Medical Expenses

It is no accident some writers use the adjective “extraordinary” to describe medical expenses as this cluster of costs qualifies as an only if it totals more than a hefty 7.5% of (AGI). A single taxpayer reporting in 2007 AGI of $75,000 and paying $5,600 in medical expenses and $6,000 for the miscellaneous expense of job-related legal fees would be in the unhappy situation of being able to itemize (legal fees alone, even after subtracting the 2% of AGI floor for miscellaneous expenses, are greater than the $5,350 standard deduction amount) yet unable to deduct medical expenses because they fall short of the 7.5% AGI floor or $5,625 ($75,000 x 7.5%). Although not subject to phase out, medical expenses fall under the iron sway of the and its harsher 10% AGI floor for high income taxpayers.

However, there is good news for the self-employed: health insurance premiums for the business owner and his or her spouse and dependents are not subject to the 7.5% AGI floor. Instead, these premiums are 100% deductible. But an individual is not required to be self-employed in order to take an above the line deduction for certain medical expenses. For example, the unreimbursed cost of a checkup required by an employer is a miscellaneous expense that is deductible but subject to a 2% AGI floor, but an employee required to pay for and pass a physical exam as a condition of continued employment may take an above the line deduction for this expense.

What are ? Paraphrasing the Internal Revenue Code, deductible medical expenses are unreimbursed amounts paid for diagnosing, mitigating, treating, and preventing disease. The cost of a procedure or treatment affecting the body’s structure or function is also deductible.

A taxpayer can deduct medical costs for a dependent even if the dependent doesn’t qualify for the regular dependency exemption. In other words, the restrictions on claiming individuals as dependents are relaxed for medical deductions:

A taxpayer’s share of unreimbursed payments of a dependent’s medical expenses under a multiple support agreement (e.g., brothers and sisters agree to share in the support of a parent in need of medical services at a nursing home) is deductible even if that dependent doesn’t pass the gross income test. Payments of a deceased spouse’s or dependent’s medical expenses are deductible in the year paid. Even if the executor of the deceased spouse’s or dependent’s estate pays decedent’s medical expenses within one year of date of death, the survivor can still deduct these expenses by filing an amended return.

An abbreviated list of products, procedures, and services eligible for the medical expenses deduction follows below:

For the most part, capital expenditures are not deductible, but a special exception applies if the main purpose of a home improvement is to provide medical care or benefits. The excess of the actual cost of the medical home improvement over the increase in the home’s fair market value is deductible as a medical expense; the remainder of the cost outlay is booked as an increase in the home’s basis. Ramps, railings, support bars, bathroom modifications, and other structural changes not increasing the value of the home are fully deductible.

Generally speaking, medical expenses beneficial to general health, costs of cosmetic surgery to improve appearance, and payments for illegal treatments or drugs are not deductible. Any portion of a judgment or settlement earmarked for medical care is a nondeductible reimbursement. In the case of a policy providing both medical and nonmedical benefits, the medical portion is deductible only if it is reasonable in relation to the total premium and separately stated.

Despite the large number of available medical expense deductions, the most significant benefit for the taxpayer comes not in the form of a deduction but rather by way of an exclusion. Section 106(a) of the Internal Revenue Code excludes from the employee’s gross income health insurance premiums paid by the employer: “gross income of an employee does not include employer-provided coverage under an accident or health plan.” According to several sources, this is the largest single exclusion from income in the Code for individual taxpayers. The exclusion from an employee’s gross income of health insurance premiums paid (and deducted) by an employer is arguably the most important exception to the longstanding rule that (pdf file) deductible by one party in a transaction are taxable income to the other. However, there is a stopgap in the form of a timely application of the : payments received under health insurance plans are not excludable from income to the extent the taxpayer has benefited from prior deductions. And, as emphasized in the definition above, a taxpayer can only deduct medical expenses not compensated by insurance or otherwise, that is, only unreimbursed expenses are deductible.

Additional relevant articles on the deduction for medical expenses are listed below:

Many happy returns, Roger

Charitable Contributions

The category of charitable contributions is an important exception to the general rule that personal expenses are not deductible. For critics, the charitable contributions deduction is an inefficient tax expenditure for pet projects of the wealthy; but for advocates, the nongovernmental funds the deduction creates are put to more effective use than any federally spent dollar. Of even greater significance is the fact that Congress has granted this exception because it believes charitable organizations relieve the government of significant welfare costs. And given the complexity of Code section 170 (”Charitable, etc., contributions and gifts”), one could argue this legislative grace also provides a windfall for tax lawyers and public accountants.

Charitable contributions are deductible below the line, that is, they are classified as itemized deductions. As a general rule, individuals who itemize can deduct the fair market value of property donated to qualified organizations. There are exceptions to this rule, however. In brief, for individuals who itemize, the ceiling for the charitable contributions deduction is 50%, 30%, or 20% of taxpayer’s adjusted gross income (AGI), depending on the character of asset donated and the type of donee organization. In any event, total charitable contributions for the year cannot exceed 50% of the taxpayer’s AGI and may be subject to the phase out of itemized deductions for high AGI taxpayers; in 2008, the phase out will affect individuals married filing jointly with AGI over $159,950 ($79,975 for married filing separately). Charitable contributions that exceed any of the ceilings can be carried forward for five years.

For the most part, deductible charitable contributions are donations of cash or property to or for the use of a qualified charitable organization. Qualified charitable organizations include U.S. governmental entities and any donee organized primarily for charitable, educational, literary, religious, or scientific purposes. In a part sale, part gift transaction, the bargain element (market price less selling price of property) is deductible as a charitable gift, but the donor must apportion basis between the gift and sale components. Amounts paid for admission to fundraising events are deductible only if the taxpayer can demonstrate that a clearly identifiable portion of the admission price is a charitable gift. However, the cost of bingo, lottery, or raffle tickets is not deductible because the purchaser, by reason of having a chance to win a valuable prize, receives full consideration. (In this article, I focus on the charitable contributions deduction for individuals, but for those interested, a corporation can generally deduct for charitable contributions up to 10% of its taxable income.)

Nondeductible charitable contributions include money or property given to individuals, foreign organizations, civic leagues, chambers of commerce, social and sports clubs, lobbying organizations, homeowners’ associations, political parties, or individuals running for public office. Even if made to a qualified donee, contributions earmarked for particular individuals are not deductible. No deduction is allowed for the value of personal services donated to a charitable organization, but a taxpayer can deduct any out-of-pocket expenses incurred while rendering such services. Also, if a charity is given the right to use property but the transfer is for less than the taxpayer’s entire interest, then no deduction is allowed for rent or other value of this right. Instead, the use is viewed not as a gift but rather as a grant of a privilege to the charity. The same type of restriction applies to donations of stock without surrender of voting rights: the IRS considers this to be an incomplete and therefore nondeductible transfer because the donor retains a substantial interest in the property.

In larger terms, a taxpayer cannot take a charitable deduction if he or she benefits from the transaction; any contribution made with the anticipation of economic benefit rather than from a “detached and disinterested generosity” [Commissioner v. Duberstein, 363 U.S. 285 (1960)] is not deductible. Put differently, a contribution is deductible only if made with donative intent and to the extent it exceeds the market value of any benefit received. The burden of proof is on the taxpayer to establish that a contribution does in fact meet these standards.

Several other basic principles apply to charitable contributions. As mentioned earlier, donations must be “to or for the use of” a qualified charity in order to be deductible; “to” a charity is obvious, but “for the use of” means “in trust for” the charity, or, in the words of Justice O’Connor, “the recipient charity exercises control over the donated funds” [Davis v. United States, 495 U.S. 477 (1990)]. In short, to be deductible, the transfer must be directly to the charity or a trust for the charity. Second, the charity must have a possessory interest in the property; this restriction rules out the deductibility of future interests in tangible personal property, but gifts of a fractional or future interest in the donor’s personal residence or farm are deductible for the value of the interest. Another exception to a strict reading of the possessory interest rule is the deduction for a charitable remainder annuity trust or unitrust. These trusts are qualifying split-interest trusts that have noncharitable beneficiaries; a deduction is also available for a pooled income fund, which is essentially the same as a charitable remainder annuity trust or unitrust, except that it is maintained by a public charity authorized to accumulate remainder interests for several donors. Congress has prescribed strict restrictions on these split-interest trusts to ensure that charities actually receive amounts previously deducted by donors. Third, a gift of an income interest is deductible only if the income remains taxable to the donor; this provides a foundation for the deduction and prevents donors from realizing a double tax benefit. Finally, gifts other than cash over $5,000 ($10,000 for nonpublicly traded securities) must be supported by an appraisal. For more on documents needed to substantiate charitable contributions, click on , (pdf file), and (pdf file).

Qualified public charities (also known as “50% organizations”) include:

  1. Churches, church associations, church conventions, mosques, synagogues, etc.;
  2. Educational organizations maintaining a regular faculty and student body;
  3. Government-supported organizations administering property for qualified educational organizations;
  4. Hospitals and medical research organizations;
  5. Governmental units;
  6. Corporations, trusts, foundations, or community chests formed in the United States and operated exclusively for charitable, educational, literary, religious, or scientific purposes;
  7. Corporations, trusts, foundations, or community chests formed in the United States and organized for the promotion of national or international amateur sports competition or the prevention of cruelty to children or animals;
  8. Private operating foundations, organizations that distribute substantially all of their income for charitable purposes; and
  9. Private nonoperating foundations that distribute all of their income to public charities.

Qualified private charities (also known as “30% organizations”) include:

  1. Private nonoperating foundations not meeting the payout requirements for 50% organizations;
  2. Veterans’ organizations;
  3. Fraternal societies; and
  4. Nonprofit cemeteries.

Click on to see a more comprehensive review of qualified charitable organizations and for a list of charitable organizations eligible to receive deductible contributions of cash or property.

The deductibility of charitable contributions for individuals is subject to the following ceiling amounts:

  1. 50% public limitation category. 50% of the donor’s AGI for (a) contributions of cash and ordinary income property (property that if sold rather than donated would cause the taxpayer to recognize income other than long-term capital gains) or capital gain property held short term to 50% organizations or (b) contributions of capital gain property or unrelated use property (i.e., property unrelated to the donee organization’s primary charitable purpose) to 50% organizations where any amount deducted in (a) or (b) is reduced by the property’s unrealized appreciation or depreciation that would be recaptured as ordinary income on a sale.
  2. 30% public limitation category. 30% of the donor’s AGI for contributions of capital gain property or appreciated, publicly traded stock held long term (but limited to 10% of the value of outstanding stock) to 50% organizations.
  3. 30% private limitation category. 30% of the donor’s AGI for contributions of cash and ordinary income property or capital gain property held short term to 30% organizations provided any amount deducted is adjusted downward for unrealized appreciation or depreciation that would be recaptured as ordinary income on a sale.
  4. 20% private limitation category. 20% of the donor’s AGI for (a) contributions of capital gain property or unrelated use property to 30% organizations where the amount deducted is reduced by the property’s unrealized appreciation or recaptured depreciation producing ordinary income or (b) contributions of appreciated, publicly traded stock held long term (no more than 10% of the value of outstanding stock) to 30% organizations.

In a nutshell, a taxpayer may deduct, up to 30% of his or her AGI, the fair market value of long-term capital gain property donated to public charities; but only basis for donations of ordinary income property, short-term capital gain property, and unrelated use property to public or private charities. Regardless of type of property or charitable donee organization, if the property’s fair market value is below its basis, the deduction is limited to fair market value.

An algorithm to figure the overall charitable contributions deduction is detailed below:

  1. Contributions in the 50% public limitation category are limited to 50% of AGI, hereafter referred to as the 50% AGI maximum.
  2. Contributions in the 30% public limitation category are limited to the 50% AGI maximum minus contributions in the 50% public limitation category.
  3. Contributions in the 30% private limitation category are limited to the 50% AGI maximum minus contributions in the 50% public and 30% public categories.
  4. Contributions in the 20% private limitation category are limited to the 50% AGI maximum minus contributions in the 50% public, 30% public, and 30% private categories.

More information on the charitable contributions deduction can be found in the following resources:

Many happy returns, Roger

Mortgage Interest

Before the Tax Reform Act of 1986, interest was deductible regardless of the loan’s purpose. After the Tax Reform Act, with an important exception for home mortgage interest, only interest expenditures with a business purpose are deductible. In short, although home mortgage interest is a distinctly personal expense, Congress made an exception to the Tax Reform Act’s strict rule prohibiting deductions for personal interest expenses by maintaining in the Code an itemized deduction for interest on home acquisition or home equity loans secured by a qualified residence. A home is a qualified residence if it is (1) the taxpayer’s main home or (2) a second home used by the taxpayer or close relatives for more than the greater of 14 days or 10 percent of the number of days it is rented at fair market value, what I term as the “personal use vs. rental use test.” If the second residence is not used by taxpayer (or close relatives) or rented during the year, the personal use vs. rental use test does not apply and the second home is considered a qualified residence for tax purposes. Many prospective buyers worry that Congress may eliminate the .

For mortgages taken out after October 13, 1987, acquisition indebtedness is defined as debt incurred to acquire, build, or substantially improve a qualified residence and secured by such residence. The (pdf file) is interest paid on acquisition debt up to $1,000,000 ($500,000 for married filing separately). Moreover, for interest payments to qualify as a deductible expense, the indebtedness cannot exceed the lesser of the residence’s fair market value or the taxpayer’s adjusted basis in the residence; interest paid on borrowings against unrealized appreciation is not deductible. However, taxpayers with qualified residence debt over the $1,000,000 ceiling may consider converting a second home into a full-time rental property. Click on for more details.

Taxpayers with 2007 adjusted gross income over $156,400 ($78,200 for married filing separately) are subject to a . In addition, interest on home equity indebtedness is not allowed when figuring the unless the loan is used to buy, build, or substantially improve a qualified residence.

Home equity indebtedness is debt secured by a qualified residence that exceeds acquisition indebtedness. For interest to be deductible, home equity debt cannot exceed the lesser of (1) $100,000 ($50,000 for married filing separately) for qualified residences combined (i.e., main and second homes) or (2) the fair market value of the residence in question minus total acquisition debt outstanding on that home. Other than the general prohibition against using loans with deductible interest to purchase tax-free investments, home equity loans can be spent (or squandered) for any purpose.

A home refinancing loan to buy, build, or substantially improve a first or second residence is considered home acquisition debt with deductible interest payments provided it does not exceed the adjusted basis of the home (i.e., principal balance outstanding on the original acquisition debt immediately before refinancing plus any portion of the new loan used to improve the residence) or cause total acquisition debt to exceed $1 million. If a home refinancing loan is used for any other purpose, the excess of debt over the home’s adjusted basis is classified as home equity debt and deductible provided it doesn’t exceed the $100,000 maximum for all home equity indebtedness. And if the refinancing proceeds are used for mixed purposes, the combined $1,100,000 acquisition/equity limit applies. A summary and warning: once you pay off all or part of the original mortgage, you lose the corresponding interest deduction and cannot get it back by refinancing unless refinancing includes the cost of substantial improvements to the home (thus increasing the tax basis of the home) or is classified as home equity indebtedness subject to a $100,000 limit for all outstanding home equity debt.

Any home improvement loans that cause the total amount of acquisition indebtedness to exceed $1,000,000 are considered home equity loans and subject to a $100,000 limit and other restrictions for home equity indebtedness. Interest on indebtedness in excess of the combined $1,100,000 acquisition/equity limit is a nondeductible personal expense. The restrictions imposed by the Tax Reform Act of 1986 do not apply to mortgages taken out before October 14, 1987; that is, the rules for home mortgage indebtedness booked before this date are, in effect, grandfathered by the Revenue Act of 1987. Thus, pre-October 14, 1987 mortgages are treated as acquisition indebtedness (but such indebtedness reduces the $1 million limit on new, post-October 13, 1987 acquisition debt) and interest is fully deductible regardless of purpose (but not deductible if used to purchase tax-exempt investments). If pre-October 14, 1987 debt is refinanced after October 13, 1987, it is considered acquisition indebtedness if it doesn’t exceed the original balance outstanding immediately before refinancing and does not extend beyond the original term of the loan or, in the case of a loan without a fixed term, the term of the first refinancing (but not to exceed 30 years).

Generally speaking, points on home mortgages must be charged for the use of money in order to be deductible. Points charged for specific services (appraisal fees, notary fees, settlement fees, etc.) are not interest and therefore not deductible. Points paid on refinancing must be amortized over the life of the loan unless the refinancing is but a temporary step in obtaining permanent financing. However, points allocable to that portion of a refinancing loan used to substantially improve the main residence are deductible in the year paid. Points on a mortgage for a second home must be amortized over the loan term.

Additional information on the mortgage interest deduction is listed below:

Many happy returns, Roger

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