How to Itemize Deductions

We recently wrote this letter to a client who purchased a house and wanted to know what to deduct:

Dear Andrew…
Congratulations on your home purchase. Your home mortgage interest is tax-deductible so you are now going to be able to itemize deductions instead of claiming the standard deduction on your tax return. You must attach Schedule A to your tax return. Here are the categories of itemized deductions:

Medical Expenses

This category includes prescription medications but not over-the-counter medicine or supplements, even if recommended by a physician. Also included are premiums for healthcare, vision, dental, and long-term care insurance, as long as they are paid by you and not out of pre-tax dollars from your paycheck. Of course you include any direct payments to doctors, dentists, chiropractors, physical therapists, hospitals, labs, and clinics as well as your insurance co-payments. Only deduct what you actually paid last year for you, your spouse, and your dependents, even if you were billed for more. There are many other categories of expenses that are deductible, including a portion of home improvements made for medical reasons. Let me refer you to IRS Publication 502 for a complete list. Unfortunately, most taxpayers do not qualify for a medical deduction because expenses must exceed 7-1/2% of income before they trigger a deduction.

Taxes

This category includes state and local income tax withheld from your paycheck, any amounts you paid the state when you filed your return last year, and any state estimated tax payments made. You also get to deduct property taxes on your home. Be sure to look on your escrow closing statement to find the amount of pro-rated property tax you were charged when you bought the home. If your taxes are paid by a mortgage impound, deduct the amount paid by the mortgage company to the county, not the amount you paid to the mortgage company. In most states your vehicle registration is also a deductible tax.

Interest

The interest on purchase-money mortgages of up to $1 Million on your principal and one second residence is deductible. In addition, you may deduct the interest on up to $100,000 of home equity financing. Points paid to purchase a principal residence are usually deductible in the year of purchase, but points on a re-finance must be deducted ratably over the life of the loan. Any remaining points on a previous re-finance are written off when you re-finance a second time. You also may deduct investment interest (like on a margin account) to the extent of your investment income.

Charity

See How to Maximize Charitable Deductions for details.

Miscellaneous

This is the catch-all category of itemized deductions. Included are unreimbursed business and investment expenses, education in your profession, and your tax-preparation fees. The instructions for Schedule A at www.irs.gov describe these deductions in detail. Only expenses in excess of 2% of income generate a deduction. Business expenses for self-employed individuals are claimed elsewhere, but since you are an employee and you work in internet multimedia, you should be able to reasonably deduct your home computer expenses, internet access, purchases of software, CDs, and DVDs, and attendance at concerts and movies. You may also qualify for office-in-home deductions if you maintain the office for the convenience of your employer.

Home Improvements

Alas, except as medical expenses, home improvements are not tax-deductible. They do, however, add to the basis of your home. The basis is used to calculate your capital gain when you sell your house. You are entitled to an exclusion of capital gain up to $250,000 per person provided you meet certain requirements, but anything over that would be subject to tax, so it is best to save your receipts for home improvements until 3 years after you sell your house.

Congratulations on your new tax-deduction. Now how about some grandchildren?

Love, Dad

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