Since most people won't itemize, they can tune out this next section, but if you're one of the 25 percent of people who do itemize, here's the skinny on what you can or can't deduct on Schedule A.
The first deductible item is for medical expenses. When I first started to do my taxes as a youngster, I thought I'd be smart and save my receipts for all my routine medical and dental check ups.
I figured that I'd clean up by deducting these bills. Boy was I wrong. The truth is, unless you've got one foot in the grave and don't have insurance, you probably won't be able to take advantage of this deduction.
The reason for this is that the medical deduction only helps you if your unreimbursed medical expenses total more than 7.5 percent of your AGI.
Still, if you have a low AGI and high medical bills, you might want to look into this deduction. Note that medical insurance payments and payments to an HMO are potentially big payments that qualify for this deduction. Also, long-term care insurance premiums became deductible medical expenses starting in 1997.
Next comes state and local taxes. You also can deduct foreign taxes on Schedule A, but you're better off getting a credit, which I'll explain later.
When it comes to state and local taxes, there are no real strings attached. Just total up the state and local income taxes you paid, and the property taxes you paid. There's no AGI threshold to worry about.
There are a few caveats, however. The first is that sales taxes are no longer deductible. Another is that assessments by a local government for services like garbage removal aren't deductible either.
Finally, if you itemize and deduct state income taxes this year, and then receive a state income tax refund next year, you'll have to report that refund as taxable income next year.
And be careful here. The IRS and state governments exchange tax information, and if you don't include the refund in next year's federal return, you'll probably get an IRS letter.
Interest you paid
The next deductible item is interest. The main items here are mortgage and investment interest. You no longer can deduct personal interest for things like credit cards or automobiles used for personal reasons.
You can deduct the interest you pay to buy up to two homes. Mortgages that total up to $1 million, and the interest on up to $100,000 in home equity financing, are deductible.
The interest you paid is reported to you on Form 1098 which your lender should send to you. It should go without saying that if your deduction is different from the amount on the Form 1098, you'll be asking for an IRS letter.
If you've just purchased a house, you can deduct the entire amount of the points or prepaid interest that you made. However, if you paid points when you refinanced a mortgage, you can't deduct the points immediately. You'll have to amortize or spread-out the points over the life of the loan.
Note that the IRS says that a home is defined as a place that has sleeping, cooking, and bathing facilities, so even a houseboat or motor home may qualify as a first or second house.
If you have a second home that you don't use personally but instead rent out on a full-time basis, you should deduct that home's interest on Schedule E. However, if you have a second home that you use personally, as well as rent out, you've got some hoops to jump through. Read the IRS instructions to see how to handle this.
In addition to home mortgage interest you can also deduct investment interest. I'm always amazed about how people get all excited about piling on mortgage debt. This is a great deal, they tell you, because mortgage interest is deductible.
But strangely, these same people don't have the faintest idea that they can deduct investment interest. If your goal in life is to maximize deductible interest, you also can look at investment interest.
Investment interest is interest you pay to buy an investment like stocks, bonds, mutual funds or raw land. A more popular way to describe this type of borrowing is a margin loan.
Unlike home mortgage interest, which is limited to $1.1 million in principal, you can deduct an unlimited amount of investment interest, with one big caveat : You can only deduct interest equal to your current income from investments.
You can treat the capital gains from your investments as income which can offset the interest expense, but you can't get favorable capital gains treatment for the income and then fully offset the investment interest with that income.
Buying stocks and bonds on margin becomes more attractive because the deductibility of investment interest lowers your effective interest rate. Still, I can't recommend that you take advantage of this.
See my tape on stock investing for details on this, but buying securities on margin is not for the faint of heart. If the market moves against you for an extended period of time you could wind up with a large loss or even become bankrupt. Play it safe and don't buy securities on margin.
Charitable gifts are the next item on Schedule A. One nice thing about charitable items is that there's no threshold level like there is for medical expenses.
If you give $1,000 to a recognized charity, you should be able to get a $1,000 deduction. Your deduction may be limited, however, if you give away more than 20 percent of your AGI, but for most people this isn't an issue.
There are, of course, other regulations. The first is that you must give to a recognized charitable, educational, or religious organization. Money that you give to individuals like your down-on-his-luck-brother-in-law isn't deductible.
Check the IRS list if you have a question about the group you're giving money to. Donations for political reasons are not deductible. If you give more than $250 to an organization, you should get a receipt.
Also, if you receive something of value for your contribution, the entire contribution is not deductible. Suppose you attend a $100-a-plate charity dinner. You'll only be able to deduct $75 if the value of the dinner is $25.
Finally, the value of your time is not deductible. If you make $20 an hour and you donate 10 hours to a charity, you can't deduct $200. You can only deduct out-of-pocket expenses.
Casualty and theft losses
Casualty and theft losses come next on Schedule A. These losses are like medical expense deductions. Unless you've had a big uninsured loss, don't bother with this.
There are several reasons for this. One is that there is a $100 deductible for each loss. Let's say someone stole your $95 watch. You won't be able to claim the loss because of the $100 deductible per loss.
A threshold level also limits your ability to use this deduction. You can only deduct total casualty losses that exceed 10 percent of your AGI. Insurance reimbursements also reduce the losses you can claim.
If you suffered a major loss from something like a natural disaster, you should look into this deduction, but it won't help the majority of people.
The last deduction on Schedule A is job expenses and other miscellaneous deductions. These expenses have a threshold level like medical and casualty items, but the threshold is lower at only 2 percent of your AGI.
These threshold levels are one of the big reasons why you want a low AGI. If your adjusted gross income is low, your threshold is also low, and more of your expenses become deductible.
I think more people should take a look at job expenses and miscellaneous deductions. Here's an example of why.
Assume that you work for a small publishing company. Three times a week you have to drive from your employer's office, cross-town to the printer, and then back to the office. Your employer doesn't reimburse you for your expenses.
Commuting to and from your home is never deductible, but your day trips to the printer should be deductible.
The round trip to the printer is 40 miles, so in a year you drive about 6,000 miles. Since the standard IRS mileage rate is about 30 cents a mile, you've run up $1,800 in travel expenses, according to the IRS.
Further assume your AGI is $25,000. Two percent of $25,000 is $500. So after the 2 percent threshold, you can deduct $1,300 in employee business expenses.
Remember, only a few people benefit from deductions
However, remember this before you start adding up all those unreimbursed business expenses. This makes sense only if you itemize your deductions. The standard deduction for singles is about $4,000, and it's about $6,700 for couples filing jointly.
If your itemized deductions don't add up to more than these figures, don't even bother itemizing. Again, having a large home mortgage is probably the single biggest factor that will push you into itemizing your deductions.