For years, the IRS has been concerned that many taxpayers were routinely exaggerating the deduction they claimed for their non-cash contributions. In an effort to close this popular loophole, two recent tax acts have included provisions limiting the deduction people can claim when donating vehicles, clothing and household items. In this article, we'll show you how these new rules can mean a smaller payback on your return. (To read more about tax deductions, see Traditional IRA Deductibility Limits, 10 Steps To Tax Preparation and Money Saving Year-End Tax Tips.)

New Rules for Donated Vehicles
During October 2004, the American Job Creations Act changed the rules for people who donate their vehicles. As of January 1, 2005, the amount you can deduct for a donated vehicle is generally limited to what the charitable organization sells it for, and not its Blue Book value. Within 30 days of your vehicle's sale, the charity is required to provide you with written acknowledgment including the gross proceeds from the sale.

There are three exceptions to this rule, however. If the charity will use the vehicle for its own purposes, make major repairs or improvements to increase its value, or donate or sell it at a discount to a needy individual, the pre-2005 rules apply and you can base your deduction on the car's fair market value. Just make sure that the charity includes a statement detailing its intentions on its acknowledgment.

If you plan to claim a deduction in excess of $500 in connection with a donated vehicle, make sure you attach the charity's acknowledgment to your tax return. Many charities will incorporate all of this information on new IRS Form 1098-C. Failure to attach an acknowledgment or Form 1098-C to your tax return could result in your deduction being disallowed. (For related reading, see Deducting Your Donations.)

Clothing and Household Items
The Pension Protection Act of 2006, signed into law on August 17, 2006, further limits the deduction you can claim for your non-cash contributions. In addition to sweeping changes to the pension plan rules, this tax act included a provision that limits the charitable deduction you can claim for your clothing and household items. Under the new rules, you can only claim a deduction for donated goods that are in good condition or better.

As always, prior to dropping off your clothing and household items to a charity, don't forget to make a list of what you donate, including each item's condition and approximate fair market value, and file that list along with your other tax documents. Keep in mind that unless an item is brand new or in excellent condition, it is probably worth no more than one-quarter to one-third of its original cost.

To better comply with this new standard, consider taking a few photos of the goods donated, and staple those photos to the list you prepared. If you ever get audited, the IRS will most likely disallow the complete deduction claimed unless you are able to substantiate that the condition of the donated goods was good or better. (Being audited? Check out Surviving The IRS Audit.)

To claim a deduction in excess of $500 for donated goods, you need to complete and attach a Form 8283 to your federal income tax return. And if you're looking to claim a deduction in excess of $5,000, you generally need to attach a written appraisal to your tax form as well. More information about non-cash contributions can be found in IRS Publication 526: Charitable Contributions.

Increased Penalty
What happens if you overstate the amount of your non-cash contributions? The Pension Protection Act of 2006 increases the penalties you might pay. Expect the IRS to assess a penalty of 20% of the understated tax liability if you overstate your charitable donation by at least 150%, and a penalty of 40% if you overstate the deduction by 200% or more.

Complying with New Standards
Complying with this new standard raises many questions for taxpayers. What will the process for determining whether an item is in good condition or better be? Unlike vehicles that have a secondary market allowing charities to easily establish a value for the donated vehicles, coming up with a standardized system to determine the condition and value of donated clothing and household items will be significantly more challenging.

Related Articles
  1. Professionals

    How Legacy Planning Can Help Capture New Clients

    Don’t underestimate the importance of legacy planning with your clients—it could serve as method for you to create new business with any heirs.
  2. Investing

    Baby Boomer Philanthropy Shifts Wealth Adviser Focus

    Wealth advisers who integrate philanthropy and finance planning can stand out with baby boomer clients.
  3. Taxes

    The Top 10 Caribbean Tax Havens

    Discover relevant tax policy information about the top 10 tax havens located in the Caribbean, including the Cayman Islands and the Bahamas.
  4. Investing

    Why Is Financial Literacy and Education so Important?

    Financial literacy is the confluence of financial, credit and debt knowledge that is necessary to make the financial decisions that are integral to our everyday lives.
  5. Investing

    5 Ways to Reduce Your Taxes After a Windfall Gain

    Windfall income is a welcome padding to any bank account, but plan for the government's share before you start spending.
  6. Retirement

    How Are 401(k) Withdrawals Taxed for Nonresidents?

    As a U.S. nonresident, deciding what to do with your 401(k) after you return home comes down to which tax penalties, if any, you're willing to incur.
  7. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  8. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  9. Retirement

    Why Some Celebs Say 'No Inheritance for My Kids'

    To some of the super rich, inherited wealth is not the ultimate gift, it's a burden. Here's how their children—as well as charities—stand to benefit.
  10. Taxes

    The 5 Countries Without Income Taxes

    Discover information on some of the best countries to consider relocating to that offer the financial benefit of charging no income tax.
  1. Are Cafeteria plans taxable?

    Whether the benefits you receive through your employer-sponsored cafeteria plan are taxable depends entirely on which benefits ... Read Full Answer >>
  2. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  3. Why is Luxembourg considered a tax haven?

    Luxembourg has been the tax haven of choice for many corporations and mega-rich individuals around the world since the 197 ... Read Full Answer >>
  4. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  5. Why is Panama considered a tax haven?

    The Republic of Panama is considered one of the most well-established pure tax havens in the Caribbean due to extensive legislation ... Read Full Answer >>
  6. Why is Andorra considered a tax haven?

    Andorra is one of many locations around the globe considered a tax haven because of its relatively lenient tax laws. However, ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!