The term deduction is widely used in the tax field. If you are carrying out any procedure at the tax level and you do not have much experience in the area, it is very likely that you need to know what is a tax deduction. In this article we will explain it in detail.
What is a tax deduction and what does it mean?
For tax purposes, a deduction is an expense that an individual or business can subtract from adjusted gross income while filing their tax form. The deduction reduces the declared income and, therefore, the amount of income taxes that must ultimately be paid.
Individual US taxpayers can choose to use the standard deduction or itemize their allowable deductions, they can choose the option that requires them to pay less tax.
Understanding what a tax deduction is and how it is applied
For individual wage earners, the most commonly used tax deductions are for mortgage interest payments, state and local tax payments, student loan interest, and charitable deductions. There is also a deduction for medical expenses, but only for expenses that exceed 7.5% of the taxpayer’s adjusted gross income.
- Earners can take the standard deduction or itemize the different allowable deductions. Most take the standard deduction.
- People who work from home can deduct many of the expenses that correspond to the space used.
- Businesses must itemize all of their operating expenses, as these are deducted from their gross income to arrive at the correct taxable income figure.
People who work from home and maintain a dedicated space for their work can deduct many of the related expenses.
But nevertheless, the vast majority of Americans have taken the standard deduction since 2018, when that number doubled.
As of 2020, the standard deduction for single and married filers filing separately is $12,400. For married filing jointly, the deduction is $24,800. The deduction for a head of household is $18,650.
Standard Deduction Example
Whether the taxpayer uses the standard deduction or applies the itemized one, the amount is subtracted directly from the adjusted gross income. For example, if a single taxpayer reports $50,000 of gross income, based on the figure on the W2 form, they can deduct $12,400. The person’s taxable income is now $37,600.
The current standard deduction for single filers is $12,400. For married filing jointly, the deduction is $24,800.
Itemizing deductions instead of taking the standard deduction also requires completing an additional form. The Schedule A form, used to record the various deductions being claimed, must be attached to the main tax form, Form 1040 or Form 1040-SR.
Filers who take the standard deduction can file only Form 1040. Those who are 65 years of age or older can use Form 1040-SR. It is almost identical to Form 1040, but with larger type.
Tax deductions for businesses are considerably more complex than individual tax deductions and require more control of records. A business or self-employed person must list all income received and all expenses paid in order to report the actual profit of the business. That profit is the gross taxable income of the business.
Examples of ordinary deductible business expenses include payroll, utilities, rent, leases, and other operating expenses. Additional deductions include capital expenses, such as depreciation on equipment or real estate.
Allowable deductions vary by business structure. Limited liability companies (LLCs) and corporations differ in the types and amounts of deductions available to their owners.