Paying taxes is a social contract that everyone enters as members of society. Taxes paid to various tax authorities like federal, state, and local governments are used to provide social services, such as education and health care. A person pays taxes just by being a consumer through sales tax and property taxes.
Your federal tax liability is the total amount of taxes you owe to the Internal Revenue Service (IRS). For individuals classified as employees, this can easily be determined by consulting the tax table for the specified year. However, for a business owner or a self-employed person, the process can be more complex.
In this article, we’ll discuss the difference between standard and itemized deductions. We’ll also explore itemized deductions as a way to reduce your tax liability as a small business owner.
What Are Itemized Deductions?
Businesses and individuals can claim deductions, exemptions, and tax credits to lower their federal income tax obligation. Deductions are expenses you incur during a tax year that you can use to decrease your taxable income. For this, you have a choice between applying the standard deduction or itemizing your deductions.
The standard deduction is a preset amount modified every year to account for inflation. On the other hand, an itemized deduction is what you spent on products, services, or contributions that the IRS deemed eligible. You can find the list of itemized deductions on Schedule A of Form 1040. These expenses can be subtracted from your adjusted gross income (AGI) to lower your tax obligation.
Itemized deductions include expenditures such as mortgage interest, charitable donations or contributions, and unreimbursed medical fees. Some allowable deductions may be subject to limits. However, it may still be worth exploring, especially if you are in the higher income tax bracket with considerable items to deduct.
The Benefits of Itemized Deductions
Personal exemptions were eliminated when the Tax Cuts and Jobs Act (TCJA), or tax reform, was enacted in 2017. This change framed deductions as the primary way for individuals to decrease their taxable income. The decision to apply the standard deduction or itemized deductions also became an important consideration for taxpayers.
Some benefits of itemized deductions include:
- Itemized deductions could equal more than the standard deduction amount.
- You can qualify for a number of possible deductions.
- You can potentially save money on taxes by itemizing your deductions.
Itemized Deductions Could Equal More Than the Standard Deduction Amount
Itemizing your deductions can potentially decrease your household’s tax bill. Depending on your expenses, your deductions could result in a much higher amount than the standard deduction. Track your expenses, and make sure you include all eligible spending when itemizing.
You Can Qualify for a Number of Possible Deductions
You can lower your tax debt if you incurred expenses in allowable deductions, such as medical fees, property taxes, mortgage interest, and more. No matter your tax bracket, these tax deductions lower your taxable income.
You Can potentially Save Money on Taxes by Itemizing Your Deductions
Aside from lowering an individual’s tax obligations, itemized deductions also work as an economic incentive for taxpayers to do certain things, like buy a house, donate to charity, or start a business. Hence, homeownership and work-related expenses are deemed allowable deductions by the IRS. So, keep your records organized, and you could save money on them come tax season.
Itemized Deductions vs. Standard Deductions
The standard deduction is an amount set by the IRS that you can use to lower your tax bill. Every year, you can apply the standard deduction to lower your taxable income or itemize your deductions. You can only choose one and not both.
Choosing the standard deduction means you’ll be taking a fixed-dollar amount reduction in your AGI. The amount of the standard deduction you can subtract depends on your age, filing status, and whether you are disabled or claimed as a dependent by another person on their tax return.
The standard deduction does not apply to all taxpayers, such as nonresidents. But many people use it to calculate their tax since it doesn’t require keeping track of eligible expenses or keeping records and receipts. It’s also easier and beneficial for taxpayers who don’t have qualifying itemized spending to opt for the standard deduction.
Itemized Deductions You Can Take
If you think you have sufficient qualifying expenses to take advantage of itemized deductions for your income tax return, make sure to start keeping records. It doesn’t hurt to be organized, as well. You’ll need to be able to justify your deductions. So, save your receipts and proof of payments, such as bank statements, medical bills, insurance bills, and tax receipts for qualifying charitable contributions.
Here are some examples of the most common itemized deductions:
- Medical and dental expenses
- Property, state, and local income taxes
- Home mortgage interest expenses
- Charitable donations
- Investment interest expense
- Miscellaneous deductions
Medical and Dental Expenses
Medical and dental expenses for you and your dependents are deductible as an itemized deduction. You can apply unreimbursed, eligible medical bills that are more than 7.5% of your AGI. Unreimbursed means medical expenses you’ve incurred not covered or paid by insurance.
For example, if your adjusted gross income is $50,000, any amount after the first $3,750 is deductible. In this scenario, if you paid for $7,500 out of pocket for medical or dental fees, you can deduct $3,750 from your total taxable income. You can also deduct an additional 20 cents for every mile you have to travel to get medical care.
Eligible medical and dental expenses include:
- Payments/copays you’ve made to cover fees for doctors, dentists, surgeons, chiropractors, psychiatrists, and other medical professionals
- Hospital and nursing care
- Insurance premiums
- Physical handicap costs
Find the full list of qualifying medical and dental expenses on IRS Publication 502.
Property, State, or Local Income Taxes
State and local taxes, as well as personal property taxes, including real estate taxes that you’ve paid within a tax year, are eligible itemized deductions. You may deduct a combination of these taxes up to $10,000. If married filing separately, you have allowable deductions of $5,000 each.
You may deduct qualifying property and real estate taxes you’ve paid on your:
- Primary home
- Co-op apartment
- Vacation homes
- Cars, RVs, and other vehicles
- Taxes for maintenance or repair of sidewalks, water, or sewer systems
To avoid confusion, the following are not allowable property tax deductions:
- Property taxes on property you don’t own
- Property taxes you haven’t paid yet
- Transfer taxes on the sale of a house
- Homeowners association fees
Home Mortgage Interest Expenses
As a homeowner, if you took out a mortgage to buy a home, you can claim the interest you’ve paid on that loan as an itemized deduction. The Form 1098 that your mortgage lender sends you records the amount of your deductible interest and points from payments you’ve made each year. If you’ve bought or refinanced your mortgage during the tax year, you can also claim the points you’ve paid as deductibles following certain guidelines.
The mortgage interest deductible is allowed up to the first $750,000 borrowed for a mortgage and applicable for two residences for each taxpayer. Before the enactment of the TCJA, the deduction allowed was on the first $1,000,000 of mortgage debt. However, this higher limit still applies if you refinance the debt, and the amount stays the same.
Any home equity loan interest or line of credit interest you’ve paid on a home equity debt also qualifies as a deduction, as long as the loan was used to buy, build, or improve the home that was used as collateral.
If you’ve contributed to charitable organizations during the tax year, you can claim these donations as deductibles. Remember that contributions to political campaigns and individuals are not eligible deductions. Generally, you can deduct donations you’ve made up to 60% of your adjusted gross income.
But, depending on the type of contribution and the organization, the amount you can deduct may be limited to 20%, 30%, or 50% of your AGI. These lower limits are applied to some private foundations, veterans associations, and fraternal societies. The limits also apply to all donations made throughout the tax year, regardless of the number of organizations contributed to. Any amount that you can’t claim as a deductible because of the limits can be carried over on your tax returns for the next five years until they’re used up.
For the 2020 tax year, you can deduct up to $300 of charitable donations, even if you choose to apply the standard deduction. This is called an "above-the-line" deduction. It is part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. It loosens the limits to increase the benefits of charitable donations during the COVID-19 epidemic. It counts toward cash contributions and donations of food, and they apply to individuals and businesses.
Investment Interest Expense
If you borrow money for investment purposes, any interest you pay on that loan can also be considered a deductible. You are allowed to deduct up to the amount of the investment income you earn within the tax year. However, if you don’t have investment earnings during the year, you cannot claim any deductions. You can still use the interest expense deductions toward any earnings in the next year, though.
There are numerous miscellaneous deductions that individuals and businesses can claim. These deductibles include gambling losses equal to gambling winnings, losses from business partnerships or subchapter S-corporations, and job-related, out-of-pocket expenses exceeding 2% of a worker’s AGI.
However, as a freelancer or independent contractor, you might want to pay more attention to deductibles allowed to self-employed individuals. There are a handful of valuable deductions for business owners, such as:
- Home office deduction: If you work from home, you can claim a portion of your mortgage or rent, a percentage of the cost of utilities, and maybe repairs and maintenance.
- Health insurance premiums: You can claim medical and dental insurance premiums that you pay for you, your spouse, and dependents or children under the age of 27 at the end of the tax year.
- Eligible work-related education: If you attend any classes or seminars to gain more knowledge to run or improve your business, the cost of tuition, books, supplies, and transportation to and from classes can also be used as a deductible.
- Transportation costs: You are also allowed to deduct any transportation costs you incur to meet with clients, deliver products, or any business-related travel.
- Business-related expenses: These expenses may include a portion of your phone or internet bill, office supplies, the depreciation cost of computers or other equipment, and tax preparation fees.
- Business insurance premiums: If you pay premiums for a business insurance policy and employee accident and employee health insurance, those could also be used as deductibles to lower your taxable income. You can find out more about these deductibles in the IRS Publication 535.
Organized Record-Keeping Helps You Choose the Best Approach
Every year during the tax season, you’ll have to look at your expenditures the previous year and decide whether to apply the standard deduction or itemized deductions to calculate your tax obligation. As your circumstances vary, what may be beneficial for you this year might not work next year.
As a business owner, you will probably have more eligible itemized deductions than your average employee. And whether you employ the services of a tax professional, use a tax preparation software like TurboTax, or do your income tax return yourself, make sure you save your receipts and keep your records organized.
Don’t miss out on any eligible deductions because you misplaced or mislabeled your receipts. Consider Skynova’s all-in-one invoicing and accounting software. With Skynova’s platform, you can keep your receipts organized, backed up, and in one place. Simply log into your account, and they’re available at your fingertips.