There is no downside to a tax exemption: The term has a specific meaning in tax law, which is always favorable. Federal, state or local governments create them to provide a benefit to specific people, businesses or other entities in special situations. Bottom line: Those entitled to them save on taxes.
The impact of an exemption may be a subtraction in figuring income tax, a reduction in the value of property on which real estate taxes are computed or a complete out from income taxes for organizations furthering the public interest such as helping those in need or providing education. Here’s a look at the different kinds, starting with the one every taxpayer gets.
Federal tax law gives each individual a basic deduction just for being a taxpayer who files a return; it’s called a personal exemption. The personal exemption is as old as the income tax. The first personal exemption in the amount of $600 was created during the Civil War when the first income tax was imposed (that income tax was later declared unconstitutional). After the 16th Amendment to the Constitution allowed an income tax in 1913, the first $3,000 of income per taxpayer was exempt from tax. Over the years, the amount of the personal exemption has been raised according to revenue needs of the federal government (for example it was increased during WWI and WWII) and lowered when fiscally possible.
The amount of the exemption for 2015 is $4,000. The exemption amount can be adjusted annually by the IRS for inflation.
A similar deduction can be claimed for individuals who qualify as a taxpayer’s dependents (called a dependency exemption). The same dollar amount ($4,000 in 2015) applies for each dependent. There are two classes of dependents: qualifying children and qualifying relatives. Different tests apply to each class.
- Qualifying children. This includes a taxpayer’s child who is under the age of 19 (or under 24 if a full-time student at least five months of the tax year), who does not provide more than half of his or her own support.
- Qualifying relatives. This includes a member of the taxpayer’s household who does not have gross income more than the exemption amount; other tests apply.
So-called high-income taxpayers may lose some or all of the benefit from exemptions. The total amount of their exemptions are phased out when their income for the year exceeds set limits.
Similar personal and dependency exemptions may be allowed for state income tax purposes. The amount of exemptions varies by state.
Property tax exemptions
State and/or localities may give property owners certain exemptions from the real estate taxes owed on their property. The exemptions are designed to reward or protect certain classes of homeowners and reduce the amount of taxes paid on the property. Here are some common property tax exemptions:
- Homestead. This exemption is for owners whose home is their principal residence. For example, in Florida a homestead exemption of up to $50,000 applies for homeowners whose residence is Florida. The exemption does not apply to those owning vacation homes in the state.
- Age and disability. Seniors and the disabled may qualify for property tax reductions. Age alone may not be sufficient; a showing of financial need may also be necessary. The term “senior” differs with locality (e.g., Washington state offers an exemption starting at age 61).
- Public service. Military veterans may claim a property tax exemption in some localities; disability resulting from military service may be required. The exemptions may continue for the widow(er)s or parents of disabled service members. Some localities offer exemptions for volunteers (e.g, certain counties in New York give exemptions to volunteer firefighters and ambulance workers).
These are not the only exemptions that may be available. Others may apply for renovating older homes, installing renewable energy systems (e.g., solar panels) or being a widow(er). Some exemptions may be limited to a portion of property taxes (e.g., New York’s STAR exemption applies only for the school tax portion of the bill). And taking one exemption does not preclude you from taking others (e.g. in Miami, someone taking the homestead exemption might also qualify for other exemptions for being legally blind and a disabled veteran.)
Property tax exemptions are not automatic. Property owners must apply for them and demonstrate eligibility.
Charities, fraternities, labor organizations, trade associations, religious organizations and certain other entities operate for a specific purpose that does not include the objective of making a profit. The law lets these entities operate without any income tax obligation on the income they receive in connection with their exemption function (they pay the same employment taxes for their staff as any for-profit business). 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 can deduct contributions only to specific types of 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 for it from the IRS. Special reporting rules apply to those who receive IRS approval. (For more, see 5 Steps To Forming A Tax-Exempt Nonprofit Corporation.)
If a tax-exempt entity has income from a business unrelated to its exempt purpose that’s derived from an activity it carries on regularly, it has to pay taxes on this income like any other business (called the unrelated business income tax, or UBIT). For example, if a college runs a coffee bar open to the public, this activity could be treated as one giving rise to UBIT (if the coffee bar was restricted to the college’s students it would not be a problem). The tax on unrelated business income came about in 1954 because the IRS rightly suspected that some for-profit companies were operating under the guise of being a tax-exempt entity but could not prove the case in the courts (the most well-known case was New York University’s ownership in the 1940s of C.H. Mueller Co. the largest macaroni company at the time).
The bottom line
It always pays to check on which tax exemptions you may qualify for and then take appropriate action to obtain your tax savings. (For other ways to save on your tax bill, read 7 Most Overlooked Tax Deductions.)