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Tax deductions, also known as tax-deductible expenses, or more commonly as tax write-offs, represent expenses accrued by a taxpayer as a result of producing income. Tax deductions are designed to offset the costs accrued by taxpayers in the course of making money. They appear on an individual’s income tax return as amounts that can be deducted, or subtracted, from an individual’s gross income. This reduces the overall taxable income, which in turn lowers the amount of tax a taxpayer is required to pay.
The different types of tax deductions depend on the country's taxation system. In the United States, there are many different kinds of tax deductions. Each individual’s deductions depend upon variations in income, filing status and other requirements. Applicable tax deductions are governed by the Internal Revenue Code and are subject to particular regulations, requirements, income limits, or rules involving information from prior tax years.
US tax deductions can be categorized as above the line or below the line. Above the line deductions are subtracted from an individual’s total income in order to calculate his or her adjusted gross income (AGI). These deductions are generally considered to be more advantageous for a taxpayer than their below the line counterpart because they not only reduce the amount of income the taxpayer must claim and therefore pay taxes on, but they also reduce the taxpayer's AGI which can affect other taxes. Examples of above the line deductions include alimony payments, rental deductions, student loan interest paid, and traditional IRA contributions.
Below the line tax deductions, on the other hand, are taken after a taxpayer's AGI is determined, but these types of deductions can reduce the taxpayer's taxable income even further. Medical expenses and charitable donations are some examples of below the line deductions.
Taxpayers can claim a standard deduction or he or she may choose to itemize his or her below the line deductions depending upon which is more beneficial. Standard deductions are subtracted from a taxpayer’s income based upon filing status. Itemized deductions are itemized individual expenses which a taxpayer reports on his return in order to reduce his taxable income. Certain below the line deductions are denied to wealthier taxpayers, while others may be claimed only if they exceed a certain portion of the taxpayer’s AGI.
To summarize, a taxpayer starts off with his or her gross income — the amount of income he or she received in the tax year. Above the line deductions are applied to reduce that gross income value to his or her AGI. Below the line deductions, or the standard deduction, depending on which is higher, takes the taxpayer to his or her taxable income.
The exact amount of savings a taxpayer may accrue from tax deductions is dependent upon a variety of shifting variables such as the tax rate. Moreover, since American taxpayers are obligated to pay both federal and state taxes with different tax obligations, deductions allowed on a federal tax return may or may not be applicable to individual state tax returns. Items which are deductible are subject to change depending upon relevant changes in tax laws and the Internal Revenue Code.
Businesses may also claim tax deductions for expenses incurred in the course of trying to make profit. In order to claim deductions for business expenses, all costs claimed must be both ordinary and necessary for running a business. Businesses may generally claim tax deductions for such things as employee pay, employee benefits, the cost of producing goods and storage. Some business expenses must be claimed as capital expenses. Capital expenses are considered assets, and include business start-up costs, business assets and improvements.