Tax Deduction
A tax deduction is an amount subtracted from an individual’s or entity’s total income, thereby reducing the taxable income for that year. In the United States, the tax code allows certain specific expenses to be legally deducted from gross income, in order to decrease the tax burden on both individuals and businesses. To explore this concept, consider the following deduction definition.
Definition of Deduction
Noun
- Something that may be deducted
- The act of taking away something from the total
Origin
1400-1450 late Middle English deduccioun
What is a Deduction
Deductions are an important part of tax law in the U.S., as they allow both people and businesses to reduce or lower their taxable income, therefore lowering the amount of taxes they owe. Deductions are not a direct reduction of the taxes a person owes, they only lower the amount of taxable income, upon which a percentage is paid in taxes. There are many types of tax deductions that are legal, making the process of claiming all possible deductions a confusing task.
On occasion, people attempt to claim deductions to which they are not legally entitled. In most cases, this is done by mistake, but some people do try to artificially reduce their tax liability by claiming illegal deductions. Deductions are an important part of the American tax process, and they are constantly changing. For this reason, it is a good idea to consult an experienced tax professional or attorney when preparing tax documents.
Standard Deduction
A standard deduction is a set amount that a person who chooses not to itemize their deductions on his tax return. The tax code allows for a standard deduction to be taken, rather than itemizing such expenses as medical bills, premiums paid for medical insurance, mortgage interest, and charitable contributions. Because the method of determining the amount of expenses on the list of legal deductions that may be applied, many people simply claim the standard deduction. In fact, in many cases, the standard deduction is larger than the itemized deductions would add up to, giving another incentive to use it.
The amount of a standard deduction is set each tax year, and is based in the taxpayer’s filing status. For example, a married couple filing a joint tax return receives a larger standard deduction than a single person does. For any given tax year, the tax rates, the amount of standard deductions, and the amount allowed for personal exemptions may be found on the IRS website.
For example, according to the tax laws, the basic standard deduction amounts for 2013-2015 are as follows:
|
Year |
Single | Married Filing Jointly | Married Filing Separately |
Head of Household |
| 2013 | $6,100 | $12,200 | $6,100 | $8,950 |
| 2014 | $6,200 | $12,400 | $6,200 | $9,100 |
| 2015 | $6,300 | $12,600 | $6,300 | $9,250 |
The standard deduction may be higher than the basic standard deduction if any of the following conditions are met:
- The taxpayer is over the age of 65
- The taxpayer’s spouse is over the age of 65
- The taxpayer is legally blind
Itemized Deductions
People who enjoy a comfortable or high level of income are the more likely candidates for itemization. Deductions may be taken only for items on a list of allowable deductions. A formula is applied to determine whether each such deduction taken meets the income and expense requirements, and to apply the actual allowable amount for each one. The total amount of allowable deductions is subtracted from the taxpayer’s adjusted gross income, to determine his taxable income.
What is a Mortgage Interest Deduction
A mortgage interest deduction may be taken by taxpayers who have a mortgage on their home, which is secured by their primary residence. A mortgage interest deduction may only be taken for interest paid on this loan, and only applies to the first $1 million of debt incurred in purchasing, constructing, or repairing the home, or on the first $100,000 of home equity. Home mortgage interest deductions have many limitations, the first of which includes choosing to itemize deductions, rather than take a standard deduction.
What is a Home Office Deduction
If a taxpayer uses part of his home to operate a business, he may be able to take a home office deduction. Like all deductions, the home office deduction has many restrictions, though it is available to homeowners and renters alike, and applies to any type of home. The home office deduction is based on the percentage of space used in the home solely for conducting business, and takes into account utilities, business equipment and supplies, and such necessary expenses as utilities, internet access. While a taxpayer may itemize home office expenses, the IRS now offers a simplified home office deduction.
For example:
Mary Ellen and her husband live in a 2,400 sq. ft. home. Mary Ellen operates a graphic design business, claiming a 12 ft. x 10 ft. bedroom as her office. This home office is exclusively used by Mary Ellen for her business, and contains all of her business equipment and records.
When filing the couple’s federal tax return, Mary Ellen claims her home office using the IRS’ simplified deduction. This is based on the size of her office, which is 120 sq. ft. out of the 2,400 sq. ft. home. Mary Ellen can also claim deductions for her office equipment and furniture, as well as other business expenses, as long as they are not used for personal or family use.
Illegal Tax Deductions
The IRS maintains a list of allowable itemized deductions, though in an attempt to lower the amount of taxes owed, many Americans attempt to deduct expenses that are not allowed. Claiming illegal tax deductions often triggers an audit of the taxpayer’s returns, receipts, and other records, and may result in being fined, or facing other penalties. The most common illegal tax deductions include large gifts, questionable automobile deductions, and personal expenses.
Large Gift Expenses
Sometimes, businesses give clients gifts to help build business relationships. While this is good for business, the entire amount spent for such gifts cannot be claimed as a deduction. As of 2015, only $25 per client can be deducted for gifts. This is true even if the gift is over $1,000. For example, if a company gives $10,000 to clients over the year and claims the full $10,000 on its tax return, it would suggest it had given gifts to 400 clients. This may cause the IRS to become suspicious, and may trigger an audit.
Automobile Expenses
The IRS allows businesses to deduct certain expenses associated with vehicles owned by the company. Such expenses may only be used if they are incurred with “business mileage.” This means that a business owner may not deduct car expenses if the car is also driven on personal business. If good records are kept, it is possible to designate a percentage of the car’s use that is business, and a percentage of its use that is personal. This is similar to taking a home office deduction. Many people do not understand that they can deduct either automobile expenses, OR mileage, but not both.
Personal Expenses
It is common for business owners to deduct personal expenses on their business tax returns. Examples include deducting personal meals out, personal travel, personal computer equipment, furniture, and personal cell phone expenses. While some people get away with a few of these types of deduction, the IRS eventually catches on, and too many deductions of this nature is likely to trigger an audit.
Related Legal Terms and Issues
- Audit – An official inspection of an individual’s or organization’s accounts.
- Taxable Income – The amount of income that determine a person’s or business’s income tax that is due.
