Chapter #10 Deductions and Losses: Certain Itemized Deductions
Chapter Introduction
Learning Objectives
After completing Chapter 10, you should be able to:
⦁ LO.1Distinguish between deductible and nondeductible personal expenses.
⦁ LO.2Define medical expenses and compute the medical expense deduction.
⦁ LO.3Contrast deductible taxes with nondeductible fees, licenses, and other charges.
⦁ LO.4Explain the Federal income tax treatment of property taxes, state and local income taxes, and sales taxes.
⦁ LO.5Distinguish between deductible and nondeductible interest and apply the appropriate limitations to deductible interest.
⦁ LO.6Recognize charitable contributions and identify their related measurement problems and percentage limitations.
⦁ LO.7List the expenses that are deductible as other itemized deductions.
⦁ LO.8Identify tax planning strategies that can maximize the benefit of itemized deductions.
The Big Picture
Impact of Itemized Deductions on Major Purchases
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John and Kiara Williamson, a young professional couple, have been renting an apartment in Atlanta, Georgia, since they were married. Their income has grown as they’ve become more established in their careers, and they now believe the time has come to purchase their own home. In addition, their desire to buy a home now may be coming at a good time, because John’s mother, Martha, needs to move in with them due to her declining health and their current apartment is too small to accommodate her. John and Kiara’s current monthly rent is $2,000, but they are willing to spend up to $2,600 per month on an after-tax basis for their first home.
After months of house hunting, they have found the perfect home, but they are concerned it may be too expensive. If they acquire a standard mortgage to finance the purchase of the home, the total cash outlay during the first year of ownership will be $43,000 ($2,000 principal payments, $37,000 interest payments, and $4,000 real estate taxes). Alternatively, if they use their retirement and taxable investments to secure the home financing, they can qualify for a lower interest rate and thereby reduce the interest charge from $37,000 to $35,000. They expect their Federal AGI to be about $200,000 and their taxable income to range between $170,000 and $185,000 for the year. John and Kiara have not itemized their deductions in prior years because the amount of their qualifying expenses has been just below the standard deduction amount. Assume that the Willliamsons face a 6 percent state income tax rate (after any Federal tax benefit).
Can John and Kiara Williamson afford to pursue their dream of home ownership?
Read the chapter and formulate your response.
Framework 1040
Tax Formula for Individuals
This chapter covers the boldfaced portions of the Tax Formula for Individuals that was introduced in Concept Summary 3.1. Below those portions are the sections of Form 1040 where the results are reported.
LO.1
Distinguish between deductible and nondeductible personal expenses.
As a general rule, personal expenses are not deductible (see § 262 of the Code). However, Congress has chosen to allow certain personal expenses to be deducted as itemized deductions. Personal expenses that are deductible as itemized deductions include medical expenses, certain taxes, mortgage interest, and charitable contributions. These (and other) personal expenses allowed as itemized deductions are covered in this chapter. Although certain exceptions exist (e.g., certain alimony and traditional IRA contributions are deductible for AGI), personal expenses not specifically allowed as itemized deductions by the tax law are nondeductible.
Certain business and investment expenses are also deductible, like interest expense on loans to acquire investment assets (e.g., publicly traded securities) and state income taxes on business and investment income. These rules are covered in this chapter and Chapter 11.
Allowable itemized deductions are deductible from AGI in arriving at taxable income if the taxpayer elects to itemize. A taxpayer will elect to itemize when total itemized deductions exceed the standard deduction based on the taxpayer’s filing status.
Itemized deductions are reported on Schedule A (Form 1040) and filed with an individual’s Federal income tax return (Form 1040).
Example 1
The Big Picture
Return to the facts of The Big Picture. John and Kiara Williamson will discover that with the purchase of a home, they will be able to itemize their deductions for the first time instead of claiming the standard deduction. Assuming that the home mortgage interest expense and real estate taxes meet the requirements discussed in this chapter, they can be deducted from AGI because their total will exceed the amount of the standard deduction for a married couple filing a joint return. Other qualifying expenses, including up to $10,000 of state and local taxes as well as charitable contributions, also will be deductible as itemized deductions. All of these items provide a tax benefit to the Williamsons.
Medical Expenses
LO.2
Define medical expenses and compute the medical expense deduction.
Medical expenses paid for the care of the taxpayer, spouse, and dependents are allowed as an itemized deduction to the extent the expenses are not reimbursed. The medical expense deduction is limited to the amount by which these expenses exceed 7.5 percent of the taxpayer’s AGI.
The threshold percentage, sometimes referred to as a “floor,” is used to restrict deductions, because expenses below the floor are not deductible. Here, the floor is significant. Only medical expenses in excess of the “7.5%-of-AGI floor” are deductible. As a result, a medical expense deduction is rare (especially for high-income taxpayers).
Example 2
The Big Picture
Return to the facts of The Big Picture. If, as expected, the Williamsons’ AGI for the year is $200,000, to receive a tax benefit from any unreimbursed medical expenses, they must itemize their deductions and have more than $15,000 ($200,000 × 7.5%) of those expenses.
If they accumulate $27,000 of unreimbursed medical expenses during the year and itemize their deductions, their total itemized deductions will increase by only $12,000 ($27,000 unreimbursed medical expenses − $15,000 AGI floor).
aMedical Expenses Defined
The term medical care includes expenses incurred for the “diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.” A partial list of deductible and nondeductible medical items appears in Exhibit 10.1.
Exhibit 10.1
Examples of Deductible and Nondeductible Medical Expenses Paid by Taxpayer
Deductible Nondeductible
Medical (including dental, mental, and hospital) care
Prescription drugs and insulin
Personal protective equipment to prevent spread of COVID-19; COVID-19 home testing kit
Special equipment:
⦁ Wheelchairs
⦁ Crutches
⦁ Artificial limbs
⦁ Eyeglasses (including contact lenses)
⦁ Hearing aids
Transportation for medical care
Medical and hospital insurance premiums
Long-term care insurance premiums (subject to limitations)
Cost of alcohol and drug rehabilitation
Certain costs to stop smoking
Weight reduction programs related to obesity Funeral, burial, or cremation expenses
Over-the-counter medicines (except insulin)
Bottled water
Toiletries, cosmetics
Diaper service, maternity clothes
Programs for the general improvement of health:
⦁ Weight reduction
⦁ Health spas
⦁ Social activities (e.g., dancing and swimming lessons)
Unnecessary cosmetic surgery
A medical expense does not have to relate to a particular ailment to be deductible. Because the definition of medical care is broad enough to cover preventive measures, the cost of periodic physical and dental exams qualifies even for a taxpayer in good health.
Amounts paid for unnecessary cosmetic surgery are not deductible medical expenses. Cosmetic surgery is necessary—and, therefore, deductible—when it improves the effects of (1) a deformity arising from a congenital abnormality, (2) a personal injury, or (3) a disfiguring disease.
Example 3
Jacob, age 75, paid $21,000 to a plastic surgeon for a face-lift. Jacob merely wanted to improve his appearance. The $21,000 does not qualify as a medical expense because the surgery was unnecessary.
In contrast, Marge’s face is disfigured as a result of a serious automobile accident. Here, the cost of restorative cosmetic surgery is deductible as a medical expense.
The cost of care in a nursing home or home for the aged, including meals and lodging, is a deductible medical expense if the primary reason for being in the home is to get medical care. If the primary reason for being there is personal, any costs for medical or nursing care are deductible medical expenses, but the cost of meals and lodging must be excluded.
Example 4
Norman has a chronic heart ailment. In October, his family decides to place Norman in a nursing home equipped to provide medical and nursing care. Total nursing home expenses amount to $80,000 during the year. Of this amount, $50,000 is directly attributable to medical and nursing care.
Because Norman is in need of significant medical and nursing care and is placed in the facility primarily for this purpose, all $80,000 of the nursing home costs are deductible (subject to the AGI floor, explained earlier).
Tuition expenses of a dependent at a special school for a mentally or physically handicapped individual may be deductible as a medical expense. The deduction is allowed if a principal reason for sending the individual to the school is the school’s special resources for alleviating the infirmities. In this case, the cost of meals and lodging, in addition to the tuition, are deductible medical expenses.
Example 5
Jason’s daughter Jasmine attended public school through the seventh grade. Because Jasmine was a poor student, she was examined by a psychiatrist who concluded that Jasmine has dyslexia. Acting on the psychiatrist’s recommendation, Jason enrolls Jasmine in a private school so that she can receive individual attention. The school specializes in students with learning disabilities and has a program of study designed to help students with dyslexia (including a staff of educational and psychological professionals who have developed the specialized curriculum).
The expense related to Jasmine’s attendance is deductible as a medical expense. The cost of any psychiatric care also qualifies as a medical expense.
Capital Expenditures for Medical Purposes
When capital expenditures are incurred for medical purposes, they must be deemed medically necessary by a physician and used primarily by the patient. In addition, their costs must be reasonable. Examples include dust elimination systems, elevators, and vans specially designed for wheelchair-bound taxpayers. Other expenditures that may qualify are swimming pools (if the taxpayer does not have access to a neighborhood pool) and air conditioners if they do not become permanent improvements (e.g., window units).
Both a capital expenditure for a permanent improvement and related operating and maintenance costs may qualify as medical expenses. The allowable costs are deductible in the year incurred. Although depreciation is required for most other capital expenditures, it is not required for those qualifying for medical purposes (in other words, the entire cost of a qualifying capital expenditure is immediately deductible).
A permanent capital improvement that ordinarily would not have a medical purpose qualifies as a medical expense if it is directly related to prescribed medical care (e.g., an elevator in a personal residence). Here, the cost is deductible to the extent it exceeds the increase in value of the related property. Appraisal costs related to capital improvements are not medical expenses. Instead, these costs are classified as miscellaneous itemized deductions (expenses incurred in the determination of the taxpayer’s tax liability). However, the deduction for miscellaneous itemized deductions has been suspended from 2018 through 2025 (see text Section 10-6).
Example 6
Fred is afflicted with heart disease. His physician advises him to install an elevator in his residence so that he will not be required to climb the stairs. The cost of installing the elevator is $10,000, and the increase in the value of the residence is determined to be only $4,000.
Therefore, $6,000 ($10,000 − $4,000) is treated as a medical expense. Additional utility costs to operate the elevator and maintenance costs are also medical expenses as long as the medical reason for the capital expenditure continues to exist.
The full cost of certain home-related capital expenditures incurred to enable a physically handicapped individual to live independently and productively qualifies as a medical expense. Qualifying costs include expenditures for constructing entrance and exit ramps to the residence, widening hallways and doorways to accommodate wheelchairs, installing support bars and railings in bathrooms and other rooms, and adjusting electrical outlets and fixtures. These expenditures are only subject to the AGI floor; the increase in the home’s value is deemed to be zero.
Medical Expenses Incurred for Spouse and Dependents
In computing the medical expense deduction, a taxpayer may include medical expenses for a spouse and for a person who was a dependent at the time the expenses were paid or incurred. Of the requirements that normally apply in determining dependency status, neither the gross income nor the joint return test applies in determining dependency status for medical expense deduction purposes.
Example 7
William (age 22) is married and a full-time student at a university. During the year, William incurred medical expenses that were paid by Sheba (William’s mother). She provided more than half of William’s support for the year.
Even if William files a joint return with his wife, Sheba may claim the medical expenses she paid for him. Sheba would combine William’s expenses with her own before applying the AGI floor.
For divorced persons with children, a special rule applies to the noncustodial parent. The noncustodial parent may claim any medical expenses paid even though the children are not the noncustodial parent’s dependents.
Example 8
Sam and Joan were divorced last year, and Joan was awarded custody of their child, Keith. During the current year, Sam pays $2,500 of Keith’s medical bills. Together, Sam and Joan provide more than half of Keith’s support.
Even though Keith is Joan’s dependent, Sam can combine the $2,500 of medical expenses that he pays for KTransportation, Meal, and Lodging Expenses for Medical Treatment
Payments for transportation to and from a point of treatment for medical care are deductible as medical expenses (subject to the AGI floor). These costs include bus, taxi, train, or plane fare; charges for ambulance service; and out-of-pocket expenses for the use of an automobile. A mileage allowance of 18 cents per mile for 2022 may be used instead of actual out-of-pocket automobile expenses. Whether the taxpayer chooses to claim out-of-pocket automobile expenses or the 18 cents per mile automatic mileage option, related parking fees and tolls also can be deducted. Also included are transportation expenditures for someone like a family member or nurse who must accompany the patient. The cost of meals while en route to obtain medical care is not deductible.
A deduction is allowable for lodging while away from home for medical care if the following requirements are met:
⦁ The lodging is primarily for and essential to medical care.
⦁ Medical care is provided by a physician in a licensed hospital or a similar medical facility (e.g., a clinic).
⦁ The lodging is not lavish or extravagant.
⦁ There is no significant element of personal pleasure in the travel.
The deduction for lodging expenses cannot exceed $50 per night for each person. The lodging deduction is allowed not only for the patient but also for anyone who must travel with the patient.
Example 9
The Big Picture
Return to the facts of The Big Picture. John’s mother, Martha, eventually moves in with the Williamsons because of her declining health, and she becomes their dependent. Later, John is advised by Martha’s physician that she needs specialized treatment for her heart condition. Consequently, John and Martha fly to Cleveland, Ohio, where Martha receives the therapy at a heart clinic on an outpatient basis. Expenses in connection with the trip are as follows:
Round-trip airfare ($250 each) $500
Lodging in Cleveland for two nights ($120 each per night) 480
Assuming that the Williamsons itemize their deductions (including medical expenses), the medical expense deduction for transportation is $500 and the medical expense deduction for lodging is $200 ($50 per night per person). Because of the severity of Martha’s health condition, it is assumed that John’s accompanying her is justified.
No deduction is allowed for the cost of meals unless they are part of the medical care and are furnished at a medical facility. If deductible, these meals are not subject to the 50 percent limit applicable to business meals (see text Section 9-6).
eith with his own when calculating his medical expense deduction.
Amounts Paid for Medical Insurance Premiums
Medical insurance premiums (including Medicare insurance costs withheld from a Social Security recipient’s monthly benefits) are included with other medical expenses subject to the AGI floor. Premiums paid by the taxpayer under a group plan or an individual plan are included as medical expenses. If an employer pays all or part of the taxpayer’s medical insurance premiums, the amount paid by the employer is not included in the employee’s gross income (and these amounts are not deductible by the employee). However, the medical insurance premiums paid by the employer are deductible as business expenses on the employer’s tax return.
If a taxpayer is self-employed, insurance premiums paid for medical coverage are deductible as a business expense (for AGI). The deduction for AGI is allowed for premiums paid for the taxpayer, the taxpayer’s spouse, and dependents of the taxpayer. However, this deduction is not allowed if the taxpayer (or taxpayer’s spouse) is eligible to participate in an employer-provided health plan.
Example 10
The Big Picture
Return to the facts of The Big Picture. John Williamson is the sole practitioner in his unincorporated accounting practice. During the year, he paid health insurance premiums of $12,000 for his own coverage and $8,000 for coverage for his wife, Kiara. John can deduct $20,000 as a business deduction (for AGI) in computing their taxable income.
Taxpayers also may include premiums paid on qualified long-term care insurance contracts in medical expenses, subject to limitations based on the age of the insured. For 2022, the per-person limits range from $450 for taxpayers age 40 and under to $5,640 for taxpayers over age 70.
Year of Deduction
Regardless of a taxpayer’s method of accounting, medical expenses are deductible only in the year paid. In effect, individual taxpayers are on a cash basis for the medical expense deduction. One exception, however, is allowed for deceased taxpayers. If the medical expenses are paid within one year from the day following the day of death, they can be treated as being paid at the time they were incurred. As a result, these expenses may be reported on the final income tax return of the decedent or on earlier returns if incurred before the year of death.
No current deduction is allowed for payment for medical care to be rendered in the future unless the taxpayer is under an obligation to make the payment. Whether an obligation to make the payment exists depends on the policy of the physician or the institution furnishing the medical care.
Example 11
Upon the recommendation of his regular dentist, in December 2022, Terrell consults Dr. Smith, a prosthodontist, who specializes in crown and bridge work. Dr. Smith tells Terrell that he can do the necessary restorative work for $12,000 and that he requires all new patients to prepay 40% of the total cost of the procedure. Accordingly, Terrell pays $4,800 in December 2022. The balance of $7,200 is paid when the work is completed in January 2023.
Under these circumstances, the qualifying medical expense deductions are $4,800 for 2022 and $7,200 in 2023. The result would be the same even if Terrell prepaid the full $12,000 in 2022.
Reimbursements
If medical expenses are reimbursed in the same year as paid, the reimbursement merely reduces the amount that would otherwise qualify for the medical expense deduction. But what happens if the reimbursement occurs in a later year than the expenditure? In computing casualty losses, any reasonable prospect of recovery must be considered (refer to text Section 7-3). For medical expenses, however, any expected reimbursement is disregarded in measuring the amount of the deduction. Instead, the reimbursement is accounted for separately in the year in which it occurs.
Under the tax benefit rule, a taxpayer who receives an insurance reimbursement for medical expenses deducted in a previous year must include the reimbursement in income up to the amount of the deductions that decreased taxable income in the earlier year. A taxpayer who did not itemize deductions in the year the expenses were paid did not receive a tax benefit and is not required to include a reimbursement in gross income.
Example 12
Daniel had AGI of $45,000 for 2022. He was injured in a car accident and paid $4,300 for hospital expenses and $1,700 for doctor bills. Daniel also incurred medical expenses of $600 for his dependent child. In 2023, Daniel was reimbursed $950 by his insurance company for the medical expenses attributable to the car accident. His deduction for medical expenses in 2022 is computed as follows:
Assume that Daniel would have elected to itemize his deductions even if he had no medical expenses in 2022. If the reimbursement for medical care had occurred in 2022, the medical expense deduction would have been only $2,275 [$6,600 (total medical expenses) − $950 (reimbursement) − $3,375 (floor)] and Daniel would have paid more income tax.
Because the reimbursement was made in a subsequent year, Daniel will include $950 in gross income for 2023. If Daniel had not itemized in 2022, he would not have included the $950 reimbursement in 2023 gross income because he would have received no tax benefit for the medical expenses in 2022.
Health Savings Accounts
Qualifying individuals may make deductible contributions to a Health Savings Account (HSA). A taxpayer can use an HSA in conjunction with a high-deductible medical insurance policy to help reduce the overall cost of medical coverage. Converting from a low-deductible to a high-deductible plan generally can save an individual a considerable amount in premiums. The high-deductible policy provides coverage for extraordinary medical expenses (in excess of the deductible), and expenses not covered by the policy can be paid with funds withdrawn tax-free from the HSA.
Example 13
Antonio, who is married and has three dependent children, carries a high-deductible medical insurance policy with a deductible of $4,400. He establishes an HSA and contributes the maximum allowable amount to the HSA in 2022.
During 2022, Antonio’s family incurs medical expenses of $7,000. The high-deductible policy covers $2,600 of the expenses ($7,000 expenses − $4,400 deductible). Antonio may withdraw $4,400 from the HSA to pay the medical expenses not covered by the high-deductible policy.
High-Deductible Plans
High-deductible policies are less expensive than low-deductible policies, so taxpayers with low medical costs can benefit from the lower premiums and use funds from the HSA to pay costs not covered by the high-deductible policy. A plan must meet two requirements to qualify as a high-deductible plan.
⦁ The annual deductible in 2022 is not less than $1,400 for self-only coverage ($2,800 for family coverage).
⦁ The annual limit in 2022 on total out-of-pocket costs (excluding premiums) under the plan does not exceed $7,050 for self-only coverage ($14,100 for family coverage).
Tax Treatment of HSA Contributions and Distributions
To establish an HSA, a taxpayer contributes funds to a custodial account. As illustrated in the preceding example, funds can be withdrawn from an HSA to pay medical expenses that are not covered by the high-deductible policy. The following general tax rules apply to HSAs:
⦁ Contributions made by the taxpayer to an HSA are a deduction for AGI (i.e., the contributions reduce gross income in arriving at AGI). As a result, the taxpayer does not need to itemize to take the deduction.
⦁ Earnings on HSAs are not subject to taxation unless distributed, in which case taxability depends on the way the funds are used.
⦁ Distributions from HSAs are excluded from gross income if they are used to pay for medical expenses not covered by the high-deductible policy.
⦁ Distributions that are not used to pay for medical expenses are included in gross income and are subject to an additional 20 percent penalty if made before age 65, death, or disability. Any distributions made by reason of death or disability and distributions made after the HSA beneficiary becomes eligible for Medicare are taxed but not penalized.
HSAs have at least two other attractive features. First, an HSA is portable. Taxpayers who switch jobs can take their HSAs with them. Second, anyone under age 65 who has a high-deductible plan and is not covered by another policy that is not a high-deductible plan can establish an HSA.
Deductible Amount
The annual deduction for contributions to an HSA is limited to an amount that depends on whether the taxpayer has self-only coverage or family coverage. The annual limit for an individual who has self-only coverage in 2022 is $3,650, and the annual limit for an individual who has family coverage in 2022 is $7,300. These amounts are subject to annual cost-of-living adjustments. An eligible taxpayer who has attained age 55 by the end of the tax year may make an additional annual contribution in 2022 of up to $1,000. This additional amount is referred to as a catch-up contribution. A deduction is not allowed after the individual becomes eligible for Medicare coverage.
Example 14
Determining the Maximum HSA Contribution Deduction
Liu (age 45), who is married and self-employed, carries a high-deductible medical insurance policy with family coverage and an annual deductible of $4,000. In addition, he has established an HSA. Liu’s maximum annual deductible contribution to the HSA in 2022 is $7,300.
Example 15
Determining the Maximum HSA Contribution Deduction
During 2022, Adam, who is self-employed, made 12 monthly payments of $1,200 for an HSA contract that provides medical insurance coverage with a $3,600 deductible. The plan covers Adam, his wife, and two children. Of the $1,200 monthly fee, $675 was for the high-deductible policy and $525 was deposited into an HSA.
Because Adam is self-employed, he can deduct $8,100 of the amount paid for the high-deductible policy ($675 per month × 12 months) as a deduction for AGI (refer to Example 10 and related discussion). In addition, he can deduct the $6,300 ($525 × 12) paid to the HSA as a deduction for AGI. Note that the $6,300 HSA deduction does not exceed the $7,300 annual ceiling.
Affordable Care Act Provisions
Information about the tax provisions of the Affordable Care Act can be found in an online appendix to the text.
Taxes
LO.3
Contrast deductible taxes with nondeductible fees, licenses, and other charges.
A deduction is allowed for certain state and local taxes paid or accrued by a taxpayer.
Deductibility as a Tax
It is important to understand the difference between a tax and a fee, because fees are not deductible unless incurred as a business expense or as an expense in the production of income. Here is the IRS definition of a tax:
The word taxes has been defined as an enforced contribution, exacted pursuant to legislative authority in the exercise of taxing power, and imposed and collected for the purpose of raising revenue to be used for public or governmental purposes and not as payment for some special privilege granted or service rendered.
As a result, fees for dog licenses, automobile inspections, automobile titles and registration, hunting and fishing licenses, bridge and highway tolls, driver’s licenses, parking meter deposits, and postage are not taxes.
Not all taxes are deductible. For example, Federal income taxes are not deductible. Other taxes are not deductible by individuals if they relate to personal activities (rather than business activities). An example is excise taxes included in the cost of purchasing gasoline. Deductible and nondeductible taxes are summarized in Exhibit 10.2.
Exhibit 10.2
Deductible and Nondeductible Taxes
Deductible Nondeductible
State, local, and foreign real property taxes
State and local personal property taxes
State and local income taxes or sales/use taxes
Foreign income taxes Federal income taxes
FICA taxes imposed on employees
Employer FICA taxes paid on domestic household workers
Estate, inheritance, and gift taxes
Federal, state, and local excise taxes (e.g., gasoline, tobacco, and spirits)
Foreign income taxes if the taxpayer chooses the foreign tax credit option
Taxes on real property to the extent these taxes are to be apportioned and treated as imposed on another taxpayer
State and Local Taxes—For AGI versus From AGI
State and local taxes imposed directly on business or rental property are deductible for AGI. For example, real property taxes imposed on the buildings or personal property taxes imposed on the equipment used by a sole proprietor are deductible as a business expense [for AGI; reported on Schedule C (Form 1040)]. Real property taxes imposed on an individual’s rental property are also deductible for AGI [reported on Schedule E (Form 1040)].
In contrast, real property taxes imposed on an individual’s personal residence are only deductible if the individual itemizes deductions [i.e., from AGI; reported on Schedule A (Form 1040)]. Additionally, real property taxes imposed on investment property (e.g., undeveloped land held for investment) are deductible as an itemized deduction (and not subject to the annual cap on state and local taxes discussed below).
Generally, state and local income taxes are considered to be only indirectly imposed on an individual’s business and investment activity. Consider a sole proprietor with income who is operating in a state that imposes an income tax. This business owner pays state income taxes on this business income. The calculation of this state income tax, though, depends on other income and deductions of the sole proprietor as well as filing status and tax credits. As a result, the income tax is not directly imposed on the sole proprietorship business income (unlike property taxes that are directly imposed on the property used by the business). Since the income tax is not directly imposed on the business income, the state income tax is only deductible from AGI.
Changes made by Congress in 2017 make more relevant the distinction between state and local taxes directly imposed on a business versus those taxes indirectly imposed, as explained next.
Overall Limit on State and Local Taxes
From 2018 through 2025, the deduction for state and local taxes (including property taxes and either income taxes or sales taxes) is limited to a maximum of $10,000 per year ($5,000 if married filing separately). This limit applies to the taxes deductible from AGI that are not directly imposed on business and investment activity or property.
Example 16
Adam owns and operates a dry cleaning business as a sole proprietorship. During 2022, Adam paid $7,000 of real property taxes on the building used in the business and $1,200 of personal property taxes on the equipment used in the business. In calculating and paying estimated state income taxes of $5,600 for 2022, Adam included the profit from his sole proprietorship, his investment income, and his itemized deductions and claimed a state tax credit for solar panels he installed on his home.
The $8,200 of property taxes imposed on his business ($7,000 + $1,200) is deductible for AGI [on Schedule C (Form 1040)], but his state income taxes are deductible from AGI [on Schedule A (Form 1040)]. Only the $5,600 of state income taxes is subject to the $10,000 limit on state and local taxes, not the $8,200.
Now assume that in addition to his state income taxes, Adam paid $6,000 of property taxes on his personal residence in 2022. His total state and local taxes are $11,600 ($5,600 + $6,000), and his Federal itemized deduction for state and local taxes is limited to $10,000.
Property Taxes
LO.4
Explain the Federal income tax treatment of property taxes, state and local income taxes, and sales taxes.
State, local, and foreign taxes on real property are generally deductible only by the person upon whom the tax is imposed. Foreign real property taxes are not deductible from 2018 through 2025 unless the taxes relate to an individual’s business or investment property. Deductible personal property taxes must be ad valorem (assessed in relation to the value of the property). So a motor vehicle tax based on weight, model, year, and horsepower is not deductible. However, a tax based on value and other criteria will be partially deductible.
Example 17
The Big Picture
Return to the facts of The Big Picture. Assuming that the Williamsons proceed with the purchase of a home, the real estate taxes they pay will be deductible from AGI (subject to the aggregate $10,000 limit) because they qualify to itemize their deductions. They also should review their annual registration statement for their car because a portion of it may represent personal property tax (if based on the value of the car).
For example, assume that in their state, the government imposes a motor vehicle registration tax on 2% of the value of the vehicle plus 40 cents per hundredweight. The Williamsons own a car having a value of $20,000 and weighing 3,000 pounds. They pay an annual registration fee of $412. Of this amount, $400 (2% × $20,000 of value) is deductible as a personal property tax (subject to the aggregate $10,000 annual limit). The remaining $12, based on the weight of the car, is not deductible. Any other amount included in the annual fee (e.g., processing charges) is not a tax.
Assessments for Local Benefits
As a general rule, real property taxes do not include taxes assessed for local benefits if the assessments increase the value of the property (e.g., special assessments for streets, sidewalks, curbing, and other similar improvements). Instead of being deductible, these assessments are added to the basis of the taxpayer’s property. Assessments included for personal benefit (e.g., trash removal and tree trimming) are not deductible and do not affect the basis of the property.
Apportionment of Real Property Taxes between Seller and Purchaser
Real estate taxes for the entire year are apportioned between the buyer and seller on the basis of the number of days the property was held by each during the real property tax year. This apportionment is required whether the tax is paid by the buyer or the seller or is prorated according to the purchase agreement. The apportionment determines who is entitled to deduct the real estate taxes in the year of sale. The required apportionment prevents the shifting of the deduction for real estate taxes from the buyer to the seller or vice versa. In making the apportionment, the assessment date and the lien date are disregarded.
Example 18
A county’s real property tax year runs from January 1 to December 31. Sara, the owner on January 1 of real property located in the county, sells the real property to Bob on June 30. Bob owns the real property from June 30 through December 31. The tax for the real property tax year, January 1 through December 31, is $3,650.
Assuming that this is not a leap year, the portion of the real property tax treated as imposed upon Sara, the seller, is $1,800 [(180/365) × $3,650, January 1 through June 29], and $1,850 of the tax [(185/365) × $3,650, June 30 through December 31] is treated as imposed upon Bob, the buyer.
If the actual real estate taxes are not prorated between the buyer and seller as part of the purchase agreement, adjustments are required. The adjustments are necessary to determine the amount realized by the seller and the basis of the property to the buyer. If the buyer pays the entire amount of the tax, the buyer has, in effect, paid the seller’s portion of the real estate tax and has therefore paid more for the property than the actual purchase price. As a result, the amount of real estate tax that is apportioned to the seller (for Federal income tax purposes) and paid by the buyer is added to the buyer’s basis. The seller must increase the amount realized on the sale by the same amount.
Example 19
Seth sells real estate on October 3 for $400,000. The buyer, Barbara, pays the real estate taxes of $3,650 for the calendar year, which is the real estate property tax year.
Assuming that this is not a leap year, $2,750 (for 275 days) of the real estate taxes is apportioned to and is deductible by the seller, Seth, and $900 (for 90 days) of the taxes is deductible by Barbara.
Barbara has, in effect, paid Seth’s real estate taxes of $2,750 and has therefore paid $402,750 for the property. Barbara’s basis is increased to $402,750, and the amount realized by Seth from the sale is increased to $402,750.
The opposite result occurs if the seller (rather than the buyer) pays the real estate taxes. In this case, the seller reduces the amount realized from the sale by the amount that has been apportioned to the buyer. The buyer is required to reduce the basis by a corresponding amount.
Property Taxes
LO.4
Explain the Federal income tax treatment of property taxes, state and local income taxes, and sales taxes.
State, local, and foreign taxes on real property are generally deductible only by the person upon whom the tax is imposed. Foreign real property taxes are not deductible from 2018 through 2025 unless the taxes relate to an individual’s business or investment property. Deductible personal property taxes must be ad valorem (assessed in relation to the value of the property). So a motor vehicle tax based on weight, model, year, and horsepower is not deductible. However, a tax based on value and other criteria will be partially deductible.
Example 17
The Big Picture
Return to the facts of The Big Picture. Assuming that the Williamsons proceed with the purchase of a home, the real estate taxes they pay will be deductible from AGI (subject to the aggregate $10,000 limit) because they qualify to itemize their deductions. They also should review their annual registration statement for their car because a portion of it may represent personal property tax (if based on the value of the car).
For example, assume that in their state, the government imposes a motor vehicle registration tax on 2% of the value of the vehicle plus 40 cents per hundredweight. The Williamsons own a car having a value of $20,000 and weighing 3,000 pounds. They pay an annual registration fee of $412. Of this amount, $400 (2% × $20,000 of value) is deductible as a personal property tax (subject to the aggregate $10,000 annual limit). The remaining $12, based on the weight of the car, is not deductible. Any other amount included in the annual fee (e.g., processing charges) is not a tax.
Assessments for Local Benefits
As a general rule, real property taxes do not include taxes assessed for local benefits if the assessments increase the value of the property (e.g., special assessments for streets, sidewalks, curbing, and other similar improvements). Instead of being deductible, these assessments are added to the basis of the taxpayer’s property. Assessments included for personal benefit (e.g., trash removal and tree trimming) are not deductible and do not affect the basis of the property.
Apportionment of Real Property Taxes between Seller and Purchaser
Real estate taxes for the entire year are apportioned between the buyer and seller on the basis of the number of days the property was held by each during the real property tax year. This apportionment is required whether the tax is paid by the buyer or the seller or is prorated according to the purchase agreement. The apportionment determines who is entitled to deduct the real estate taxes in the year of sale. The required apportionment prevents the shifting of the deduction for real estate taxes from the buyer to the seller or vice versa. In making the apportionment, the assessment date and the lien date are disregarded.
Example 18
A county’s real property tax year runs from January 1 to December 31. Sara, the owner on January 1 of real property located in the county, sells the real property to Bob on June 30. Bob owns the real property from June 30 through December 31. The tax for the real property tax year, January 1 through December 31, is $3,650.
Assuming that this is not a leap year, the portion of the real property tax treated as imposed upon Sara, the seller, is $1,800 [(180/365) × $3,650, January 1 through June 29], and $1,850 of the tax [(185/365) × $3,650, June 30 through December 31] is treated as imposed upon Bob, the buyer.
If the actual real estate taxes are not prorated between the buyer and seller as part of the purchase agreement, adjustments are required. The adjustments are necessary to determine the amount realized by the seller and the basis of the property to the buyer. If the buyer pays the entire amount of the tax, the buyer has, in effect, paid the seller’s portion of the real estate tax and has therefore paid more for the property than the actual purchase price. As a result, the amount of real estate tax that is apportioned to the seller (for Federal income tax purposes) and paid by the buyer is added to the buyer’s basis. The seller must increase the amount realized on the sale by the same amount.
Example 19
Seth sells real estate on October 3 for $400,000. The buyer, Barbara, pays the real estate taxes of $3,650 for the calendar year, which is the real estate property tax year.
Assuming that this is not a leap year, $2,750 (for 275 days) of the real estate taxes is apportioned to and is deductible by the seller, Seth, and $900 (for 90 days) of the taxes is deductible by Barbara.
Barbara has, in effect, paid Seth’s real estate taxes of $2,750 and has therefore paid $402,750 for the property. Barbara’s basis is increased to $402,750, and the amount realized by Seth from the sale is increased to $402,750.
The opposite result occurs if the seller (rather than the buyer) pays the real estate taxes. In this case, the seller reduces the amount realized from the sale by the amount that has been apportioned to the buyer. The buyer is required to reduce the basis by a corresponding amount.
State and Local Income Taxes and Sales Taxes
The position of the IRS is that state and local income taxes imposed upon an individual are deductible only as itemized deductions, even if the taxpayer’s sole source of income is from a business, rents, or royalties.
Cash basis taxpayers are entitled to deduct state income taxes in the year payment is made. This includes taxes withheld by the employer, amounts paid with the state income tax return when filed, and estimated state income tax payments. If the taxpayer overpays state income taxes, any refund received is included in gross income in the year received to the extent the deduction reduced taxable income in the prior year. See text Section 5-15 for a discussion of how the tax benefit rule applies to state income tax refunds when the overall $10,000 limit on state and local taxes applied in the prior year.
Example 20
Leona, a cash basis, unmarried taxpayer, had $800 of state income tax withheld from her paychecks during 2022. Also in 2022, Leona paid $100 that was due when she filed her 2021 state income tax return and made estimated payments of $300 toward her 2022 state income tax liability. When Leona files her 2022 Federal income tax return in April 2023, she elects to itemize deductions, which amount to $15,500, including the $1,200 of state income tax payments and withholdings, all of which reduce her taxable income.
As a result of overpaying her 2022 state income tax, Leona receives a refund of $200 early in 2023. She will include this amount in her 2023 gross income in computing her Federal income tax. It does not matter whether Leona received a check from the state for $200 or applied the $200 toward her 2023 state income tax.
Individuals can elect to deduct either their state and local income taxes or their sales/use taxes paid as an itemized deduction. This election is intended to provide equity to taxpayers living in states that do not impose a state income tax (but do have sales taxes). Taxpayers making this election can deduct either actual sales/use tax payments or an amount from an IRS table (available on the IRS website). The IRS table amount can be increased by sales tax paid on the purchase of motor vehicles, boats, and other specified items.
Interest
LO.5
Distinguish between deductible and nondeductible interest and apply the appropriate limitations to deductible interest.
A deduction for interest has been allowed since the income tax law was enacted in 1913. However, despite its long history, the interest deduction has been a controversial area for tax policy. Should all interest be allowed as a deduction? If not, what limits should apply? Should an interest deduction be allowed for only the taxpayer’s principal residence (or all residences)? What about interest on credit cards and student loans? Lawmakers and taxpayers continue to raise these questions (and others).
Personal (consumer) interest is not deductible. This includes credit card interest, interest on car loans, and other types of personal interest. However, interest on qualified student loans, qualified residence (home mortgage) interest, and investment interest are deductible, subject to the limits discussed on the next section.
Allowed and Disallowed Items
The Supreme Court has defined interest as compensation for the use of money. The general rule permits a deduction for interest paid or accrued within the taxable year on indebtedness.
Interest on Qualified Student Loans
Taxpayers who pay interest on a qualified student loan may be able to deduct the interest as a deduction for AGI. The deduction is allowed if the proceeds of the loan are used to pay qualified education expenses. These payments must be made to qualified educational institutions.
The maximum annual deduction for qualified student loan interest is $2,500. However, in 2022, the deduction is phased out for taxpayers with modified AGI (MAGI) between $70,000 and $85,000 ($145,000 and $175,000 on joint returns). The interest expense deduction is phased out by applying the following formula:
The deduction is not allowed for taxpayers who are claimed as dependents or for married taxpayers filing separately.
Example 21
In 2022, Curt and Rita, who are married and file a joint return, paid $3,000 of interest on a qualified student loan. Their MAGI was $152,500. Their maximum potential deduction for qualified student loan interest is $2,500, but it must be reduced by $625 as a result of the phaseout rules.
Curt and Rita are allowed a student loan interest deduction of .
Qualified Residence Interest
Qualified residence interest is interest paid or accrued during the taxable year on indebtedness (subject to limitations) secured by a qualified residence of the taxpayer. Qualified residence interest falls into two categories: (1) interest on acquisition indebtedness and (2) interest on home equity loans.
A qualified residence includes the taxpayer’s principal residence and one other residence of the taxpayer or spouse. The principal residence meets the requirement for nonrecognition of gain upon sale under § 121 . The one other residence, or second residence, is used as a residence if not rented or, if rented, meets the requirements for a personal residence under the rental of vacation home rules. A taxpayer who has more than one second residence can choose the qualified second residence each year . A residence includes a house, a cooperative apartment, a condominium, and mobile homes and boats that have living quarters (sleeping, bathroom, and cooking facilities).
Although in most cases interest paid on a home mortgage is fully deductible, there are limitations. A deduction is allowed for interest paid or accrued during the tax year on aggregate acquisition indebtedness. Acquisition indebtedness refers to amounts incurred in acquiring, constructing, or substantially improving the taxpayer’s qualified residence that serves as security for that indebtedness. The amount of acquisition indebtedness is limited based on when the debt was incurred. If the debt is incurred after December 15, 2017, and before January 1, 2026, acquisition indebtedness is limited to $750,000 ($375,000 for married taxpayers filing separate returns). Debt incurred on or before December 15, 2017, is limited to $1 million ($500,000 for married taxpayers filing separate returns). These higher debt limits will apply to all homeowners after 2025, regardless of the date of borrowing.
Example 22
The Big Picture
Return to the facts of The Big Picture. Given that John and Kiara Williamson will need to borrow at least a portion of the purchase price of a new home, a standard mortgage likely will qualify as acquisition indebtedness because the borrowed funds are used to acquire a principal residence. However, the interest on the acquisition indebtedness will be fully deductible only if the amount of the mortgage is $750,000 or less and the mortgage is secured by the home, which is the typical case.
Recall that the Williamsons also are considering what appears to be a less expensive route of using their retirement and taxable investments to secure the debt. If they choose this alternative, the interest will not be deductible as qualified residence interest because the loan would not be acquisition indebtedness .
From 2018 through 2025, interest on home equity loans is not deductible unless the funds are used to improve the principal residence . Home equity loans utilize the personal residence of the taxpayer as security, typically in the form of a second mortgage. If the funds from home equity loans are used for personal purposes (e.g., auto purchases, vacations, medical expenses), the related interest expense is not deductible.
Example 23
Larry owns a personal residence with a fair market value of $600,000 and an outstanding first mortgage of $420,000. Therefore, his equity in his home is $180,000 ($600,000 − $420,000). Larry borrows $75,000 that is secured by a second mortgage on his home to put an addition on his home.
All of Larry’s interest is deductible; both loans are secured by his residence, and the total of the loans ($420,000 + $75,000) does not exceed $750,000 or the value of his residence. If Larry used the home equity loan proceeds to buy a new car and boat, the home equity loan interest would not be deductible.
Mortgage insurance premiums paid by the taxpayer on a qualified residence are deductible (and treated as qualified residence interest). The amount allowed is subject to a phaseout based on AGI; the deduction expired at the end of 2021 but might be extended by Congress.
Interest Paid for Services
Mortgage loan companies commonly charge a fee, often called a loan origination fee, for finding, placing, or processing a mortgage loan. Loan origination fees are typically nondeductible amounts included in the basis of the acquired property. Other fees, sometimes called points and expressed as a percentage of the loan amount, are paid to reduce the interest rate charged over the term of the loan. Essentially, the payment of points is a prepayment of interest and is considered compensation to a lender for the use of money.
In general, points are capitalized and are amortized and deductible ratably over the life of the loan. However, the purchaser of a principal residence can deduct qualifying points in the year of payment. This exception also covers points paid to obtain funds for improvements to a principal residence.
Points paid to refinance acquisition indebtedness (i.e., an existing home mortgage) must be capitalized and amortized as an interest deduction over the life of the new loan.
Example 24
Sandra purchased her residence many years ago, obtaining a 30-year mortgage at an annual interest rate of 6%. In the current year, Sandra refinances the mortgage to reduce the interest rate to 4%. To obtain the refinancing, she has to pay points of $2,600.
The $2,600, which is considered prepayment of interest, must be capitalized and amortized over the life of the mortgage.
Points paid by the seller for a buyer are, in effect, treated as an adjustment to the price of the residence, and the buyer is treated as having used cash to pay the points that were paid by the seller. A buyer may deduct seller-paid points in the tax year in which they are paid if certain conditions are met.
Prepayment Penalty
When a mortgage or loan is paid off in full in a lump sum before its term (early), the lending institution may require an additional payment . This is known as a prepayment penalty and is considered to be interest in the year paid. The general rules for deductibility of interest also apply to prepayment penalties.
Investment Interest
Taxpayers sometimes borrow funds to acquire investment assets (e.g., stock). Congress, however, has limited the deductibility of interest on funds borrowed to purchase or hold investment property. The deduction for investment interest expense is limited to the net investment income for the year and is only deductible if the taxpayer itemizes deductions. A complete discussion of investment interest occurs in text Section 11-4.
Tax-Exempt Securities
No deduction is allowed for interest on debt incurred to purchase or hold tax-exempt securities. Refer to text Section 6-3l for further discussion of this topic.
Restrictions on Deductibility and Timing Considerations
Even if interest expense is deductible (e.g., qualified residence interest), a current deduction still may not be available unless certain additional conditions described below are met.
Taxpayer’s Obligation
Allowed interest is deductible if the related debt represents a bona fide obligation of the taxpayer. For interest to be deductible, both the debtor and the creditor must intend for the loan to be repaid. Intent of the parties can be especially crucial between related parties .
In addition, an individual may not deduct interest paid on behalf of another taxpayer. For example, a shareholder may not deduct interest paid by the corporation on the shareholder’s behalf. Likewise, a husband may not deduct interest paid on his wife’s property if he files a separate return, except in the case of qualified residence interest. If both husband and wife consent in writing, either the husband or the wife may deduct the allowed interest on the principal residence and one other residence.
Time of Deduction
Under the cash method, interest must be paid to secure a deduction. Under the accrual method, interest is deductible ratably over the life of the loan.
Example 25
On November 1, 2022, Ramon borrows $2,000 to purchase computers for his consulting business. The loan is payable in 90 days at 6% interest. On the due date in late January 2023, Ramon pays the $2,000 note and interest amounting to $30.
Ramon can deduct the accrued portion of the interest in 2022 only if he is an accrual basis taxpayer. Otherwise, the entire amount of interest ($30) is deductible in 2023.
Prepaid Interest
The accrual method treatment must be used by cash basis taxpayers for interest prepayments that extend beyond the end of the taxable year. These payments must be allocated to the tax years to which the interest payments relate. This provision prevents cash basis taxpayers from creating tax deductions before the end of the year by prepaying interest.
Classification of Interest Expense
Whether interest is deductible for AGI or as an itemized deduction (from AGI) depends on whether the indebtedness has a business, investment, or personal purpose. If the debt proceeds are used for a business expense (other than performing services as an employee) or for an expense for an activity for the production of rent or royalty income, the interest is deductible for AGI. Business expenses appear on Schedule C of Form 1040, and expenses related to rents or royalties are reported on Schedule E.
If the indebtedness produces qualified residence interest, any deduction allowed is taken from AGI and is reported on Schedule A of Form 1040 (the taxpayer must itemize deductions to get any benefit). Recall, however, that interest on a limited amount of student loans is a deduction for AGI. If the taxpayer is an employee who incurs debt in relation to the taxpayer’s employment, the interest is considered to be personal interest and is not deductible. Debt proceeds used for personal purposes (e.g., to pay for a vacation or personal credit card bills) produce nondeductible personal interest expense.
See Concept Summary 10.1 for a summary of the interest deduction rules.
Concept Summary 10.1
Deductibility of Personal, Student Loan, Mortgage, and Investment Interest
Type Deductible Comments
Personal nterest No Includes any interest that is not qualified residence interest, qualified student loan interest, investment interest, or business interest. Examples include interest on car loans and credit card debt.
