As you go through life, you'll often hear references to things being "tax deductible." All kinds of different things are. Understanding what is tax deductible could save you hundreds or even thousands of dollars each year.
Being tax deductible means that you can deduct the expense (a charitable gift, your mortgage interest, business expenses, etc.) from your income on your tax return. If you give $100 to charity, that will not reduce your taxes by $100. It will reduce your taxable income by $100. If your marginal tax rate is 28 percent then you would save $28 on your taxes by donating $100 - under certain circumstances. Many Americans have an effective tax rate of zero so a tax deduction is of no value.
Consider the following examples to illustrate how tax deductions work.
Charitable Contributions
: A donation to charity is deductible (subject to some limitations that rarely apply) so long as your total deductions for medical care, mortgage interest, and charitable contributions (along with a few other categories) total more than the standard deduction ($12,750 for 2011 for most married couples filing jointly). In other words, if your total mortgage interest, charitable donations and other eligible expenses total less than $12,750 for most couples, there is no benefit to having tax deductible expenses.
Mortgage Interest
: Mortgage interest on your primary residence works just like charitable contributions to offset income if the sum of eligible deductions exceeds the standard deduction. Interest on a second home is generally not deductible. Mortgage interest on investment property is deductible on another form; it isn't impacted by the standard deduction threshold.
Medical Expenses
: Medical expenses are only deductible to the extent that they are more than 7.5% of your income; you can only deduct the portion that exceeds 7.5%. They, together with charitable contributions and mortgage interest must exceed the standard deduction in order to be deductible.
Business Expenses
: If you have a small business you may deduct customary business expenses on your tax return. If you run a day care center in your home, for instance, you may be able to deduct food and other supplies used by the children in your care against the income you generate with the business. Under some circumstances, you can deduct depreciation on the space in your home devoted exclusively to the business. If the business loses money, you may be able to offset other income with the business losses (this won't work if the IRS thinks your business is a hobby).
Understanding these basic concepts won't make it easy for you to file your own tax return - especially if you have a business. Knowing how tax deductions work, however, may help you to make better spending decisions during the year. If you are in a situation where you can deduct your charitable contributions, for instance, you now understand that charitable contributions are effectively cheaper for you because of the tax savings.
Before you file your tax return, seek help from an experienced CPA.
