Business Owner Basics: Itemized DeductionsTax Planning
If you are like the business owners that I work for every day, the thought of reading a blog about itemized deductions may have you rolling your eyes and saying “no thank you, I have to get back to work!”
I totally understand, most accountants are not that thrilled with the idea of reading about tax concepts either.
But you should know something about itemized deductions. The decisions you make in your personal life are of huge importance when it comes to tax returns, and how else will you know how to make the right choices if you are unfamiliar with any of it.
Also remember, if you don’t have enough in itemized deductions, you will use the standard deduction. That means you get the full amount regardless of what you spent. For 2016, here are the standard deductions: $6,300(singles), $12,600(married joint), $9,300(head of household).
I am going to walk you briefly through each piece of the itemized deductions schedule, and show you what you need to know to make the right decision. Here we go…
The 7 Sections of The Schedule A
The Schedule A is the form we use to report all of these deductions. The 7 main areas of the Schedule A are:
1) Medical and Dental Expense
2) Taxes You Paid
3) Interest Paid
4) Gifts to Charity
5) Casualty and Theft Losses
6) Job Expenses and Misc. Deductions
7) Other Misc. Deductions
To keep things brief, 2 sections I am going to skip for the most part other than to say this about them:
Casualty and Theft Losses- Just know that if you have something stolen or destroyed by an outside event, you need to research if you can claim a loss. House burns down, car stolen, etc.
Other Misc. Deductions- Gambling losses, estate taxes, bond premiums, and a few other things. These are deductions for things that are not all that ordinary so research them if you need to.
Medical and Dental Expense
This one is a real bait-and-switch. Most people know that medical and dental expenses are deductible.
What they don’t know is that most of the time, taxpayers don’t qualify.
During tax season I have client after client pull together all kinds of paperwork, prescription bills, co pays, etc. It can often be two-thirds of the paperwork that a taxpayer has for taxes.
And in most cases, it is a huge waste of time.
For anyone born after 1950, when you add up all of your medical expenses, that total must exceed 10% of your total income (actually the rule is 10% of your AGI but think of that for the most part as your income).
So if you earn $100K a year, you need to have at least $10K of medical expense to get above the “AGI floor”. And remember, if you had $10K of expenses, you still get no benefit.
In a situation where you earn $100K and had $15K of medical expenses, then you get to use the amount that is above that 10% number. In this case $5K. See what I mean, even if you have a ton of medical, you don’t get to use that much of it.
Let’s take it further. What if you have $15K of medical, so you can use $5K as a deduction, but you have no other deductions that go on the Schedule A (like mortgage, charity, etc.). Then your $5K is less than your standard deduction, and again… worthless.
That is why I say it is a bait-and-switch. The system has led you to believe you can deduct medical, but in most cases you cannot.
My advice: Use a vehicle where you can get a deduction like a Health Savings Account. That way you are guaranteed to see a benefit. They are easy to setup and much better to use. You need to have a high deductible plan and meet some other criteria, but it is worth a look if you have medical costs.
Taxes You Paid
It makes sense to get a deduction for the taxes you pay. Keep in mind, you don’t get a deduction for federal taxes, but rather for taxes paid to states and municipalities. Some common taxes that qualify are:
· State income taxes
· City income taxes
· Sales taxes
· Real estate taxes
· Personal property taxes
For those of you who live in states that do not have income tax, you really want to pay attention to the amount of sales tax you pay in a year. It can add up, and the safe harbor amounts can be much less than what you actually spend.
My advice: Keep track of your sales tax spent
Also, something that is nice about the deduction for these taxes, it is not limited by any AGI floors, etc. (the total of itemized deductions can be limited based on income, but not this category specifically)
So if I had a choice between paying more in real estate tax vs. paying more money in mortgage interest (which does have limitations, we will discuss later) then I would pick the real estate tax, because I will likely get full benefit from that.
My advice: Purchase price of the home is not the only consideration when buying real estate.
Make sure you are keeping good records of the personal property tax you pay at the DMV or other places.
Use tax is another good one, if you purchase large items online, the state may ask you to pay use tax on them (state of FL got me on this for a BBQ smoker I bought last year). That tax is deductible if you are using the sales tax option.
Mortgage Interest & Investment Interest
Nothing is more important to the itemized deduction game in my opinion than mortgage interest. Usually it is the difference between using the standard deduction or itemizing.
Not only is mortgage interest deductible, but so is mortgage insurance, so make sure you know what your mortgage has so you can take full advantage.
If you are like any of my clients, you will eventually ask yourself if you should pay off your mortgage. This deduction is a massive part of that calculation. Here is how I break the question down:
Let’s say you own a home and your mortgage is $300K. And you pay 4.5% interest on it a year.
Let’s also assume you make $180K per year, so your top marginal tax rate is 28%.
In 2016 you will pay interest of $13,500. Because you are able to deduct this interest, you save $3,780 on your taxes for 2016. So really, the interest is costing you $9,720 ($13,500 - $3,780).
Now, we should compare that cost to what that $300K could make you if you invested it rather than paying off your mortgage. With interest rates so low right now, a CD will only make you 1-2% or $3K-6K per year. And that interest is taxable so really only makes you $2K-4K per year.
In this case, it is better to pay off the mortgage, you will save more than you can make. However, if you invest it in say preferred stock or other more lucrative investments, that make 6.5%, then the earnings will be $19,500 and after you pay tax on that income, you still take home $14,040.
In that case, investing is better than paying off the mortgage.
Another point about mortgages, especially if you earn more than $300K, is you need to have ENOUGH mortgage. A general rule I have is you should have a mortgage that is at least about 2.5x your annual salary.
So if your family makes $100K a year, you should have at least $250K in mortgage debt. If you are working, you need the deduction. However, if you are saving more than 25% of your earnings each year, after 5 years I sometimes change that advice because you may want to evaluate the mortgage payoff vs. investment calculation above.
My advice: Remember mortgage interest can be your tax friend, don’t be afraid to have some more.
Investment interest is another type you can deduct. If you borrow money to purchase securities or other investment property, that could be deductible. Take a look at Form 4952 for more information.
Gifts to Charity
I am sure many of you know that gifts to charity are deductible. Something fewer people know is you can also contribute appreciated stock to charities and avoid the capital gains on the stock and still get the full benefit of the FMV of the donation.
But I want to use this space for a concept I need to tell those who DO NOT itemize…
If you do not itemize, you are not getting any benefit from gift to charity on your tax return.
I realize that is not the only reason we give to charity, nor am I saying you should stop. What I am asking is that perhaps you group 3 years’ worth of gifts into 1 year, so that maybe you can receive benefits of giving.
I am a huge proponent of making charity an adjustment on the 1040 rather than an itemized deduction (that would mean everyone benefits on their return, not just itemizers) but until that rule changes, please think about how you can make the code work for you.
Also, most of my clients are big fans of the “non-cash charitable contribution” and for good reason, you should take advantage. But just remember, you too are not getting any benefit if you do not itemize, so group these deductions into 3 year periods or some other method that allows you to benefit from the contribution.
My advice: Contribute to charity, but use timing or other methods to make sure you get a deduction benefit.
Job Expenses and Miscellaneous Deductions
They call them Unreimbursed Employee Expenses; I call them the last real honey-hole of the personal tax return. For those who do not own a business, the UEE (reported on Form 2106) provides a wide open place to put business related costs that your employer does not reimburse you for.
Here you can deduct any ordinary and necessary job expenses you paid for but were not reimbursed. And if they gross your wages up for this, that does not count, you can still deduct your expenses.
Some common examples of these expenses are:
· Car Usage
· Safety Equipment
· Dues to professional organizations
Also in this section of the Schedule A are some of the Miscellaneous Deductions. These are:
· Tax preparation fees- What you spent on professional tax prep.
· Investment expenses- if you pay an investment manager to direct your portfolio, deduct that here.
· Safe deposit box cost- Kind of self-explanatory right?
· Other income producing costs- Legal, accounting, clerical, office rent, etc. But don’t use this line really for these things, if you are running some kind of business, go use the Schedule C or setup a formal corporation if the amounts are large.
The main thing to remember with all of these deductions, is they are subject to a 2% AGI floor. Meaning a similar calculation to the medical calculation must be done to see what you can really deduct. Only this time it is 2% of AGI you have to get over vs. 10% in the medical category.
My advice: If you are a W-2 wage earner and you have big travel or equipment costs that are not reimbursed, deduct them.
So that is a walk in the park with itemized deductions. Hopefully it will help you make the right tax decision when faced with some of these situations. If you need more information, here are some links that will help: