Standard deductions vs Itemized deductions
A very common tax return related question is one that goes “Can I deduct the cost of (this thing I spent money on)?”.
If your asking from the point of view of a business please review our articles about Self Employment.
Otherwise, the answer usually comes down to whether on your tax return you are Itemizing your deductions or taking the Standard deduction.
Itemized deductions
Let’s start with itemized deductions and a simplified version of how a tax return works: First, a tax return adds up all the money you made in a year from every source. That’s called Adjusted Gross Income. Then, you subtract out all the money you spent in certain categories. The most common categories that you are allowed to deduct (subtract) are:
Mortgage interest
Charitable donations
Medical expenses (Subject to a special limitation, see below)
State and Local Income Taxes (Subject to a special limitation, see below)
Property taxes including real estate taxes on your house, personal property taxes on your car, etc. These must be what are called Ad Valorem taxes, that means the tax is based on the value of the property. That means payments to state or towns for things like water, which is based on usage not property value, are not deductible. (Subject to a special limitation, see below)
NOTE: items 4 and 5 on this list are capped at $10k since the Tax Cuts and Jobs Act. For example, if you paid $12k total in State and Local income taxes, property taxes, etc, you only get a deduction of $10k towards your itemized deductions.
So lets say in a simplified example you made $50 from your ice cream stand and you gave a $10 donation to an animal shelter and paid $10 on your state income tax return. You have an Adjusted Gross Income of $50, you subtract $10+10 itemized deductions, and you arrive at $30. In this scenario you would be taxed on $30 for that year.
Standard deduction
Tracking your itemized deductions and adding them all up every year can be very time consuming. To make things simpler, you can take the standard deduction. This is an amount set each year that any tax payer can deduct from their Adjusted Gross Income instead of taking itemized deductions. Let’s say that the standard deduction in our simplified example was $45. Now you get a choice as a taxpayer:
Itemize vs Standard
Do you want to itemize your deductions and get the following result:
$50-itemized deductions of $20= $30 taxable income
Or, do you want to take the standard deduction and get the following result:
$50-standard deduction of $45= $5 taxable income
Standard deduction is better right? The takeaway is that you itemize deductions only if your itemized deductions are higher than the standard deduction that year.
The standard deduction for 2020 is $24,800 for taxpayers with the filing status Married Filing Jointly
The standard deduction for 2020 is $12,400 for taxpayers with the filing status Single or Married Filing Separately
The standard deduction for 2020 is $18,650 for Heads of Households. (This is a filing status for unmarried individuals with a dependent.)
Add up in your head rough estimates of what you paid during the year for the itemized deductions listed above. If they are higher than the standard deduction you qualify for, itemize. If they are lower, stop and take the standard deduction.
State and Local Taxes limitation (SALT taxes)
Since the passage of the Tax Cuts and Jobs act the itemized deduction for State and Local Taxes is capped at $10k. That means if you add up your state income tax, real estate taxes, property taxes and they come out to $15k, you still only get a $10k itemized deduction.
Medical deductions limitation
Medical deductions have a special limitation, they are capped at the amount by which the medical deductions exceed 7.5% of your adjusted gross income. Lets look at a full example to understand this limitation.
Say you have the following tax attributes:
Filing status: Single
AGI $100,000
Medical expenses $10,000
$6,000 in mortgage interest paid
Standard deduction $12,400
Lets find out if you should itemize your deductions. First you need to find out what 7.5% of your AGI is. $100k * 7.5% = $7,500. The amount by which your medical deductions exceed this number is the amount that counts towards your itemized deductions so that’s $10k-$7.5k=$2,500.
So your itemized deductions are $6,000 in mortgage interest and $2,500 in deductible medical expenses, a total of $8,500. Standard deduction is $12,400, so you should take the standard deduction.