Tax Tip: Tax Deductions Are Not Always Helpful – Itemized Deductions vs. Standard Deduction
Many people consider the tax benefits of owning a house when deciding if they can afford to buy. They consider the mortgage interest expense as a full deduction, but it might not be that simple. When determining your taxable income you are allowed to take deductions against your adjusted gross income. These deductions are either itemized on Schedule A or the standard deduction is used. Basically, Schedule A lists categories of deductions that you can use to lower your taxable income. For some people this is very beneficial because it includes things such as state taxes, mortgage interest, and charitable contributions. However, for many people, especially non-home owners, this may not be a substantial amount. As an alternative, the IRS allows taxpayers to take a defined amount in lieu of completing Schedule A – this is the standard deduction. Therefore, taxpayers have to determine if it is more beneficial to itemize deductions on Schedule A or to simply take the IRS’s standard allowance.
It is a very important distinction to understand whether your tax return is itemizing deductions or using Schedule A. This is because many times there are people who will try to convince you of the tax benefits of doing things such as donating to charity or owning a house. However, these benefits may only reach their full potential if you are itemizing deductions. If you are taking the standard deduction it could be much different. First, it is very possible this added deduction still will not make Schedule A more beneficial than the standard deduction. On the other hand, when performing your analysis of the added deduction even if it makes Schedule A more beneficial than the standard deduction, you can only consider the benefit in the incremental deduction amount of Schedule A over your standard deduction.
For example, the standard deduction for a married couple in 2012 is $11,900. If the couple had no Schedule A deductions it would clearly be better to use the standard deduction. Now, if a charity contacts the taxpayer and asks for a $5,000 donation touting the tax benefits, the taxpayer has to understand this will have no effect on the tax return – the $11,900 standard deduction is still better than the $5,000 itemized deduction on Schedule A. As mentioned above, even if the deduction exceeds the standard deduction you can only consider the incremental increase. Suppose a real estate agent is trying to convince a married couple to purchase a home and advising them of the tax benefit of the $1,000/month of mortgage interest. Over a year, this would result in a $12,000 deduction on Schedule A. If the couple doesn’t have any other Schedule A deductions they would only have $100 more of deduction than taking the standard deduction. In the end, this means that the mortgage interest expense would have very little benefit on the tax return. However, if the couple did decide to purchase the home so they were now itemizing deductions for $12,000/year, any additional items for Schedule A would have a direct benefit, even a $500 charitable contribution would now lower taxable income by the full $500 because the taxpayer is no longer using the standard deduction.
Overall, tax planning is not always as simple as deciding if something is a deduction or not. Every taxpayer’s situation is unique and contains different scenarios that can determine how beneficial a certain tax advantage will actually be when the tax return is filed. If you have questions about tax planning or deductions contact us at Hone Maxwell LLP today. Also, you can follow us on twitter @HMLLPTax or facebook at www.facebook.com/HoneMaxwellLLP for more tax tips and the latest updates on tax news.