Itemized deduction

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Individual taxpayers in the United States are faced with a choice when preparing their tax returns. Starting with their AGI (adjusted gross income), they can itemize their deductions (from a list of allowable items) and subtract the total from their AGI (and any applicable personal exemptions) to arrive at their taxable income. Alternately, they can elect to subtract the standard deduction for their filing status (and any applicable personal exemptions) to arrive at their taxable income.

The choice between the standard deduction and itemizing involves a number of factors:

• A comparison between the available standard deduction and allowable itemized deductions - the larger number is generally advantageous
• Whether or not the taxpayer has or is willing to maintain the records required to substantiate the itemized deductions
• If the total itemized deductions and the standard deduction are very close in value, whether the taxpayer would prefer to take the standard deduction to reduce the risk of change upon IRS audit. (The standard deduction amount cannot be changed upon audit unless the taxpayer's filing status changes.)
• Whether the taxpayer is otherwise eligible to file a shorter tax form (like the 1040EZ or 1040A) and would prefer not to prepare (or pay to have prepared) the more complicated 1040 form and the associated Schedule A for itemized deductions.

There are a number of allowable deductions:

• Medical expenses, to the extent that the expenses exceed 7.5% of the taxpayer's AGI. (e.g., a taxpayer with an AGI of $20,000 and medical expenses of $5,000 would be eligible to deduct $3500 of their medical expenses ( 20,000 X .075 = 1500; 5000 - 1500 = 3500 ).) The 7.5% floor means that most taxpayers are unable to take advantage of the medical expense deduction. Allowable medical expenses include:
  • Payments to doctors, dentists, surgeons, chiropractors, psychologists, counselors, physical therapists, osteopaths, podiatrists, home health care nurses
  • Premiums for medical insurance (but not if paid by another, or with pre-tax dollars)
  • Premiums for qualifying long-term-care insurance, depending on the taxpayer's age
  • Payments for prescription drugs and insulin
  • Payments for devices needed to treat or compensate for a medical condition (crutches, wheelchairs, prescription eyeglasses, hearing aids)
  • Mileage for travel to and from doctors and medical treatment
  • Necessary travel expenses
  • Non-deductible medical expenses include:
    • Over-the-counter medications
    • Health club memberships (to improve general health & fitness)
    • Cosmetic surgery (except to restore normal appearance after an injury or to treat a genetic deformity)
• State and local taxes paid, including:
  • Income taxes
  • Property taxes (assessed by reference to the value of the property)
  • but not including:
    • Sales taxes
    • Use taxes
    • Excise taxes
    • Fines or penalties
• Mortgage interest on up to two homes, subject to limits (up to $1,000,000 in purchase debt, or $100,000 in home equity loans)
  • also, points paid to discount the interest rate on up to two homes; points paid upon acquisition are immediately deductible, but points paid on a refinance must be amortized (deducted in equal parts over the lifetime of the loan)
• Investment interest, up to the amount of income reported from investments (the balance is deferred until more investment income is declared)
• Charitable contributions to allowable recipients; this deduction is limited to either 30% or 50% of AGI, depending on the characterization of the recipient. Donations can be made as money, or in the form of goods. The value of donated services cannot be deducted as a contribution. Reasonable expenses necessary to provide donated services can, however, be deducted (such as mileage, special uniforms, or meals). Non-cash donations valued at more than $500 require special substantiation on a separate form. Non-cash donations are deductible at the lesser of the donor's cost or the current fair market value. Eligible recipients for charitable contributions include:
  • Churches, synagogues, mosques, other houses of worship
  • IRS-recognized nonprofit corporations
  • Federal, state, or local government entities
  • Fraternal or veterans' organizations
  • Non-eligible recipients include:
    • Individuals
    • Political campaigns or political action committees (PACs)
• Casualty and theft losses, to the extent that they exceed 10% of the taxpayer's AGI (in aggregate), and $100 (per event)
• Miscellaneous expenses related to the production of income or the calculation of taxes, to the extent that they exceed 2% of the taxpayer's AGI, including:
  • Job-related clothing or equipment, such as steel-toed boots, hardhats, uniforms (if they are not suited for social wear; suits and tuxedoes are not deductible, even if the taxpayer does not like to wear them; but nurses' and police uniforms are), tools and equipment required for work
  • Unreimbursed work-related expenses, such as travel or education (so long as the education does not qualify the taxpayer for a new line of work; law school, for example, is not deductible.)
  • Fees paid to tax preparers, or to purchase books or software used to determine and calculate taxes owed
• Gambling losses, but only to the extent of gambling income (e.g., a gambler who wins $1000 and loses $2000 can deduct $1000 of their losses; a gambler who wins $3000 and loses $2000 can deduct $2000 of their losses.)

If the taxpayer's income is above a threshold ($145,950 for single/HH/MFJ in 2005), then the total allowable itemized deductions is reduced according to a formula provided by the IRS.