Before we get into the nitty-gritty of standard deduction or itemized deductions, let us look at the concept of adjusted gross income or AGI on which the IRS bases your tax liability. The calculation starts with your gross income which is the sum of all your earnings during the tax year. Your gross income would include wages or salaries, rental income, interest, dividends, capital gains, pensions, unemployment compensation, alimony receipts, etc. There are some adjustments that are subtracted from your gross income to arrive at your AGI (also called ‘above the line deductions’). These include any alimony payments you have made, educator expenses, employee business expenses (applicable only to specified persons), health savings account deductions, self-employed health insurance deduction, student loan interest deductions, etc. Incidentally, you will need to remember your AGI for the last year as this figure is used by the IRS to identify you when you e-file your return.
From your AGI, you can choose to either reduce the fixed standard deductions applicable to your filing status or itemize individual deductions (‘below the line’ deductions)to finally arrive at your taxable income. The standard deductions for the five filing statuses are: filing singly or married filing separately: $12,550, filing as head of household: $18,800, and for married filing jointly or qualifying widow/widower: $25,100. You can choose the option which gives you the maximum deduction from your AGI and lower your taxable income. You could do this by summing up the itemized deductions you are eligible for and comparing this with the standard deduction for your filing status. This requires some effort on your part which is perhaps why the Tax Cuts and Job Cuts Act 2017 doubled the amount of standard deduction so that you are spared the complex process of identifying and quantifying the individual deductions. Following the increase in the standard deduction, more taxpayers chose not to itemize deductions from the tax year 2018 onwards. It is generally observed that it is the taxpayers in the higher tax brackets rather than those on the lower tax brackets who benefit from itemizing.
Itemized deductions
For the tax year 2021, you can itemize the following deductions in lieu of standard deduction. You will need to use Schedule A of Form 1040 for this purpose.
Medical and dental expenses: Expenses incurred during the year for medical and dental expenses in excess of 7.5% of your AGI can be itemized. You will first calculate the amount you are eligible for and then reduce this by the amount of reimbursement you may have received from your insurance company. These expenses typically include the cost of prescription drugs, consultation fees, nursing care, diagnostic tests, hospital care (including meals and lodging), the insurance premium you paid for medical and dental care, etc. You can also claim the cost of medical aids like hearing aids, crutches, wheelchairs, eyeglasses as also guide dogs. If you had to receive medical care in a hospital or a medical care facility away from your home, you can claim lodging expenses to the extent of $50 a night. You have the option to claim the expenses incurred for an ambulance service or if you used your own car, you can claim expenses for gas and oil for the travel. Alternatively, you can claim 16 cents a mile for the distance you travelled as also parking charges and tolls. While you can deduct expenses for qualified long-term care services, there is a cap depending on your age. There are expenses that you cannot claim under this head. These illustratively include certain cosmetic surgeries, diet food, non-prescription drugs, imported drugs not approved by Food and Drug Administration, life insurance or income protection policies, etc.
You can claim these expenses for yourself and your spouse and dependents you include in your tax return. You can claim for others also who may not be your dependents subject to certain conditions.
Taxes you paid: These include: State and local income taxes, State local and general sales taxes, State and local Real Estate taxes, and State and Local Personal Property taxes. Deduction for State and local taxes is normally limited to $10,000 or $5,000 if filing married separately. You can elect to include either the State and local income taxes or State local and general sales taxes but not both.
Under state and local income taxes, you can include income taxes withheld from your salary and taxes paid in 2021 for prior years including estimated taxes.
If you elect to deduct State local and general sales taxes instead of local income taxes, you can deduct the actual taxes you paid if the tax rate was the same as the general sales tax rate. You can include taxes paid on items used only for your personal use and not for your trade or business. Alternatively, in place of the actual expenses you paid, you can use the 2021 Optional State Sales Tax Table and the Optional Local Sales Tax tables available at the end of instructions for filling up Schedule A to calculate your State local and general sales tax deduction. Please note that if you are married filing separately, you will have to use the same option your spouse chooses.
You will be able to deduct the state and local real estate taxes you paid on any real estate you own which was not used for business purposes subject to certain conditions and limits.
You can also deduct the State and local personal property taxes you paid during the year, only if these taxes were based on value and paid yearly. For instance, the fee paid yearly for registration of your car can include a part on the basis of the car’s value and part on its weight. You can claim as a deduction only that part of the tax paid which was based on the car’s value. Further, only those taxes paid in 2021 and as assessed prior to 2022 can be claimed.
Home Mortgage Interest: This includes interest paid on any loan taken against the mortgage of your main home or second home and also includes home equity loans and refinanced mortgages. You can deduct the home loan interest only if it was used to buy, build or substantially improve your home and not for any other purpose. Incidentally, there are a number of limits for your home mortgage interest depending on when you bought or built your home and other conditions. You would normally receive Form 1098 from your financing bank which would help, to some extent, claim your deductions. If you have paid a mortgage insurance premium for your mortgage loan, you can claim this also as a deduction.
The interest you paid: Depending on the purpose for which you availed yourself of the loan – whether it was used for personal, investment, or business purposes – rules for deduction are different. Personal interest cannot be deducted except interest on certain student loans.
Gifts to charity: Contributions or gifts you gave during the year to any charitable, educational, literary, religious, or scientific organization can be deducted. You have to make sure that the organization has a qualified charitable status. The organization should be able to provide you with the information. Contributions need not be only by way of cash or kind. If you did voluntary work for an organization, you can claim actual expenses incurred for travel or you could claim 14 cents a mile for the distance travelled.
Casualty, Disaster, and Theft Losses: Generally you can claim a deduction of the loss you incurred on account of a federally notified disaster or fire. The loss should relate to your home, household items, or any vehicle. If any portion of the loss was covered by an insurance cover you had taken, you must reduce the reimbursement you received from the insurance company for the loss as also any salvage value you obtained. There is however a limit, which is calculated as First, you subtract from the total loss figure the insurance or salvage value you received and then subtract $100 for each casualty or theft event. Then you subtract 10% of your AGI to arrive at the casualty and theft losses you are allowed. You have to use and attach Form 4864 to your return for calculating the deduction.
Itemized deductions or standard deduction?
After you have arrived at the total of your itemized deductions – the IRS provides you various forms to arrive at this figure – you can decide what to do. The items listed above are indicative and there are conditions, caps, or limits for all these items. For instance, home mortgage interest is capped at a loan value of $750,000 if you bought your home after December 16, 2017. Your charity deductions can be 100% of your AGI for the 2021 tax year only so long as they are qualified cash contributions otherwise it is capped at 60% of your AGI.
To complicate matters, there are some items that can be claimed both above the line and below the line. You will have to take a call on the choice. These items generally relate to business expenses or if you are self-employed. If you are a small business owner, you can take a portion of the State real estate taxes as a business deduction above the line. Contributions to self-employed health insurance or retirement plans can be deducted on both sides of the line.