A tax deduction or a tax-deductible expense represents an expense incurred by a taxpayer that is subtracted from
gross income and results in a lower overall taxable
income.
In everyday terms, this means that tax-deductibility increases a person's purchasing power (if the person is paying taxes), by
"adding money" to the purchase that would have otherwise gone to taxes.
As a simplified example, if we assume someone has a flat tax rate of 33% and is paying taxes, they can buy something for $600
that is not tax-deductible, or something for $900 that is, and have just as much money left over. This is because the $600
represents the same $900 in earnings, but after taxes have been paid on it. However, the simplification (a flat rate of 33%
taxes) does not describe the U.S. tax system in most circumstances.
Instead, the United States income tax system is progressive; as taxable income rises, a higher percentage is charged on a
tiered system. E.g., in 2006 for Single taxpayers, the first $7,550 of taxable income is charged 10 percent; however, if a person
has more than $7,550 in taxable income, then he or she must pay a flat $755 (10 percent of the first $7,550), plus 15% of the
amount over 7,550. The next progressive tier is reached at $30,650; the percentage that is charged goes up again (to 25%) for
taxable incomes above $30,650.[1]
A tax credit is generally more valuable than an equivalent tax deduction because a tax
credit reduces tax dollar-for-dollar, while a deduction only removes a percentage of the tax that is owed. Because tax deductions
reduce taxable income, and taxes owed are a percentage of taxable income, then tax deductions offer a fractional reduction in
taxes owed. Tax credits, on the other hand, come directly out of the taxes owed, saving the taxpayer one dollar for each dollar
of credit.
As an example, if a person's highest portion of taxable income is taxed at 25% (progressive scale from 10 to 35 percent), then
a $1,000 charitable contribution will result in a reduced tax bill of $250 (25%
of the contribution). E.g., if a taxpayer would otherwise have owed the federal government $3,250 in income taxes; the new tax
bill would be $3,000. As a second example, if a person was charged an early withdrawal penalty of $1000 for breaking a banking
certificate of deposit (CD) before maturity, and that person's highest taxable income was in the 35% bracket, then the deduction
would reduce the overall tax bill by $350.
United States
In the United States there are many different types of deductions. One may choose
between a standard deduction or itemized deductions.
Some deductions are aimed at individuals; many are directed to businesses. The complicated maze of tax deductions that
Congress has instituted over the past 70 years has contributed to the view that the tax code in the United States needs to be
completely redone in a simpler fashion. [citation needed]
Opponents of the current tax code favor reducing or eliminating many existing tax deductions, particularly for corporations
that have come to rely on the code as a welfare crutch. Reformers contend that the government should encourage spending on things
like charities, home ownership, and education through means other than tax deductions. [citation needed]
Common examples of tax deductions for individuals follow. Each of these deductions may or may not be appropriate, given a
taxpayer's filing status, income, and so forth, and may have separately calculated limits (dollars or percent of expense or
percent of AGI, etc), or be carried from one year to the next.
- An exemption amount for the taxpayer, the
spouse, each child, and any other qualified dependents, and certain disabilities;
- Mortgage interest paid on one's primary
residence or other residence[1];
- Qualified mortgage insurance premiums that are treated as qualified residence interest expense, for certain home loans, for
mortgage insurance contracts issued on or after January 1, 2007[2]
- Equity loan or Line of Credit interest;
- Charitable contributions to eligible entities[3];
- Business deductions, such as mileage, related to an individual's
expenses regarding their employment[4];
- Business startup and operation, and farming expenses (including travel, meals, and the so-called three-martini lunch), not to exceed business income;
- Removal of architectural barriers to the disabled and
elderly;
- Union and professional dues;
- Medical expenses above a certain percentage of the individual's Adjusted Gross
Income (AGI);
- The cost of tax advice, software, and books;
- Depreciation of business assets;
- Work uniforms and clothing, including such items as safety goggles or steel-toed shoes;
- Moving expenses, in some cases;
- Job search expenses as one searches for work in the same industry;
- Casualty (fire, theft) losses not covered by casualty insurance;
- Educational expense (but only if it does not prepare one for a new career);
- The oil-depletion allowance or similar for depletion of timber and other natural resources, and reforestation expenses;
- State and local taxes (i.e., income tax or property tax or use taxes);) in 2004 and 2005, one could choose between
deducting State Sales Tax or alternatively deducting State Income Tax. This deduction was extended for two additional years in
December of 2006. [2]
- Capital losses (to a limit), such as from the sale of stock that has lost value, that exceed an individual taxpayer's
capital gains in that year;
- Gambling losses (but not in excess of gambling winnings).
Many tax deductions allowed by federal law are also allowed under the tax laws of various states. Each state government may
allow additional types of expenditures to be tax-deductible, such as rent in lieu of mortgage.
[citation needed]
Tax deductions start to "phase out" for married individuals, filing jointly, with an income of about $145,000 or higher
(2005); beyond that point, the full amount of the expenses cannot be deducted.
Australia
While broadly similar, tax deductibility in Australia differs from the United States in a number of key areas:
- There are no State and Local income taxes, although the States administer a Pay-roll Tax regime
- Personal and Corporate taxation regimes are significantly different
- There is a tax free threshold (income up to this level is not taxed)
- Income tax is charged at a higher rate for those on very large incomes
- There is a small allowance (tax offset) for a dependent spouse - children may be covered by social security type payments
known as Family Tax Benefits
- Loan interest payments on a primary residence (where one actually lives) is not deductible
- Loan interest payments and other expenses on investment properties are generally deductible
- Business lunches (and similar meal entertainment-type expenses) are only deductible when Fringe
Benefits Tax is incurred
- Travel to/from work is generally not deductible, although there are some exceptions
- Job search expenses are not deductible
- In general terms, expenses incurred directly in pursuit of future profits from personal investment/business activity are tax
deductible. This includes interest payments on a loan to buy shares, for example.
United Kingdom
In the UK, Her Majesty's Revenue
and Customs allow certain expenses to be deductible as necessary to complete the work from which the income was
derived.
Examples of allowable expenses include:
- Professional Subscriptions
- Mileage or other expenses incurred as part of the work
- A proportion of home expenses where part of the home is used for work purposes (e.g. a self-employed person who works on a
computer in the spare bedroom)
Notes
See also
References
- 26 US Code §§ 161 to 198 (Part VI Itemized Deductions)
External links
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