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Individual Deductions: Types, Eligibility, and Calculations

Learn about the common deductions necessary for calculating adjusted gross income (AGI) and the different types of itemized deductions available to individuals. Understand how the standard deduction works, determine deductions for personal and dependency exemptions, and compute taxable income.

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Individual Deductions: Types, Eligibility, and Calculations

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  1. Chapter 06 Individual Deductions

  2. Learning objectives • Identify the common deductions necessary for calculating adjusted gross income (AGI) • Describe the different types of itemized deductions available to individuals and compute itemized deductions • Explain the operation of the standard deduction, determine the deduction for personal and dependency exemptions, and compute taxable income

  3. Deductions for AGI • Three categories of deductions for AGI • Directly related to business activities • Indirectly related to business activities • Deductions subsidizing specific activities

  4. Deductions for AGI • Directly Related to Business Activities • Taxpayers are allowed to deduct expenses incurred to generate business income • For tax purposes activities are either profit-motivated or motivated by personal objectives • Profit-motivated activities are classified as • business activities (called “trade or business”) or • investment activities

  5. Deductions for AGI • Although both are motivated primarily by profit, business activities are distinguished from investment activities: • Trade or Business activities require a relatively high involvement or effort from the taxpayer where as investment activities don’t require • Investment activities involve investing in property for appreciation or for income payments

  6. Deductions for AGI • Trade or Business Expenses must be: • directly connected to the business activity • ordinary and necessary for the activity (e.g., appropriate and helpful for generating a profit) • reasonable in amount (not extravagant) • Expenses are claimed on Schedule C • Revenues from the same activity are also reported on the same Schedule C • The net income or loss from Schedule C is transferred to Form 1040 (page 1) on line 12

  7. Deductions for AGI • Rental & Royalty Expenses • Claimed above the line (for AGI) • Could either be an investment activity or a trade activity depending on facts • Taxpayers report expenses and revenue on Schedule E and transfer the net income or loss from Schedule E to Form 1040 (page 1), line 17 • Flow-through Entities • Expenses and losses incurred by a flow-through entity pass through to the entity owners who typically report these amounts on Schedule E and Line 17

  8. Deductions for AGI • Losses • Taxpayers disposing of trade or business assets at a loss are allowed to deduct the loss for AGI • Losses from investment assets (called capital assets) are offset against capital gains • If capital losses exceed capital gains, this is called a net capital loss • A net capital loss is deducted for AGI but limited to $3,000. Losses in excess of the $3,000 limit are carried forward indefinitely to subsequent years

  9. Deductions for AGI • Deductions indirectly Related to Business Activities • The cost of moving personal possessions is not a direct cost of doing business or being employed • Moving Expenses are deductible for AGI if the move meets two tests • A distance test • A business test associated with a move

  10. Deductions for AGI • Distance test – the new job site must extend existing commute by 50 miles • A new job site is required, but a new employer is not essential • Business test - Taxpayer must be employed at least 39 of 52 weeks or be self-employed for 78 of the 104 weeks following the move • Taxpayers are allowed to deduct a mileage rate in lieu of the actual costs of driving their personal automobiles during the move (19 cents per mile in 2011)

  11. Deductions for AGI • Health Insurance deduction by Self-Employed Taxpayers • Deduction provides equity with employees who receive health insurance as a qualified fringe benefit • Insurance must be provided for taxpayer or dependents who are not eligible for employer-provided health insurance • Penalty for early withdrawals of savings • Reduces the taxpayer’s net interest income to the amount actually received

  12. Deductions for AGI • SE Tax Deduction • Employer and employees each pay one-half of employee’s Social Security tax • Employers deduct the portion of Social Security taxes they pay for employees • Self-employed individuals are required to pay SE tax in lieu of Social Security tax • Self-employed tax payers are allowed to deduct one-half of the SE tax they pay to compensate for employers deducting their portion of Social Security

  13. Deductions for AGI • Alimony payments are deductible for AGI to maintain equity • Contributions to a qualified retirement account are deductible for AGI to encourage savings • Interest expense on qualified educational loans • Qualified educational expenses

  14. Deductions for AGI • Deduction for Interest expense on loans used to fund qualified educational expenses • Up to $2,500 of interest on education loans is deductible for AGI • The interest deduction is phased-out for taxpayers with AGI exceeding $60,000 ($120,000 filing joint) • The deduction is eliminated for taxpayers with AGI exceeding $75,000 ($150,000 filing joint)

  15. Deductions from AGI: Itemized Deductions • Medical Expenses • Taxpayers may deduct medical expenses incurred to treat themselves, their spouse, and their dependents • Qualifying medical expenses include unreimbursed payments for care, prevention, diagnosis or cure of injury, disease, or bodily function • Taxpayers using personal automobiles for medical transportation purposes may deduct a standard mileage allowance (19 cents per mile in 2011) in lieu of actual costs

  16. Deductions from AGI: Itemized Deductions • Hospitals and Long-term Care Facilities • Taxpayers may deduct the costs of actual medical care whether the care is provided at hospitals or other long-term care facilities • Medical Expenses Deduction Limitation • It is limited to the amount of unreimbursed qualifying medical expenses paid during the year which is reduced by 7.5% of the taxpayers AGI

  17. Deductions from AGI: Itemized Deductions • Taxes • Individuals may deduct itemized deductions payments for following taxes • State, local, and foreign income taxes • Real estate taxes on property held for personal or investment purposes • Personal property taxes that are assessed on the value of the specific property • Sales Tax deduction • State and local sales taxes can be deducted in lieu of state and local income taxes

  18. Deductions from AGI: Itemized Deductions • Interest • Two itemized deductions for interest expense: • Deduction of investment interest is limited to a taxpayer’s net investment income • Any investment interest in excess of the net investment income limitation carries forward to the subsequent year • Home mortgage interest • Interest on acquisition indebtedness of $1million • Interest on home equity debt of $100K

  19. Deductions from AGI: Itemized Deductions • Charitable Contributions • Contribution of money or property must be made to a qualified charity • Special rules apply to charitable contributions of property depending on the type of property: • Capital gain property • Ordinary income property

  20. Deductions from AGI: Itemized Deductions • Casualty and theft losses on personal-use assets • The amount of the tax loss from any specific casualty event (including theft) is the lesser of • decline in value of the property caused by the casualty or • taxpayer’s tax basis in the damaged or stolen asset

  21. Deductions from AGI: Itemized Deductions • Casualty Loss Deduction Floor Limitations • It must exceed two separate floor limitations to qualify as itemized deductions • $100 for each casualty during the year • 10 percent of AGI floor limit applied to the sum of all casualty losses for the year (after applying the $100 floor) • In other words, the itemized deduction is the aggregate amount of casualty losses that exceeds 10 percent of AGI

  22. Deductions from AGI: Itemized Deductions • Miscellaneous Itemized Deductions Subject to AGI Floor • Employee Business Expenses • Travel and transportation • Employee expense reimbursements • Investment Expenses • Tax Preparation Fees • Hobby losses • Total miscellaneous itemized deductions are subject to a 2 percent of AGI floor limit

  23. Itemized Deductions and the Standard Deduction • Miscellaneous Itemized Deductions Not Subject to AGI Floor • Individuals include all gambling winnings for the year in gross income and deduct gambling losses to the extent of gambling winnings for the year • Standard Deductions • Taxpayers generally deduct the greater of their standard deduction or their itemized deductions

  24. Standard Deductions & Exemptions • Bunching Itemized Deductions • Tax benefit can be gained by implementing simple timing tax-planning strategy • Taxpayers with itemized deductions that fall just short of the standard deduction amount • These itemized deductions do not produce any tax benefit • Rather than deduct the standard deduction every year time deductions (when possible) to bunch together in one year

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