There is no downside to a tax exemption: The term has a specific meaning in tax law: Federal, state, and local governments create them to provide a benefit to specific people, businesses, or other entities in special situations.
Bottom line: Those who are entitled to them save on taxes.
A tax exemption, as most taxpayers experience it, is the right to subtract some portion of income or some amount of money from top-line income. That income is ignored, so the taxes owed are reduced.
- The most familiar tax exemption is the federal standard deduction.
- Less well-known are state and local exemptions.
- Like any exemption, they are aimed at encouraging or sheltering a particular group of people.
In fact, an exemption may shelter some income, or it may come in the form of a reduction in the value of taxable property. Or, it could mean complete freedom from income taxes for organizations that further the public interest.
Here’s a look at the different kinds of exemptions, starting with the one every taxpayer is entitled to get.
The Standard Deduction
There used to be a personal exemption, which could be claimed in addition to the standard deduction by people who did not itemize their tax deduction. Instead, there's a whopping big standard deduction, passed with the 2017 Tax Cuts and Jobs Act (TCJA).
Federal tax law gives each individual or family this deduction just for being taxpayers who file returns.
For tax year 2020, the standard deduction for single taxpayers and married couples filing separately is $12,400. For married couples filing jointly, it is $24,800, and for heads of households, it is $18,650.
For the 2021 tax year, the standard deduction for single taxpayers and married people filing separately is $12,550. For couples filing jointly, it is $25,100. For heads of households, it is $18,800.
Property Tax Exemptions
State and local governments may give property owners certain exemptions from real estate taxes owed on their property. The exemptions are designed to reward or protect certain classes of homeowners by reducing the amount of taxes paid on the property. Here are some common property tax exemptions:
- Homestead. This exemption is for people who own a home that is their principal residence, in a state or municipality that wishes to encourage that. For example, in Florida, a homestead exemption of up to $50,000 applies to homeowners who are Florida residents. The exemption is not available to those who own vacation homes in the state.
- Age and disability. Seniors and the disabled qualify for property tax reductions in some localities. Age alone may not be sufficient. A showing of financial need may also be needed. Even the term “senior” differs with the locality. Washington State offers a senior exemption from age 61 for veterans and disabled retirees.
- Public service. Military veterans may claim a property tax exemption in some localities, though some restrict the eligibility to disabled veterans. The exemption may continue for the surviving spouse or parents. Some localities offer exemptions for volunteers. For example, some counties in New York give exemptions to volunteer firefighters and ambulance workers.
These are just examples of the exemptions that may be available in some states and municipalities. Others are available for people renovating old houses, installing renewable energy systems, or surviving a spouse.
State and local tax exemptions may benefit veterans, senior citizens, or people with disabilities.
Some exemptions are limited to a portion of property taxes. For example, the New York State School Tax Relief (STAR) exemption for senior citizens applies only to the school tax portion of the bill.
Taking one exemption does not preclude a taxpayer from taking others. For example, a Miami homeowner who takes the homestead exemption might also qualify for other exemptions if they are legally blind or disabled veterans.
Property tax exemptions are not automatic. Homeowners must apply for them and demonstrate their eligibility.
Charities, fraternities, labor organizations, trade associations, churches, and various other entities operate for a specific purpose that does not include making a profit.
The law lets these entities operate without any income tax obligation on the money they receive. (They pay employment taxes for their staff, just as for-profit businesses do.)
Tax-exempt status means that the funds they raise are not treated as income that would be taxed but rather as contributions that are not taxed.
Contributors Get Deductions, Too
Taxpayers can deduct contributions to some but not all tax-exempt organizations. For example, donations to the Red Cross (a 501(c)(3) organization) are deductible, while those to a Chamber of Commerce (a 501(c)(6) organization) are not.
These entities obtain tax-exempt status by applying to the IRS. Special reporting rules apply to those who receive IRS approval.
If a tax-exempt entity receives income from a business activity that is unrelated to its exempt purpose, it has to pay taxes on this income. For example, if a college runs a coffee bar that is open to the public, the income from it could be taxable. If the coffee bar is restricted to the college’s students it would not be taxable.