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Common Tax Myths Part 2: Deductions
Added on 6/09/06
We will continue our discussion of some common tax myths and misunderstandings by looking at tax deductions. Tax professionals usually get asked a lot of questions about tax deductions. This is understandable because deductions reduce taxable income and therefore reduce income tax. A big part of the problem in this area is that, although deductions sounds like it should be simple, it can get rather complicated. We will try to cut through some of the confusion in this article.
The first problem we encounter is that there are different types of deductions that can be taken on a tax return. Two broad categories are business deductions and personal deductions. Business deductions are a separate category and could require several articles to cover properly. In this article we will focus on some of the more common personal or itemized deductions. These deductions are claimed on Schedule A and include mortgage interest, certain taxes, medical expenses and contributions. We will look at three areas in this article, medical expenses, home improvements and contributions.
Myth #1: All medical expenses are fully deductible on a tax return.
Part of this statement is based on a fact. Medical expenses are one of the allowed itemized deductions. The problem stems from the limitations that are placed on the medical expense deduction. The first limit to consider is that you can only deduct medical expenses that exceed 7.5% of a taxpayer’s adjusted gross income. This limit prevents many taxpayers from using the medical expense itemized deduction. For example if your adjusted gross income is $50,000 your allowable medical expenses would have to exceed $3,750 to claim any deduction on your return.
A second area of confusion involves what can be included in medical expenses. IRS Publication 17 defines medical expenses as “The cost of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. Medical expenses do include dental expenses. You cannot include any expenses that are merely beneficial to general health. For example you can include the cost of prescription medications, but you cannot include the cost of vitamins.
A taxpayer can include what they pay for health insurance as medical expenses. You cannot include any amount paid pre tax for the insurance. If your employer deducts health insurance premiums and does not include the amount on your W-2 than they are pre tax payments and not deductible as a medical expense. You can include the amounts paid for long term care insurance, but this is subject to additional limitations.
Myth #2: I can give someone a gift of $10,000 and deduct it on my return.
This statement comes from misunderstanding and combining the rules for two different taxes. The gift tax rules have an annual exclusion amount. The rules state that if you give a gift that is under the annual exclusion amount, currently $12,000, no gift tax return is required. The income tax rules do allow a deduction for contributions to qualified organizations. However, a gift to an individual, even a needy individual, is not a deductible contribution.
Myth #3: I can deduct the cost of improvements to my home.
This common belief was indirectly addressed in an earlier article on the tax effects of buying or selling a home. We will address it here in a bit more depth. As a general rule improvements to you residence are not an itemized deduction. If you use a part of your home for business a portion of the cost of improvements may be deducted as a business expense. Also if the improvements are required due to a medical condition all of part of the cost may qualify as a medical expense. Beginning in 2006 certain energy saving improvements can qualify for the new energy credits. Please see the previous article on the energy credits for additional information.
A final note on itemized deductions is that they are used instead of the standard deduction not in addition to the standard deduction. Therefore if your allowable itemized deductions are less than the standard deduction, it is not an advantage to claim itemized deductions.
We hope that this discussion has helped clear up some common misunderstandings about tax deductions. As always this information is a general guideline and you should ask you tax professional about your particular situation.
Reference: Common Tax Myths Part 1 - 4/25/06