Most Overlooked Deducations

Many taxpayers don’t take all the deductions to which they are entitled. Some think all the good deductions were eliminated in the Tax Reform Act of 1986. Others are afraid that the IRS will audit them for taking certain deductions. A lack of good records is the problem for a number of taxpayers. For most people, the problem is that the tax code is so complicated it takes too much time to sort through the confusion and determine which deductions are available.

For these reasons, many taxpayers are overpaying the IRS. I don’t want my readers to be in that group. Pay every tax dollar you are required to, but don’t pay any more. Here’s my list of the most overlooked deductions and how to take them.

Itemized expenses. The percentage of taxpayers who take itemized expense deductions on Schedule A declined steadily after 1986. Now, only about one third of taxpayers deduct itemized expenses. Many people who should itemize don’t do it. Schedule A should be used by anyone whose itemized expenses exceed the standard deduction amount ($4,750 for singles in 2003 and $7,950 for married couples). Anyone who pays high state income or property taxes, has a home mortgage or home equity loan, or makes meaningful charitable contributions probably qualifies for itemizing. If the sum of those expenses exceeds the standard deduction amount, you should be filing Schedule A.

Charitable property contributions. Many people get rid of old clothes, cars, and other personal use property by giving it to charity. If you itemize deductions, the current fair market value of the property is deductible as a charitable contribution. Often taxpayers don’t take these deductions because the property must be valued. Most charities won’t provide a value. They will provide an itemized receipt listing each item contributed and leave it to the donor to provide a value. Fear of arousing the IRS keeps many from establishing a value and deducting their contributions.

That is no reason not to take a deduction. It is fairly easy to establish a reasonable value.

One option is to view the prices of similar items on Ebay (www.ebay.com). Values also are available from software called ItsDeductible (www.itsdeductible.com). The firm says the software provides values for over 1,000 household items in good, fair, and poor condition. The estimates are determined by visiting various thrift stores and consignment shops around the country. You also can go to such stores yourself and see the prices placed on comparable items in your area. For automobiles, the value from the Kelly Blue Book or similar guide can be used.

Some taxpayers are deterred by the recordkeeping requirements. A charitable contribution of cash or property cannot be taken unless there is a contemporaneous written acknowledgement of the contribution from the charity. Most charities provide this routinely. When the property contribution deduction exceeds $500 and is up to $5,000, Form 8283 also must be completed. This form provides some details about the property that was contributed and the value placed on it. When the total claimed value of property contributions exceeds $5,000, a qualified appraisal must be provided with the tax return.

Supporting parents and others. Few people realize that a taxpayer can claim another as a dependent if he or she supports that person, even if it is not a child. The dependent might not even need to live with the taxpayer.

A person can be claimed as a dependent on your return if you provide over half that person’s support for the year, and the person’s gross income is less than the dependent exemption amount ($3,000 this year). The person must not file a joint return with another taxpayer and must be a U.S. citizen or resident of North America. If the person is a relative, he or she does not have to live in your home during the year. Non-relatives can be claimed as dependents if their principal place of abode is in your home and the other tests are met.

“Support” does not include everything spent by your parent or other dependent. Only expenses for necessities count. These include food, clothing, medicine, shelter, education, transportation, and other items. The fair rental value of your home also counts if the parent lives there. Details about qualifying relatives and support items are in IRS Publication 502 Medical and Dental Expenses.

The assets your parent has don’t matter. What matters is how much of the support you actually paid for. If a parent has significant assets but low income, the parent can make gifts to an adult child. Those gifts can be used to pay for support of the parent. Since the child is paying the expenses, the parent qualifies as a dependent. The parent is free to spend his or her own money on non-support items without endangering the exemption deduction.

Medical expenses of others. It is easier to deduct expenses for the medical care of another than to claim the dependent exemption. That is because to deduct the medical expenses, the income test described above doesn’t apply. Many parents receive Social Security or some other income that exceeds the personal exemption amount, so they cannot be deducted as dependents by another. Even so, if the other tests are met, the adult children can deduct any medical expenses they pay for the parent.

Suppose Max Profits’ mother is in a nursing home. Ma Profits receives some Social Security and interest income, but the nursing home cost far exceeds that. Max pays the bulk of the nursing home bills, and almost all of his mother’s support expenses for the year are the nursing home bills. To ensure that he can maximize deductions, Max instructs his mother to limit her spending on support items so that Max is sure to provide 50% of her support. That way, Max deducts the portion of nursing home expenses that qualify as medical expenses.

If Max’s mother is in the nursing home to receive skilled nursing care, the full cost of the nursing home likely is deductible as a medical expense. If she is in the facility for custodial care, then only actual medical expenses are deductible. If she is in an assisted living facility, the entire cost is deductible if she is unable to perform at least two of the six activities of daily living and there is a Plan of Care in place. Usually a doctor, nurse, or social worker draws up the Plan of Care. Otherwise, only actual medical expenses are deductible. The facility should provide an itemized bill.

IRA and annuity losses. Many people are showing big losses in their IRA or variable annuities. In some cases, these are deductible. The general rule is that losses incurred in an IRA or annuity are not deductible. But there are exceptions.

If the IRA was funded with deductible contributions, you are out of luck. That means the IRA was funded with pre-tax dollars, so there is no tax basis.

An IRA with nondeductible contributions has a basis equal to the contributions. Close out the IRA, and the difference between the balance and your contributions is a loss.

If you converted a regular IRA to a Roth IRA before the decline, then the converted amount is the basis in the IRA. Liquidate the IRA, and if the balance is below the basis you have a loss. If the Roth IRA is liquidated less than five years before the first contribution to it and the owner is under age 59 1/2, there is a 10% penalty when distributions are made.

There are a couple of catches to deducting the IRA losses. One rule is that a traditional IRA loss is deductible only if all traditional IRAs of the taxpayer are emptied and there is a net loss. This includes both deductible and nondeductible IRAs. With a Roth IRA, all Roth IRAs must be liquidated and there must be a net loss.

Another catch is that any losses are not capital losses. The loss is a miscellaneous itemized expense. That means it is deductible only on Schedule A with other itemized expenses, and only to the extent all miscellaneous itemized expenses exceed 2% of adjusted gross income.

Details of deducting IRA losses are in IRS Publication 590, free by calling 800-TAX-FORM or at www.irs.gov. Variable annuities have similar rules that were covered in the December 2002 issue.

Capital losses. These are perhaps the most overlooked deduction. Studies show that most people experience great emotional pain from an investment loss. Therefore, they don’t sell losing investments. They hang on, hoping the investments will recover.

A better move is to sell losers quickly. The loss first can be deducted against capital gains for the year. If the loss exceeds the gains, up to $3,000 of the loss can be deducted against other income. Any additional loss can be carried forward to future years to be used in the same way until it is exhausted. In the meantime, the sales proceeds can be invested in something with better prospects. That is a much better way to handle a losing investment than to wait for recovery.