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.

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