Itemized Deductions
Posted on June 26, 2008
Filed Under Federal Income Tax, Key Concepts
To paraphrase Einstein, there is nothing so complicated as the income tax, and the device of itemized deductions only adds to the complexity of the Internal Revenue Code.
The proximate cause of the category (and complexity) of itemized deductions is the two-tier concept of income in our federal tax system, namely, the “tiers” of gross income and adjusted gross income.
The first tier, gross income, is a net concept despite the adjective “gross”; that is to say, gross income is not the same as gross receipts. Instead, gross income equals gross receipts less return of capital, cost of goods sold, cost of sales, or recovery of cost. In the context of this article’s focus on the federal income tax for individuals, gross income is the recipient’s net gain from a transaction not his or her gross receipts. Also note that the scope of this article is limited to a general discussion of the concept of itemized deductions; key elements in this category will be covered in subsequent articles. (But for those seeking immediate guidance on itemized deductions, see my article Deductions Legal Fees.)
The second tier, adjusted gross income, is gross income less certain deductions expressly authorized by Congress. The deductions taken from gross income to arrive at the intermediate figure of adjusted gross income are commonly referred to as “above the line deductions.” Because, on the whole, above the line deductions comprise trade or business deductions (but with exceptions for alimony, contributions to health savings accounts and retirement plans, and student loan interest payments, among others), they are allowed in full and not subject to a floor. (The phrase “subject to a floor” means deductible only to the extent the expense in question exceeds some baseline figure, usually a fraction of adjusted gross income). On the other hand, many deductions from adjusted gross income (itemized or “below the line” deductions) are mainly personal in nature making them subject to a floor expressed as a percentage of adjusted gross income. Moreover, itemized deductions in the aggregate benefit the taxpayer only if they exceed the standard deduction amount (the 2007 standard deduction is $5,350 for single filing status, $10,700 for married filing jointly and surviving spouse, $5,350 for married filing separately, and $7,850 for head of household); that is, the standard deduction vs. itemized deduction comparison will pay off only if it tips the scales in favor of itemized deductions. Adjusted gross income (AGI) is therefore a key concept in the federal income tax because it represents the line, for the most part, between business and personal expenses. As with its above the line cousin, itemized deductions abide by the general rule that deductions are not allowed unless granted by the legislative grace of Congress. (For additional details on the role of the two tiers in the federal income tax, see my earlier Key Concepts articles on gross income and adjusted gross income.)
Historically, itemized deductions comprise medical and dental expenses (subject to a 7.5% of AGI floor), state and local taxes, home mortgage and investment interest expenses, charitable contributions (subject to various percentage-of-AGI limitations based on type of charity and character of gift), casualty and theft losses (subject to a 10% of AGI floor plus a $100 deductible for each casualty or theft loss), job expenses, and miscellaneous deductions (subject to a 2% of AGI floor); taxpayers list these expenses on Schedule A, the official itemized deductions form (pdf file). High income taxpayers should also note that miscellaneous itemized deductions (except for gambling losses to the extent of gambling winnings, impairment-related work expenses, and several other expenses) are not allowed in the calculation of alternative minimum tax, and other restrictions may apply for the “regular” itemized deductions that are allowed, including the imposition of a higher 10% of AGI floor for medical and dental expenses. See my previously published articles on this topic, Alternative Minimum Tax Individuals and Alternative Minimum Tax Credit.
Because of concern that itemized deductions are largely personal in nature, tend to erase the progressivity of the income tax because a deduction saves more per dollar for taxpayers in higher tax brackets (i.e., the net after-tax cost per dollar for a deductible expense for individuals in the 28% bracket is 72 cents but only 65 cents for those in the higher 35% bracket), and serve in substance as a tax expenditure, Congress in 1990 decided to enact an itemized deduction phase out (but no phase out for medical and dental expenses, casualty and theft losses, investment interest expenses, and wagering losses up to wagering gains) for high income taxpayers. In 2006 and 2007, taxpayers must reduce the total of itemized deductions claimed by 2% of adjusted gross income in excess of $156,400 ($78,200 for those married filing separately). This phase out of itemized deductions according to income level cannot be more than 80% of otherwise allowable deductions and it applies after subtracting various floors.
Additional resources on the key concept of itemized deductions are listed below:
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Itemized Deductions Instructions (pdf file)
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Miscellaneous Itemized Deductions (pdf file)
Many happy returns, Roger
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