auto's age or weight, for example, isn't deductible. To know whether you can deduct any part of the tag fees you pay, check with local officials.
In the early years of a home mortgage nearly all of every monthly payment you make is interest. That's disappointing from the standpoint that it means you are paying off just tiny bits of loan principal. But it's terrific in terms of tax savings.
See Principal/Interest Breakdown of Home Mortgage Payment below to see a table that shows the breakdown in various years between principal repayment and deductible interest.
The figures here, showing what part of each year's payment goes to reduce the principal on the loan and what part is tax-deductible interest, are based on a $100,000, 30-year fixed loan at 8%. The monthly payment on this loan would be $734.
Year
1
2
3
4
5
10
15
20
25
30
In the first year, $7,970 of your monthly payments – fully 90% – would be deductible as mortgage interest. Even in the 15th year, 71% of your payments would be deductible. In fact, only in the unlikely event that you live in the house for 22 years and still have the original mortgage would the scales tip so that less than half of the total paid during the year would be tax-deductible.
Just what the deductions are worth to you depends, of course, on your tax bracket. If you are in the 25% bracket, every $1,000 of deductible interest and taxes translates to a $250 subsidy from Uncle Sam. In our $100,000 mortgage example, assume that in addition to the $733.76 monthly mortgage payment you also pay $150 a month for local property taxes. During the first 12 months, you pay a total of $10,605 – about $884 a month. Of that total, $9,770 would be deductible — saving you $2,442 (or about $200 a month) if you're in the 25% bracket.
Crank the tax savings into any calculation where you compare the cost of renting to homeownership. The tax savings built into the home-buying equation is why you can afford to make higher mortgage payments than your current rent payments without squeezing your budget. As disgruntled renters often complain, there is no similar tax subsidy for tenants.
Given the favored status of homeownership in America, it's no surprise that the deductions for mortgage interest and local property taxes have survived as other deductions have gone the way of the dodo bird. Yes, there is a limit on mortgage-interest write-offs, but it kicks in only when mortgage debt exceeds $1 million. And the mortgage-interest deduction can be nicked by a restriction that applies to taxpayers whose adjusted gross income exceeds $150,500 in 2006 (half that amount on married-filing-separately returns). Prior to 2006 the law wiped out deductions equal to 3% of the amount by which adjusted gross income (AGI) exceeds the threshold. In 2006, however, the amount by which the deductions are reduced is only 2/3rds of the amount that would otherwise have applied.
It is impossible to say exactly how this will affect any specific taxpayer, since it depends on AGI and the make up of your deductions.
A "point" is a fee – 1% of the loan amount – that the mortgage lender charges up front. Assuming the charge is for the use of the borrowed money – as it clearly is when the number of points charged affects the interest rate on the mortgage – rather than a fee to cover loan-processing costs, the point is considered prepaid interest. And, when the mortgage is used to buy or build your principal residence, the points enjoy a special tax status: You can deduct the amount in full in the year it is paid. Paying three points on a $100,000 loan to buy your home costs $3,000, and it creates a $3,000 deduction that saves you $840 in the 28% tax bracket.
Until recently, this was both a controversial and confusing area. In addition to the requirement that points be paid in connection with a loan for your principal residence, a bunch of other rules had to be followed to earn an immediate deduction: Charging points had to be routine in your area; what you paid had to be in line with what other homebuyers paid; you couldn't use borrowed money or have the seller pay them for you; and on and on. A standard piece of advice, in fact, was that homebuyers write a separate check to pay the points, as proof that the expense wasn't rolled into the mortgage. That was critical because if the payment wound up as part of the mortgage, you were using borrowed money to pay the fee and therefore couldn't deduct the full expense right away. But the separate check is no longer necessary.
Now, things are a lot easier. Officially there's still a list of rules to be followed but in practice only a couple of things matter.
If you put $20,000 down to buy a house, for example, you can actually roll the points into the mortgage amount and still deduct the full amount in the year you buy the house. The IRS will assume that part of the down-payment went to pay the points rather than the money you borrowed.
You'll get a statement from the lender (Form 1098) showing how much you paid in points to buy your home.
A different rule applies if you pay points when you refinance a mortgage. The immediate deduction applies only when the mortgage is for the purchase of your home. When you refinance, you deduct the points over the life of the loan — one 30th a year in the case of a 30-year mortgage, for example. If part of the refinancing goes to a major home improvement, such as the building of an addition or installation of a swimming pool, however, that proportion of the points can be deducted in the year of the refinancing.
A few years back, the IRS performed a major flip-flop and declared that even points paid by a seller on behalf of a buyer can be deducted by the buyer. The basic conditions must be met – primarily that the buyer put enough money into the deal to at least cover the points – but the IRS has decided to recognize the reality of the situation: When a seller pays points, that expense is probably built into the price of the house. So now, the tax agency will treat seller-paid points as though the seller gave the money to the buyer and the buyer paid the points. . .and, therefore, the buyer gets the deduction. The IRS will assume the purchase price of the house is reduced by the amount of seller-paid points and that means the buyer must reduce the basis by that amount.
If your settlement costs include reimbursing the seller for interest or taxes he or she paid in advance for a period you will actually own the house, you may deduct those amounts as though you paid the bills directly. Such adjustments ought to be spelled out on your settlement sheet.
If the seller made such payments and you do not reimburse him at settlement, the amount is considered to be built into the price of the house. In that case, you still write off the prepaid interest and taxes as itemized deductions on your return and reduce your basis in the house by the same amount.
Other closing costs and acquisition expenses are generally not deductible. Instead, many such out-of-pocket costs are added to the purchase price to hike your tax basis.
Since additions to basis don't produce any immediate tax savings, you might be tempted to dismiss them. But that would be a costly mistake. Although new rules make most home-sale profits tax free, you will need to know your home's basis in the future if you ever decide to set up a home office or rent out part or all of the house. You'll have to know the basis to accurately figure depreciation deductions. If you think that's a possibility, keep track of your basis even if it seems certain that you'll never have more than $250,000 of profit on the place—the trigger point for taxes if you file an individual return. You get up to $500,000 of tax-free profit if you file a joint return, assuming you've owned and lived in the house for two of the five years leading up to the sale and it's been at least two years since the last time you claimed tax-free home-sale profit. Note that the basis could also come into play in a property settlement if you and your spouse divorce.
Maintaining detailed records from the beginning is the best way to assure accuracy. It's also a lot easier than trying to reconstruct the basis later on. As you begin the running tab on your adjusted basis, add the following costs to the purchase price:
First, look at the bright side. If your home away from home is only that, a second residence that's never rented out, the tax benefits come with few complications. You can deduct mortgage interest on a second home just as you can on your principal residence.
If you own a third house, however, you're out of luck. Interest on any additional homes – and on any debt on the first and second homes that exceeds the $1 million cap – now falls in the category of nondeductible personal interest. Although there has been talk to the contrary, a motor home or boat can qualify as a second residence for purposes of this deduction.
To meet the IRS definition of a home, the boat or recreational vehicle must have basic living accommodations, including cooking facilities, a place to sleep and a toilet. (However, if you are subject to the alternative minimum tax, interest on a loan for a boat you use as a second home can't be deducted as mortgage interest.) Property taxes are deductible too, regardless of how many homes you own.
However, points paid to get a mortgage on a vacation home are not deductible in the year paid. Rather than being able to write off that expense right away, as you can when a principal residence is involved, the points are deducted proportionally over the life of the loan.
What good is the tax subsidy if you're worrying about coming up with the cash needed each month to make the mortgage payment? Fortunately, you don't have to wait until the following year when you file a tax return to cash in on the savings.
As soon as you purchase your first home or buy a new house that carries higher deductible expenses, you can direct your employer to begin withholding less from your paychecks. If you are self-employed, it's likely you will be able to scale back your quarterly estimated tax payments beginning with the next one due. In either case, your cash flow can increase almost immediately to help cover the mortgage payments.
For a discussion on how to file a revised W-4 form with your employer to trim withholding,select Help/Form Help/IRS Forms/ W-4.
To the extent that you can exchange nondeductible personal borrowing with deductible home-equity borrowing, you can have Uncle Sam help pay the interest on your debts. This makes home-equity lines of credit the debt of choice for millions of homeowners.
These loans offer a line of credit – which you can usually tap simply by writing checks – secured by your home. In addition to preserving the deductibility of interest charged, these loans often carry much lower interest rates than unsecured borrowing.
That makes a home-equity line of credit a powerful tool. Beyond considering this source for your future borrowing needs, you may want to tap a home-equity line to pay off higher-priced debt on credit cards, auto loans and personal notes. Trading $10,000 of 18% nondeductible debt for $10,000 of 5% deductible debt would slice the after-tax carrying costs from $1,800 to $375 a year for a taxpayer in the 25% bracket.
Although the tax law encourages consumers to borrow against their homes, a note of caution is necessary. These loans must be secured by your home. If you find yourself unable to repay, your home is at stake. Don't let the siren song of deductible interest pull you into a loan or line of credit if you don't fully understand the terms.
If you consider a home-equity loan, shop carefully. The cost of setting up the line of credit varies widely and can be stiff. Interest rates and repayment schedules also differ substantially.
When you buy a home, the rules on acquisition indebtedness may encourage you to hold down your down-payment. Remember that the size of your tax-favored debt is based on your original mortgage—not the price of the house. The law can also encourage you to borrow to pay for a home improvement rather than pay cash.
As long as the debt is secured by the home, the amount that pays for the improvement counts as acquisition debt. The tax subsidy of the interest cost could make borrowing cheaper than the amount you'd lose by pulling cash out of an investment to pay for the improvement.
Keep reliable records of your borrowing to back up the deductions you claim. If you use a home-equity line, carefully distinguish between borrowing that pays for major home improvements and loans used for other purposes. The amount that goes for improvements is added to your acquisition debt, rather than eating away at your $100,000 home-equity allowance.
Also, if you use money borrowed on a home-equity line of credit or second mortgage for investment or business purposes, you can choose whether to treat the interest as home-equity interest or deduct it as investment or business interest. If, for example, you opt to count it as investment interest, the borrowing would not reduce your $100,000 home-equity allowance.
If you borrow money to make an investment, the interest on the loan is deductible – in most cases. As usual, the law includes exceptions and limitations to keep you on your toes.
Investment interest is deducted on Schedule A with your other itemized deductions. But in almost all cases you must also file Form 4952. TaxCut will generate the form for you and automatically carry the appropriate deductible amount to your Schedule A. For a complete discussion of the investment interest deduction, please see the Help for Investment Interest.
For 2006, up to $2,500 of qualifying student loan can be deducted. But this is not an itemized deduction. Rather, the student-loan-interest write off is an adjustment to income. That's a good thing. Not only does it mean that the deduction is available to all taxpayers - rather than being limited to those who itemize - but the write off also reduces adjusted gross income, which could benefit you in other ways.
For more information about deducting student loan interest and about education tax benefits, select Help/Tax Tips and Advice/Education Tax Tips.
Click here to read Help about charitable donations.
You might be intrigued by the section of Schedule A, the form on which you list itemized deductions, that asks for miscellaneous expenses NOT subject to the 2% threshold. You can be certain that qualifying expenses are few and far between. These three are the most likely to be of any benefit: