There is no downside to a tax exemption. Federal, state, and local governments create them to provide a benefit to specific people, businesses, or other entities in special situations. Those who are entitled to them save on taxes as 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. Because a portion of income is ignored, the taxpayer's total liability is reduced.
Here’s a look at the different kinds of tax exemptions.
- A tax exemption is an amount that is subtracted from a taxpayer's taxable income, reducing the amount of money they have to pay taxes on.
- The most familiar tax exemption is the federal standard deduction, though many individuals claim the itemized deduction instead.
- State and local tax filings often have less well-known exemptions, too.
- Tax exemptions are aimed at encouraging or sheltering a particular group of people by providing them a tax benefit.
- The IRS or governing agency often requires a taxpayer to list their gross income, then list all deductions, then calculate tax on the net figure.
Primary Federal Income Tax Exemptions
Federal tax law gives each individual or family this deduction just for being taxpayers who file returns. The premise of the standard deduction is that every taxpayer has a portion of their income that is tax-free. The standard deduction is driven off of a taxpayer's federal income tax filing status.
For the 2022 tax year, the standard deduction for single taxpayers and married couples filing separately is $12,950, while the standard deduction increases to $13,850 for the 2023 tax year. For married couples filing jointly, it is $25,900 for the 2022 tax year and $27,700 for the 2023 tax year.
An itemized deduction is an alternative to the standard deduction; a taxpayer may claim one or the other. Tax rules permit specific types of transactions to be deducted from a taxpayer's income. If a taxpayer incurs enough of these transactions (or incurs just one very large transaction), it may be more favorable for them to elect an itemized deduction as opposed to the standard deduction.
Examples of itemized deduction categories include mortgage interest paid on a home, state income taxes, local income taxes, sales tax returns, property taxes, medical and dental expenses that exceed 7.5% of the taxpayer's AGI, and charitable contributions.
Tax authorities will often require taxpayers to report both their gross income and their tax exemptions (as opposed to only reporting a single net number).
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 required. Even the term “senior” differs with the locality. Washington State offers a senior exemption from age 61 and 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, New York gives 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, which is no longer available to new applicants, 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 a disabled veteran.
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.
Exemptions vs. Credits
On certain tax returns, some taxpayers may receive both exemptions and credits. Both are generally favorable towards the taxpayer, but each has a different mechanism for benefiting the filer.
Tax exemptions reduce the amount of income you owe tax on. Instead of having to pay taxes on your gross earnings, you're allowed to subtract certain figures from this amount to arrive at an adjusted gross income. For example, if you earned $100,000 last year but are eligible for a $5,000 deduction, your taxable income is $95,000.
Tax credits, on the other hand, directly impact the amount of tax you are assessed. Say the applicable tax table dictates that $95,000 of taxable income is assessed $15,000 of tax. A tax credit of $1,000 would reduce the amount of taxes owed to $14,000. Non-refundable tax credits can reduce the amount of tax owed down to $0, while refundable tax credits can create a tax refund for the taxpayer.
Frequently Asked Questions
Is It Better to Claim 0 or 1 Exemptions on a W-4?
Taxpayers that list a lower number of exemptions on their W-4 will have more money automatically withheld from their paycheck for taxes. Taxpayers that report 0 exemptions on their W-4 will have the most amount of tax automatically withdrawn.
What Organizations Are Exempt From Tax?
The IRS permits companies that meet certain criteria under Internal Revenue Code Section 501(c)(3) to be exempt from federal tax. These organizations include but are not limited to religious, charitable, scientific, literary, education, or other specific types of entities.
The Bottom Line
Taxpayers often do not pay taxes on the gross or full amount of revenue they earned. This is because some or all of this income may be exempt from taxes. Tax exemptions are built into tax codification to provide benefits to certain demographics, individuals who recently entered into specific types of transactions, or specific legal entities. Tax exemptions work by reducing the income basis in which income tax is calculated.