Itemized Deductions and the Standard Deduction

Certain personal expenses, such as mortgage interest on a primary residence, can be deducted against personal ordinary income to lower the amount of income tax, but not payroll tax, owed. These personal expense deductions are often referred to as itemized deductions because the taxpayer must list each individual deduction and the amount.

Alternatively, the taxpayer can choose the standard deduction, which is based on filing status. However, a married couple where neither spouse qualifies as a head of household must both either itemize their deductions or claim the standard deduction, unless the couple is divorced or legally separated, in which case each spouse can choose independently.

The decision to itemize deductions or to use the standard deduction can be changed by amending the taxpayer's return by filing Form 1040X, Amended U.S. Individual Income Tax Return within the 3-year period of the due date for the original return. Taxpayers who were married and filed separately must make the same change — both either itemizing or claiming the standard deduction.

Itemized Deductions

Most itemized deductions are subject to a floor, which is a percentage of the adjusted gross income (AGI), that must be subtracted from the itemized amount to determine the deduction. For instance, most medical expenses can be itemized, but they are subject to a 7.5% floor. So if John Doe has an AGI of $100,000, the first $7500 of his medical expenses is not deductible. Some itemized deductibles have a ceiling, also expressed as a percentage of AGI, which sets the maximum that can be deducted. For instance, there is a ceiling of 50% of the AGI for most charitable contributions, which means that John can deduct a maximum of $50,000 for charitable contributions.

Itemized deductions are claimed on Schedule A of Form 1040, and include the following:

• Medical and dental expenses minus any insurance reimbursement, subject to a 7.5% AGI floor.
• Taxes
  • State and local income taxes or general sales taxes, but not both.
  • State, local, or foreign real estate taxes based on the assessed value of property that was not used for business.
  • State and local personal property taxes based on assessed value and paid annually.
    • Example: a state assesses a car registration fee based on the value and weight of the car. Only the part of the fee based on the value of the car can be itemized.
  • Taxes paid to a foreign country or United States possession.
• Interest paid on borrowed money for investments that earn taxable non-passive income is deductible to the extent of net investment income. Interest on first or 2nd home mortgages, home equity loans, refinanced mortgages, and points are deductible, if certain tests are satisfied. The premiums for a qualified mortgage insurance program obtained from a federal agency, such as the Federal Housing Administration, is also deductible.
• Casualty and theft losses, subject to a floor of 10% of AGI plus $100.
• Unreimbursed employee expenses, subject to a 2% AGI floor. However, the floor does not apply handicapped employees, performing artists, or to job-related moving expenses.
• Tax preparation fees.
• Expenses related to producing or collecting taxable income, including the management of income producing property.
• Other miscellaneous deductions, such as gambling losses, but only to the extent of gambling winnings.

Standard Deduction

To simplify tax calculations and to reduce the burden of auditing itemized deductions by the IRS, tax law provides for a standard deduction that most taxpayers can choose if it is greater than their itemized deductions. Sometimes, Congress has set the standard deduction to be equal to the poverty level, but this has not been consistent. Although one ostensible goal of the standard deduction is to allow poor people to keep more of their money, the standard deduction does not save on payroll taxes, which is generally the greatest tax burden on poor people.

The standard deduction is a specific amount, adjusted annually for inflation, which can be deducted from adjusted gross income to arrive at taxable income, and varies according to the filing status of the taxpayer. However, no standard deduction can be claimed when calculating the alternative minimum taxable income (AMTI).

Some taxpayers are ineligible for the standard deduction. These include married taxpayers filing separate returns where one spouse itemizes his deductions, in which case, the other spouse cannot claim the standard deduction, even if the spouse is 65 or older or blind or both unless one spouse also qualifies to file as head of household. There is also no standard deduction for nonresident aliens, estates or trusts, partnerships, and individuals with a short tax year because of a change in their annual accounting period. A dual-status alien who was not a resident of the United States for any part of the tax year cannot take a standard deduction unless the taxpayer files a joint return with a spouse who is a United States citizen or resident and elects to be taxed on worldwide income.

There are 2 types of standard deduction: the basic standard deduction and the additional standard deduction.

Basic Standard Deduction

The basic standard deduction can be claimed by most taxpayers and is based solely on filing status. Because the standard deduction is so high, most taxpayers claim the standard deduction rather than itemize deductions.

The standard deduction is different for dependents, and is equal to the greater of $950 for both 2011 and 2012 or the sum of $300 and the individual's earned income up to the applicable standard deduction amount of $5800 for single taxpayers for 2011 or $5950 for 2012.

Additional Standard Deduction

There is also an additional standard deduction for taxpayers who are 65 or over or blind. The taxpayer can claim an additional standard deduction for a qualifying spouse, but not a dependent. Hence, married taxpayers filing jointly can claim additional standard deductions if they're both over 65 and blind by the end of the tax year.

A married taxpayer can claim the additional standard deductions for a spouse who had no gross income nor was claimed by another taxpayer as a dependent. However, the taxpayer cannot claim the additional standard deduction if the spouse was also claimed as a dependent. The additional standard deduction is equal to $1150 for both 2011 and 2012, whether filing jointly or separately and for surviving spouses. $1450 can be claimed by unmarried individuals, either single or as head of household.

The requirements for the additional standard deduction for blindness include a certified statement from the doctor or registered optometrist that states that the individual cannot see better than 20/200 in the better eye with glasses or contact lenses; or that the individual's field of vision is 20° or less.

Benefit of Itemized Deductions over the Standard Deduction

Since anyone can claim the standard deduction, the benefit of claiming itemized deductions is limited to the amount that exceeds the standard deduction:

Additional Deduction Over Standard Deduction = Total of Itemized Deductions – Standard Deduction

The apportioned benefit of any given itemized deduction can be calculated by the following formula: