Tax Deductions: What Are They, and How Do They Work?
Out of all the different topics that fall under the umbrella of “taxes”, deductions have to be the most exciting. Most people are aware that deducting things from their taxes means that they get more money back on their refund. Or in the case of businesses, it means lower payments to the IRS each year.
But despite the exciting topic, many people have no idea what a tax deduction actually is. In years past, up to 70% of American taxpayers took the Standard Deduction instead of itemizing their deductions. And since the Tax Cuts and Jobs Act of 2017 passed, the Standard Deduction has increased, which has experts projecting that more Americans than ever will take the Standard Deduction.
And if you own or run a business, deductions can be even murkier and more confusing. Since there is no Standard deduction for businesses of any size, many entrepreneurs and business owners can find themselves losing money while itemizing their deductions.
No matter if you own a business, or if you only have a personal return, everyone should better understand the definition of a deduction, and how you can claim them.
What is a Tax Deduction?
A “Tax Deduction” is a way of reducing a person’s or business’ tax liability by lowering their total taxable income. Tax liability simply means the amount of money that you owe the IRS. Liability means being responsible for something. So Tax Liability means the amount of tax debt you, as the taxpayer, are responsible for paying.
A tax deduction or tax write-off is different from a tax credit, however. Tax credits reduce the amount of tax you owe directly, whereas deductions reduce your taxable income.
How Does a Deduction Affect Your Taxes?
A deduction reduces the amount of taxable income a taxpayer has for the year. Think, for example, of a coupon. If you have a coupon for $2 off of $20, you’ll only be charged sales tax on the remaining $18. In the same way, if you deduct from your taxes, it reduces the amount of money that you owe the IRS.
A deduction typically comes from expenses that a taxpayer incurs that can be applied against their gross income. The cost of the expense is then subtracted from your gross income before the amount of tax you owe is calculated.
Business Deductions Vs. Personal Deductions
Some of the major differences between personal deductions and business deductions lay in the way that the taxpayer can claim them.
Business Returns:
Business deductions have to be itemized, but most expenses that go into the cost of running the business are deductible. There are also industry-specific and state-specific rules that affect what businesses can and can’t deduct.
Common business tax deductions are:
- Software
- Supplies
- Office (home, rented, owned)
- Employee salaries
- Mileage
- Travel expenses
Deductions can be reported in Business returns on Forms 1065, 1120, or 1120S.
Personal Returns:
For personal returns, a taxpayer can either choose to itemize their deductions or claim the standard deduction.
Common personal tax deductions are:
- Standard Deduction
- Personal or family expenses
- Medical expenses
- Mortgage interest payments
- Charitable contributions
- Legal expenses
- Losses to theft or vandalism
- Tax preparation fees
Deductions can be reported in Personal returns on Forms Schedule 1, A, C, E, or F.
What are the Best Small Business Tax Deductions?
Since there is no “standard” deduction for businesses, all businesses have to keep meticulous records of their expenses and deduct them individually when it’s time to pay their taxes. The exception to this would be the QBI Deduction that the TCJA introduced in 2017.
But just because you have to do more work to claim your deductions doesn’t mean that there aren’t some great small business tax deductions out there. Some of the most common deductions for businesses are:
Vehicle Expenses
If you drive a lot for work, you can deduct a good chunk of those expenses on your taxes. You’ll need to keep records to prove that the use of your vehicle was for your business, and not personal use.
Common vehicle expenses you can claim as deductions are things like gas, parking, oil changes, maintenance, parking, and tolls.
When it comes time to file your taxes, you can either deduct the actual expenses of your vehicle, or you can use the IRS standard mileage rate. Which for the tax year 2019, is 58 cents per business mile driven.
If you drive the same vehicle for business and for personal use, make sure to keep meticulous records of how many miles you drove, as well as your expenses if you want to claim the deduction that way.
Office or Home Office
Regardless if you’re renting an office for a team, or a coworking space for a freelancer, you can deduct the rental cost from your tax return. You simply have to prove that you’re using the space for only business activities.
If you work from home, you can also deduct your home office from your return, but be aware that there are some strict rules you need to follow in order to qualify.
You have to prove that the space you’re using in your home is used exclusively for business use, and not personal use. You also have to prove that you use that area regularly and that it’s the principal place of business.
If you are prepared to prove those things, then you can claim the home office deduction. There are two ways you can claim the deduction:
- If you use the Simplified option, you aren’t deducting your actual expenses. Instead, you can take the square footage of your office space and multiply it by $5 per square foot (up to 300 square feet). The result is what you can deduct from your taxes.
- If you deduct your actual expenses, it’s a little more complicated process. You can deduct your actual expenditures against your overall residence cost – including mortgage interest, taxes, insurance, etc.
Supplies
If you’re purchasing supplies for your business, be sure to keep your receipts! Most supplies are deductible on your taxes. You can deduct the cost of things like computer software, furniture for your office, equipment, office supplies, postage, shipping, and more.
Qualified Business Income Deduction
Many businesses that are classified as pass-through for tax purposes – sole proprietorships, partnerships, and C Corporations – are eligible to claim the QBI deduction. If your business is eligible, it means that you can deduct 20% of your Qualified Business Income from your tax return.
Your Qualified Business Income is the net amount of qualified income, gains, deductions, and losses from your business in a given year. This generally includes things like self-employed health insurance, self-employed tax, and deductions to qualified retirement plans.
Additionally, under the QBI Deduction, small business owners can also deduction up to 20% of Qualified Real Estate Investment Trusts (REIT) dividends, and qualified Publicly Traded Partnership (PTP) income.
There are some complications and regulations around who qualifies to claim the QBI deduction, and if you have questions, we recommend speaking to a tax professional to see if you qualify.
What is the Standard Deduction?
The IRS provides the Standard Deduction as an additional way a taxpayer can lower their taxable income, instead of having to tally up their actual expenses. Formally, the standard deduction is the portion of your income that is not subject to tax.
Most low- to middle-income earners in the United States will claim the Standard Deduction, as it equals out to more than what their expenses would be if itemized. Higher-income earners tend to have more expenses, and therefore are more likely to itemize and deduct their individual expenses as opposed to taking the Standard Deduction.
When the Trump administration passed the TCJA in 2017, it raised the standard deduction for all taxpayers quite significantly. The new standard deductions are:
- $12,200 for taxpayers filing on their own
- $18,350 for taxpayers filing as Head of Household
- $24,400 for married taxpayers filing jointly.
- $24,400 for qualifying widowers
Married taxpayers filing separately each count as a single taxpayer, and as such can each deduct $12,200 from their taxes.
Other factors that determine the Standard Deduction rate for taxpayers include their income, age, filing status, dependent status, and certain disabilities.
Taxpayers who are filing jointly with their spouse should know that they must take the same deduction on their tax return, even if it doesn’t result in the most advantageous tax savings.
Savvy taxpayers should also note that the Standard Deduction changes from year to year to keep pace with inflation.
Changes for: Elderly Taxpayers
Taxpayers over the age of 65 receive an additional Standard Deduction amount which is added to whatever Standard Deduction they can claim in the tax year. If the individual is unmarried or filing as Head of Household, they can claim an additional $1,650 on their taxes. If they’re married filing jointly, or their spouse is over 65 years old, they can claim an additional $1,300. Either of those would simply be added on to their existing Standard Deduction.
For example, if a woman of 65 was unmarried and claiming her increased standard deduction, she would claim $12,200 plus $1,650, meaning her Standard Deduction would be $13, 850.
If both spouses filing jointly are over 65, they can both claim the $1,300, meaning they can add $2,600 to their Joint Standard Deduction of $24,400 – which bumps their deduction up to $27,000.
Changes for: Blind Taxpayers
The same rules apply to taxpayers who are legally blind. If you’re legally blind and filling Single or Head of Household, you can claim an additional $1,650. If you’re married filing Jointly or your spouse is blind, you can claim an additional $1,300.
Changes for: Dependents
If you as the taxpayer were claimed as a dependent on someone else’s tax return, your Standard Deduction will be reduced. You will either be able to claim $1,100 or your earned income plus $350 – whichever is greater.
When Should You Claim the Standard Deduction?
Most low- to middle-income earners in the United States will claim the Standard Deduction, as it equals out to more than what their expenses would be if itemized. Higher-income earners tend to have more expenses, and therefore are more likely to itemize and deduct their individual expenses as opposed to taking the Standard Deduction.
As a rule of thumb – if your expenses total up to more than the Standard Deduction, it’s worthwhile to claim your actual expenses as a deduction as opposed to the Standard Deduction. But if your expenses are low, then claiming the Standard Deduction is easy, quick, and will likely get you a better return. But either way, if you claim the Standard Deduction or itemize – you simply need to be sure that you’re getting the deductions you deserve.
Deductions Galore
Of course, there are many, many tax deductions that we didn’t get to touch on in this article. From common personal tax deductions to a more exhaustive list of small business tax deductions, there is plenty more to learn about deductions.
If you have questions about what deductions you qualify for – or how you can better calculate your expenses to deduct them from your taxes, we recommend talking with a tax expert. They can help you better understand what you can claim, and ensure you haven’t missed any deductions on your taxes.
