Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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Chapter 5
Itemized Deductions
and Other Incentives
LEARNING OBJECTIVES
.............................................. .........................
After completing this chapter, you should be able to:
LO 5.1 Understand the nature and treatment of medical expenses.
LO 5.2 Calculate the itemized deduction for taxes.
LO 5.3 Apply the rules for an individual taxpayer’s interest deduction.
LO 5.4 Determine the charitable contributions deduction.
LO 5.5 Compute the deduction for casualty and theft losses.
LO 5.6 Identify miscellaneous itemized deductions.
LO 5.7 Understand the basic theory behind the itemized deduction
and exemption phase-outs for high-income taxpayers for
years prior to and subsequent to 2010.
LO 5.8 Understand the tax implications of using educational
savings vehicles.
Overview
The tax law allows individual taxpayers to deduct certain items from gross income when cal-
culating taxable income. One kind of deduction is the deduction for (above-the-line) AGI such
as alimony paid, deductible IRAs, and the expenses of self-employed persons (on Schedule C)
or landlords (on Schedule E). These deductions are discussed in Chapters 1–4.
The other type of deduction in the individual tax formula is the deduction from AGI. The
standard deduction in Chapter 1 is an example of a deduction from AGI. This chapter will
introduce the Schedule A itemized deductions and temporary special additions to the stan-
dard deduction. Itemized deductions fall into six categories: medical, state and local taxes,
interest, charitable contributions, casualty and theft losses, and miscellaneous deductions.
Unreimbursed employee expenses are deductible as a miscellaneous itemized deduction.
Most itemized deductions are personal expenses which Congress has deemed to be deductible
for various social or economic policy purposes. For example, in order to encourage home own-
ership, the tax law allows a deduction (within certain limits) for personal home mortgage interest.
When calculating taxable income, individuals determine their standard deduction and their
allowable itemized deductions, and use the larger of the two. For example, if a taxpayer’s stan-
dard deduction is $8,400 and her itemized deductions are $14,200, she would use her itemized
deductions in calculating taxable income. On the other hand, if her itemized deductions were
$6,500, she would use the larger $8,400 standard deduction in computing taxable income.
5-1
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SECTION 5.1
MEDICAL EXPENSES
Medical expenses are the first itemized deduction on Schedule A. Taxpayers are allowed a deduc-
tion for the medical expenses paid for themselves, their spouse, and dependents. Congress
decided, however, that a certain portion of medical expenses is personal in nature and should
not be deductible; therefore, limitations have been established on the amount that may be
deducted. Medical expenses can only be deducted to the extent that they exceed 7.5 percent
of the taxpayer’s AGI. The formula for calculating a taxpayer’s medical expense deduction is
as follows:
Prescription medicines and drugs, insulin, doctors,
dentists, hospitals, medical insurance premiums
$ xxx
Other medical and dental expenses, such as lodging,
transportation, eyeglasses, contact lenses, etc.
xxx
Less: insurance reimbursements (
xxx)
Subtotal xxx
Less: 7.5 percent of adjusted gross income (
xxx)
Excess expenses qualifying for the m edical deduction
$ xxx
What Qualifies as a Medical Expense?
Expenses that are deductible as medical expenses include the cost of items for the diagno-
sis, cure, mitigation, treatment, and prevention of disease. Also included are expenditures
incurred that affect any structure or function of the body. Therefore, amounts for all of the
following categories of expenditures qualify as medical expenses:
Prescription medicines and drugs and insulin
Fees for doctors, dentists, nurses, and other medical professionals
Hospital fees
Hearing aids, dentures, eyeglasses, and contact lenses
Medical transportation and lodging
Medical aids, such as crutches, wheelchairs, and guide dogs
Birth control prescriptions
Acupuncture
Psychiatric care
Medical insurance premiums
Certain capital expenditures
Nursing home care for the chronically ill (e.g., Alzheimer’s disease care)
The IRS has allowed the follow ing unusual medical expenses:
Long-distance phone calls made to a psychological counselor
New siding replacing old siding on a home because the taxpayer was
allergic to mold growing on the old siding
A wig prescribed by a psychiatrist for a taxpayer upset by hair loss
A cell phone for a taxpayer who may need instantaneous medical help
Treatments provided by an Indian medicine man
Certain medical expenses are not deductible. For example, the cost of travel for the gen-
eral improvement of the taxpayer’s health is not deducti ble. The expense of a swimming
5-2 Chapter 5
Itemized Deductions and Other Incentives
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pool is not deductible unless the pool is designed specially for the hydrotherapeutic treat-
ment of the taxpayer’s illness. No deduction is allowed for the cost of weight-loss programs
(unless prescribed by a doctor; diet foods do not qualify) or marriage counseling. Medical
expenses for unnecessary cosmetic surgery or similar procedures are not deductible.
Cosmetic surgery is considered unnecessary unless it corrects (1) a congenital abnormality,
(2) a personal injury resulting from an accident or trauma, or (3) a disfiguring disease. In
general, unnecessary cosmetic surgery is any procedure which is directed at improving the
patient’s appe arance and does not meaningfully promote the proper function of the body
or prevent or treat illness or disease.
Although laws in California, Arizona, and some other states legalize marijuana
for medical use in some instances, the IRS has ruled that taxpayers ca nnot
deduct the cost of marijuana as a medical expense.
Medical Insurance
Medical insuranc e includes standard health policies, whether the benefits are paid to the
taxpayer or to the provider of the services directly. In addition, the premiums paid for
membership in health maintenance plans are deductible as medical insurance, as are sup-
plemental payments for optional Medicare coverage. Insurance policies that pay a specific
amount each day or week the taxpayer is hospitalized are not considered medical insurance
and the premiums are not deductible. Premiums paid for qualified long-term care insur-
ance policies are also deductible medical expenses up to specified limits which change
each year and are based on the age of the taxpayer.
Self-employed taxpayers are allowed, subject to certain limitations, a deduction in arriv-
ing at adjusted gross income equal to 100 percent of the medical insurance premiums paid
for themselves and their families. Long-term car e insurance prem iums, up to a specified
amount based on the taxpayer’s age, are considered health insurance for this pur pose. If
a deduction is taken for these items in arriving at AGI, then these same expenses are
excluded from the medical expense deduction on Schedule A.
Medicines and Drugs
Prescription medicines and drugs and insulin are the only drugs deductible as medical
expenses. No deduction is allowed for drugs purchased illegally from abroad, including
Canada and Mexico. Nonprescription medicines such as over-the-counter antacids, allergy
medications, and pain relievers, even if recommended by a physician, are not deductible as
a medical expense.
Capital Expenditures
Payments for special equipment purchased and installed in the taxpayer’s home for medical rea-
sons may also be deductible. Unlike other capital expenditures, allowable amounts are deducted
fully in the year the item is purchased. If the expenditure is for an improvement that increases
the value of the taxpayer’s property, the deduction is limited to the amount by which the expen-
diture exceeds the increase in the value of the property. If the value of the property does not
increase as a result of the expenditure, the entire cost is deductible. The cost of upkeep and
operation of an item, the cost of which qualified as a medical expense, is also deductible, pro-
vided the medical reason for the improvement or special equipment still exists.
Section 5.1
Medical Expenses 5-3
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EXAMPLE A taxpayer ha s a heart condition and installs an elevator in his home
at a cost of $6,000. The value of the home is increased by $4,000 as
a result of the improvement. The taxpayer is allowed a deduction of
$2,000 ($6,000 $4,000), the excess of the cost of the equipment
over the increase in the value of the taxpayer’s home. N
Transportation
Transportation expenses primarily for and necessary to medical care are deductible, includ-
ing amounts paid for taxis , trains, buses, airplanes, and ambulances. Taxpayers may also
claim a deduction for the use of their personal automobile for medical transportation.
However, only out-of-pocket expenses such as the cost of gas and oil are deductible. Main-
tenance, insurance, general repair, and depreciation expenses are not deductible. If the tax-
payer does not wish to deduct actual costs of transportation by personal automobile, a
standard mileage rate of 16.5 cents per mile may be used to calculate the deduction. In
addition to the deduction for actual automobile costs or the standard mileage amount,
parking and toll fees for medical transportation are deductible medical expenses. If the
transportation expenses are for the medical care of a dependent child, the amounts are
deductible by the parent.
Lodging for Medical Care
Taxpayers may deduct the cost of lodging up to $50 per night, per person, on a trip pri-
marily for and essential to medical care provided by a physician or a licensed hospital. The
deductio n is allowed for the patient and an individual accompanying the patient, such as
the parent of a child. However, no deduction is allowed if the trip involves a significant
element of recreation or vacation. No deduction is allowed for meal costs.
A Las Vegas dentist admitted he provided free dental work to an IRS revenue
officer in exchange for reductions of his $100,000 tax debt. Both men were
indicted on conspiracy and bribery charges.
Health Savings Accounts (HSAs)
Health Savings Accounts (HSAs) combine tax-deductible contributions to medical spend-
ing accounts with qualifying high-deductible medical insurance. Regular health insurance
plans with low deductibles and co-payments will not qualify for use with an HSA. Personal
contributions to an HSA are limited to certain dollar amounts depending on age and
whether the insurance is for an individual or a family. Contributions to HSAs are a deduc-
tion for AGI just l ike the deduction for IRAs. Earnings accumulated in an HSA are not
taxed, and distributions to cover medical expenses are not taxed or penalized. Any amounts
left in the HSA which are not used to pay medical expenses will compound tax free like an
IRA investment.
HSAs are meant to take the place of Medical Savings Accou nts (MSAs), allowed since
1997 but rarely used despite extensive publ icity. The newer HSAs are expected to have
wider appeal since they are available to a variety of taxpayers. Individuals with MSAs
5-4 Chapter 5
Itemized Deductions and Other Incentives
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can roll them over into the new HSAs. For more info rmation on HSAs, con sult the IRS
Web site or a tax research service.
SECTION 5.2
TAXES
The next itemized deduction that taxpayers are allowed is the deduction for certain state,
local, and foreign taxes paid during the year. The purpose of the deduction for taxes is to
relieve the burden of multiple taxation of the same income . However, the tax law distin-
guishes betwee n a ‘‘tax’’ an d a ‘‘fee. ’’ A tax is imposed by a government to raise revenue
for general public purposes, and a fee is a charge with a direct benefit to the person paying
the fee. Taxes are gener ally deductible; fees are not deductible. For example, postage, fish-
ing licenses, and dog tags are not deductible as taxes.
If a taxpayer itemizes his or her deductions on Schedule A, the following taxes are
deductible for 2010:
Income taxes (state, local, and foreign)
Sales taxes (by election in lieu of state and local income tax)
Real estate property taxes (state, local, and foreign)
Personal property taxes (state and local)
The following taxes are not deductible:
Federal income taxes
Employee portion of Social Security taxes
Estate, inheritance, and gift taxes (except in unusual situations not discussed here)
Self-Study Problem 5.1
During the 2010 tax year, Frank and Betty paid the following medical expenses:
Hospitalization insurance $ 425
Prescription medicines and drugs 364
Hospital bills 2,424
Doctor bills 725
Eyeglasses for Frank’s dependent mother 75
Doctor bills for Betty’s sister, who is claimed
as a dependent by Frank and Betty
220
In addition, in 2010, they drove 848 miles for medical transportation in
their personal automobile. Their insurance company reimbursed Frank and
Betty $1,420 during the year for the medical expenses. If their adjusted gross
income for the year is $25,400, calculate their medical expense deduction.
Use the segment of Schedule A of Form 1040 reproduced below.
Section 5.2
Taxes 5-5
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Foreign taxes if the taxpayer elects a foreign tax credit
Gasoline taxes
Excise taxes
Taxes paid in connection with a trade or business or any activity for the production of
income, such as payroll taxes, personal property taxes, etc., are deductible for adjusted
gross income by the taxpayer on Schedule C, E, or F, instead of Schedule A.
Income Taxes and Sales Taxes
Please note: As we go to press, the deduction for sales tax is expected to be extended to 2010
by Congress in the final weeks of 2010. Please see the Whittenburg companion Web site
for updated information.
Taxpayers may elect to take either state and local sales and use taxes or state and local
income taxes as it emized deductions. The election to take a deduction for state sales tax
instead of state income t ax primarily benefits taxpayers in states with no income taxes or
low income tax rates.
For taxpayers electing to deduct state and local income taxes paid during 2010, the
amount of the deduction is the t otal amount of state and local taxes withheld from
wages plus any amounts actually paid during the year, even if the tax pay ments are for a
prior year’s tax liability. If the taxpayer receives a refund of taxes deducted in a previous
year, the refund must generally be include d in gross income in the year the refund is
received. Taxes which did not provide any tax benefit (reduction in taxes) in the year
paid are not required to be included in income in the year received as a refund. For exam-
ple, a taxpayer claiming the standard deduction in the year taxes are paid does not receive a
tax benefit for the payment and is not required to include a tax refund received the follow-
ing year in income.
EXAMPLE For 2010, Mary elects to take state income taxes rather than state
sales taxes as an itemized deduction. Mary has $1,800 of state income
taxes withheld from her wages during 2010. In April of 2010, she
paid an additional $250 on her 2007 state income tax return. Mary’s
deduction for state income taxes is $2,050 ($1,800 + $250). Her state
income tax liability for the 2009 year was $1,650, resulting in a $150
refund ($1,800 $1,650) that was received in 2010. The $150 refund is
reported as income in the 2010 return, assuming Mary received a ben-
efit from the state tax deduction for 2009. N
For taxpayers electing to deduct sales taxes in 2010, the deduction may be calculated by
using either (a) actual sales taxes paid or (b) sales taxes from IRS tables plus the actual
amount of sales tax for motor vehicles, boats, airplanes, and building materials (not appli-
ances or furnishings) for building or improving a residence. Taxpayers choosing to deduct
actual sales taxes paid will be required to keep extensive records to support the amount of
the deduction claimed including receipts for every item purchased during the year subject
to sales tax.
Property Taxes
Taxes that are levied on state, local, or foreign real property for the general public welfare
are deductible. However, special assessmen ts charged to prov ide local benefit to property
owners are not deductible; these amounts increase the basis of the taxpayer’s property.
Also, service fees, such as garbage fees and homeowner association fees, are not deductible
as property taxes.
5-6 Chapter 5
Itemized Deductions and Other Incentives
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
If real estate is sold during the year, the taxes must be divided betwe en the buyer and the
seller, and the division must be made according to the number of days in the year that each
taxpayer held the property.
EXAMPLE Sally sells her home to Patty on March 2, 2010. The taxes for 2010
are paid by Patty and they total $1,825, or $5.00 per day ($1,825/
365 days). The purchaser is treated as the owner on the day of sale.
Sally is entitled to deduct 60 days of real property taxes or $300
(60 days $5.00 per day). Patty deducts $1,525 (305 days $5.00
per day). N
Generally, the escrow company or closing agent handling the sale of the property will
make the allocation of taxes for the buyer and the seller and the result will be reflected in
the settlement charges on the transfer of the title. These amounts are itemized on closing
statements for the sale, which are provided to the buyer and the seller.
EXAMPLE William purchased a new residence from John in 2010. William’s clos-
ing statement shows that he receives a credit for $299.80 in taxes
that he will pay later in the year for the seller. Assuming that William
pays $525.00 in total taxes on the property later in 2010, his property
tax deduction for 2010 would be $225.20 ($525.00 $299.80). John,
the seller, would be allowed a deduction for $299.80 plus any other
taxes he paid prior to selling the property. N
Taxpayers who do not itemize deductions on Schedule A are allowed to take
an extra deduction in addition to the standard deduction for a portion of the
property tax paid in 2008 and 2009. As we go to press, this deduction is
expected to be extended to 2010. The amount of the deduction allowed is
$500 for single taxpayers and $1,000 for married taxpayers. If the property
tax paid is less than $500, or $1,000 if ma rried, the deduction is limited to
the amount paid. Taxpayers must fill in Schedule L, ‘‘Standard Deduction
for Certain Filers,’’ to claim this deduction.
Personal Property Taxes
To be deductible as an itemized deduction, property taxes must be levied based on the
value of the property. Taxes of a fixed amount, or those calculated on a basis other than
value, are not deductible. For example, automobile fees that are calculated on the basis
of the automobile’s weight are not deductible.
EXAMPLE Rich lives in a state that charges $20 per year plus 2 percent of the
value of the automobile for vehicle registration. If Rich pays $160
[$20 þ (2% $7,000)] for his automobile registration, he may
deduct only $140, the amount that is based on the value of the
automobile. N
Section 5.2
Taxes 5-7
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SECTION 5.3
INTEREST
Taxpayers are allowed a deduction for certain interest paid or accrued during the tax year.
Interest is defined as an amount paid for the use of borrowed funds. The type and amount
of the deduction depend on the purpose for which the money is borrowed. Interest on
loans for business, rent, and royalty activities is deducted for adjusted gross income. Cer-
tain interest on loans for personal purposes is deductible as an itemized deduction. The fol-
lowing types of personal interest are deductible:
Qualified residence interest (mortgage interest)
Mortgage interest prepayment penalties
Investment interest
Certain interest associated with a passive activity
Interest on other loans for personal purposes which do not fall into one of the above
categories is generally referred to as consumer interest and is not deductibl e. Consumer
interest includes interest on any loan, the proceeds of which are used for personal purposes,
such as bank charge card interest, finance charges, and automobile loan interest. Interest on
loans used to aquire assets generating tax-exempt income is also not deductible.
The following items are not considered ‘‘interest’’ and, therefore, are also not deductible:
Service charges
Credit investigation fees
Loan fees other than ‘‘points’’ discussed later under Prepaid Interest
Interest paid to carry single premium life insurance
Premium on convertible bonds
Many lenders require that certain home mortgage borrowers pay for private
mortgage insuranc e (PMI) or other agency mortgage insurance to protect the
lender. Mortgage insurance issued related to debt used to acquire a principal
residence is fully deductible in years 2007 through 2010 for taxpayers with
adjusted gross income of $100,000 or less ($50,000 or less if married and filing
separately). The deduction is phased out for AGI over $100,000, and is fully
phased out for AGI over $109,000.
Self-Study Problem 5.2
Sharon is single, lives in Idaho, and has adjusted gross income of $21,150 for
2010. Sharon elects to deduct state income tax rather than state sales tax. The
tax withheld from her salary for state income taxes is $1,050, and in May of
the same year she received a $225 refund on her state income tax return for
the prior year. Sharon paid real estate taxes on her house of $825 for the year
and an automobile registration fee of $110, of which $25 is based on the
weight of the automobile and the balance on t he value of t he property. Use
the taxes section of Schedule A below to report Sharon’s deduction for state
and local taxes.
5-8 Chapter 5
Itemized Deductions and Other Incentives
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Taxpayer’s Obligation
To deduct interest on a debt, the taxpayer must be legally liable for the debt. No deduction
is allowed for payments made for another’s obligation, where the taxpayer is not liable for
payment. Also, both the lender and the borrower must intend for the loan to be repaid.
EXAMPLE Bill makes a payment on his son’ s home mortgage since his son is
unable to make the current payment. The interest included in the
mortgage payment is not deductible by Bill since the mortgage is not
his obligation. Bill’s son cannot deduct the interest since he did not
make the payment. N
Note: A recent court case has decided that a relative, who essentially has an own-
ership interest in the residence, may deduct mortgage interest paid even if not
named on the loan.
EXAMPLE Mary loans her daughter $50,000 to start a business. The daughter is
19 years old and unsophisticated in business. No note is signed and
no repayment date is mentioned. Mary would be surprised if the
daughter’s business venture is a success. Since, in all likelihood, a true
debtor-creditor relationship is not created, any interest paid by the
daughter is not deductible. N
Prepaid Interest
Cash basis taxpayers are r equired to use the accrual basis for deducting prepaid interest.
Prepaid interest must be capitalized and the deduction spread over the life of the loan.
This requirement does not apply to points paid on a mortgage loan for purchasing or
improving a taxpayer’s principal residence, pr ovided points are customari ly charged and
they do not e xceed the normal rate. Such points paid on a mortgage for the purchase of
a personal residence may be deducted in the year they are pa id. Points paid to refinance
a home mortgage are not deductible when paid, but must be capitalized and the deduction
spread over the life of the loan. Points charged for specific loan services, such as the lend-
er’s appraisal fee and other settlement fees, are not deductible.
EXAMPLE On November 1, 2010, Allen, a cash basis taxpayer, obtains a 6-month
loan of $500,000 on a new apartment building. On November 1, Allen
prepays $36,000 interest on the loan. He must capitalize the prepaid
interest and deduct it over the 6-month loan period. Therefore, his
interest deduction for 2010 is $12,000 ($36,000/6 months 2 months). N
Qualified Residence, Home Equity, and Consumer Interest
Since 1991, no deduction has been available for consumer (personal) interest, such as inter-
est on credit cards and loans for personal automobiles. Qualified residence interest, how-
ever, is a type of personal interest specifically allowed as a deduction. The term ‘‘qualified
residence interest’’ is the sum of the interest paid on ‘‘qualified residence acquisition debt’’
plus ‘‘qualified home equity debt.’’ The aggregate amount of qualified acquisition debt may
not exceed $1,000,000 ($500,000 for married filing separately), and the aggregate amount
of qualified home equity debt may not exceed $100,000 ($50,000 for married filing sepa-
rately). Thus, the total amount of acquisition and home equity debt on the taxpayer’s res-
idence may not exceed $1,100,000 ($550,000 for married filing separately).
Section 5.3
Interest 5-9
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The term ‘‘acquisition debt’’ is defined as debt secured by the taxpayer’s principal or
second residence incurred in acquiring, constructing, or substantially improving that resi-
dence. Refinanced debt is treated as acquisition debt only to the extent it does not exceed
the principal amount of acquisition debt immediately before the refinancing. The term
‘‘home equity debt’’ is defined as debt secured by the taxpayer’s principal or second resi-
dence, and which is not acquisition debt. Interest on qualifying home equity debt is deduct-
ible even if the proceeds are used for personal purposes.
EXAMPLE Vicky’s residence has a fair market value of $300,000. The first mort-
gage, used to buy the house 10 years ago, is $125,000. This year, she
borrows $115,000 on a second mortgage secured by the house, to
send her children to college. The interest paid on the first mortgage
is fully deductible, but interest on only $100,000 of the second mort-
gage is deductible.
Assume $8,000 of interest is paid by Vicky on the first mortgage
and $7,000 is paid on the second mortgage. Vicky’s mortgage interest
deduction is calculated as follows:
Interest on acquisition debt $ 8,000
Interest on home equity debt
$7,000 $100,000/$115,000
6,087
Mortgage interest deduction allowed
$14,087
The remaining interest on the home equity debt ($7,000 $6,087 ¼
$913) is considered nondeductible personal interest. N
An additional limit on the $100,000 qualified home equity debt allowed is the fair mar-
ket value of the residence. For example, assume a taxpayer has the maximum $1,000,000 of
acquisition debt and $100,000 of home equity debt. If the fair market value of the residence
goes down to $1,050,000, only $50,000 of the home equity debt will qualify for an interest
deduction. The reduction in home values during the recent recession has made this limi-
tation more relevant than in past years.
Deduction for consumer inter est, including any excess mortgage interest, automobile
loan interest, and interest on credit cards, is not allowed.
If the sum of mortgage interest and other itemized deductions is less than the
standard deduction, no tax benefit is received from the mortgage interest pay-
ments. In this case, a taxpayer may wish to pay the mortgage off as quickly as
possible since few investments earn a guaranteed tax-free return equal to the
interest rate on a home mortgage.
Education Loan Interest
Taxpayers are allowed a deducti on for adjusted gross income for certain interest paid on
qualified education loans. The deduction is limited to $2,500 for 2010, and is phased
out for single taxpayers with modified AGI of $60,000 to $75,000 and for married tax-
payers with modified AGI of $120,000 to $150,000. Qualified higher education expenses
include tuition, room and board, and related expenses.
5-10 Chapter 5
Itemized Deductions and Other Incentives
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.