In the United States, as in most countries, the federal government taxes personal net income. The amount taxed is calculated by subtracting any tax deductions from one's adjusted gross income ("AGI"), then multiplying that amount by the applicable tax rate. The remaining amount is the taxpayer's tax liability. Deductions are a way for taxpayers to "reduce" their taxable income; they remove or reduce a taxpayer's liability for certain expenses claimed on one's federal income tax return. There are two types of deductions in the federal scheme: the standard deduction and the itemized deduction. This article focuses on the latter.
Under the Internal Revenue Code, the term "itemized deductions" refers to specific expenses recognized by the Code. One way to think about income tax is that a taxpayer's net income is the maximum amount he or she may be taxed, and deductions are ways to reduce this overall liability. Itemized deductions are referred to as "below-the-line" deductions because they are deducted after the taxpayer determines AGI. Examples include:
- qualified interest, including mortgage interest, student loan interest, and investment interest (if more than investment income);
- qualified state and local taxes;
- losses to casualty or theft (if over 10% of AGI and over $500);
- qualified charitable donations (if no more than 30% or 50% of AGI, depending on the donee);
- medical expenses (over 7.5% of AGI);
- impairment-related work expenses;
- estate taxes of decedent;
- losses from the sale of personal property;
- restoration of amounts under a claim of right;
- annuity losses, bond payments, and cooperative housing payments.
Justice Sonia Sotomayor, as a judge for the Second Circuit, discussed the role of the itemized deduction in William L. Rudkin Testamentary Tr. v. Commissioner. This case began as a dispute between a trustee and the Internal Revenue Service (IRS) when the trustee claimed a tax deduction for the full amount of the investment advisory fees paid by the trust. The IRS rejected the trust's itemized-deduction for the total amount, permitting a deduction only for the portion of the fees that exceeded two percent of the trust's adjusted gross income. The dispute centered on the meaning of 26 U.S.C.S. § 67(e)(1), the part of the federal tax code that determines the adjusted gross income for estates and trusts. Then-judge Sotomayor, writing for the majority, cogently described the role itemized deductions fit into the larger federal tax scheme:
In calculating taxable income, a taxpayer must first determine the amount of "gross income," which is defined as "all income from whatever source derived." The taxpayer then arrives at "adjusted gross income" by subtracting from gross income certain "above-the-line" deductions, such as trade and business expenses and losses from the sale of property. Finally, "taxable income" is calculated by subtracting from adjusted gross income any "itemized" (or "below-the-line") deductions. In the case of an individual, "below-the-line" deductions include, inter alia, "all the ordinary and necessary expenses paid or incurred during the taxable year . . . for the management, conservation, or maintenance of property held for the production of income."
Taxpayers have the choice of electing to use either the standard deduction or the itemized deduction. Generally, if the taxpayer's itemized deduction exceeds the standard deduction, the taxpayer should apply the itemized deduction since this would result in a smaller tax liability. For instance, if a single taxpayer files with a gross income of $80,000 for 2019 and elects to use the standard deduction, she can reduce her income by $12,200 (the applicable standard deduction amount) to a taxable income of $67,800. Hence, in 2019, her tax bill would be $8,091 with an effective tax rate (ETR) of 11.93%. By contrast, if the taxpayer's itemized deduction added up to $14,000, her taxable income would be $66,000; in 2019, her tax bill would be $7,695 with an ETR of 11.66%. In this case, the hypothetical taxpayer should use the itemized dedication because it saves her $396.
There are several reasons why a taxpayer may choose not to use the itemized deduction. First, itemized deductions generally require tedious record-keeping. A taxpayer that uses the itemized deduction must have maintained sufficient records to support his or her claimed expenses. Moreover, a taxpayer that files as "married, filing separately" whose spouse itemizes cannot claim the standard deduction. Last, "itemized deductions are useful only when and to the extent that they exceed the standard deduction."
Why does the tax Code make the distinction between itemized and non-itemized deductions? One answer is that the Code places more limitations on itemized deductions than on non-itemized deductions. When Congress first divided deductions into non-itemized and itemized sections in 1944, a taxpayer could use the non-itemized deductions regardless of their total amount. Itemized deductions, by contrast, were useful only if the total amount exceeded the standard deduction. Medical expenses, for instance, are subject to a floor–i.e., they cannot be deducted unless they exceed 7.5% of a taxpayer's adjusted gross income. By contrast, non-itemized deductions are, in general, not subject to such floors. Another idea is that Congress sought to simplify the preparation and audit of individual tax returns by allowing a deduction of qualifying expenses only when they are especially large.
[Last updated in July of 2020 by the Wex Definitions Team]
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