What Is a Tax Deduction?

A tax deduction is a deduction that lowers a person’s or an organization’s tax liability by lowering their taxable income. Deductions are typically expenses that the taxpayer incurs during the year that can be applied against or subtracted from their gross income to figure out how much tax is owed. 

Key Takeaways

  • A tax deduction is a deduction that lowers a person’s or an organization’s tax liability by lowering their taxable income.
  • Deductions are typically expenses that the taxpayer incurs during the year that can be applied against or subtracted from their gross income to figure out how much tax is owed. 
  • Taxpayers have the option to take a standard deduction or itemize deductions (if a taxpayer chooses to itemize deductions, then deductions are only taken for any amount above the standard deduction limit).
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Tax Deductions Vs. Tax Credits

Understanding Tax Deductions

Different regions have different tax codes that allow taxpayers to deduct a variety of expenses from taxable income. Tax codes vary at federal and state levels. One form might be 2106-EZ, but that might not apply in some places.

Taxation authorities in both the federal and state governments set tax code standards annually. Tax deductions set by government authorities are often used to entice taxpayers to participate in community service programs for the betterment of society. Taxpayers who are aware of eligible federal and state tax deductions can greatly benefit through both tax deduction and service-oriented activities annually. In the United States, tax deductions are available for federal and state taxes.

An example of a tax deduction is a realized capital loss on a stock, which can be deducted from your overall income tax bill as long as the shares sold were owned for investment purposes.

Tax deductions fall under two categories: standard deductions and itemized deductions. 

Standard Deductions vs. Itemized Deductions

In the United States, a standard deduction is given on federal taxes for most individuals. The amount of the federal standard deduction varies by year and is based on the taxpayer’s filing characteristics. Each state sets its own tax law on standard deductions, with most states also offering a standard deduction at the state tax level. Taxpayers have the option to take a standard deduction or itemize deductions. If a taxpayer chooses to itemize deductions, then deductions are only taken for any amount above the standard deduction limit.

Standard deductions are often the easiest route to choose because there is no need to make a calculation—the amount is already set and determined. Itemized deductions require some calculation and work on the part of the tax filer. For example, if you’re married and filing jointly, have several major expenses like a home and/or major medical expenses, and put money into a retirement fund, then you may benefit from going through the itemized-deductions route. According to the Internal Revenue Service (IRS), the following expenses qualify under itemized deductions:

  • Healthcare costs, including medical bills, dental bills, and prescription drugs
  • Property taxes 
  • Mortgage interest
  • Home office and other job-related expenses

There are a number of common tax deductions, as well as many overlooked tax deductions at federal and state tax levels, that taxpayers can utilize to lower their taxable income. Common tax deductions include charitable donations to nonprofit, religious, humanitarian, or governmental organizations.

Some uncommon tax deductions include sales tax on personal property purchases and annual tax on personal property, such as a vehicle. Many expenses incurred throughout the year for business reasons may also be eligible for itemized deductions, such as networking expenses, travel expenses, and some transportation expenses.

Special Considerations

It’s important to keep in mind that there may be certain limitations on what you can deduct each year to reduce your tax obligation to Uncle Sam. The IRS sets a threshold amount for many deductions that you should research before filing.

For example, if you’re itemizing healthcare deductions, then the threshold for any costs that were not reimbursed during the tax year (and that were paid for yourself, your spouse, and your dependents) has to exceed a certain percent of your adjusted gross income (AGI) or they cannot be deducted. For your 2020 tax return, the threshold for medical expenses is 7.5% of AGI for all taxpayers. Your accountant will be aware of these and any other thresholds, so if you’re using a tax professional, then there should be no need to worry. 

Tax Loss Carryforward

One additional type of deduction not included in the standard or itemized tax deductions is the deduction for capital losses. A tax loss carryforward is a legal means of rearranging earnings to the benefit of the taxpayer. Individual or business capital losses can be carried forward from previous years. You can claim up to $3,000 in capital losses as a tax deduction as of the 2020 tax year (the tax return you would file in 2021).