What Does It Mean To Be “Tax Deductible” And Why Does It Matter?

As go through life, you’ll often hear references to things being “tax deductible.” All kinds of different things are. Figuring out what tax deductible could save you hundreds or even thousands of dollars each year.

Being tax deductible allows you to deduct the expense (a charitable gift, your mortgage interest, business expenses, etc.) from your income on your tax return. If you give $100 to charity, that will not cut taxes by $100. It will reduce taxable income by $100. If your marginal tax rate is 28%, then you would save $28 on your taxes by donating $100—under certain circumstances. Many Americans have an effective tax rate of zero so a tax deduction does not have value.

Note the following examples to illustrate how tax deductions work.

Charitable Contributions: A donation to charity is deductible (subject to some limitations that rarely apply) so long as your total deductions for medical care, mortgage interest, and charitable contributions (along with a few other categories) total more than the standard deduction (1.usa.gov/UtEQpw) ($12,750 for 2011 for most married couples filing jointly). In other words, if your total mortgage interest, charitable donations and other eligible expenses total less than $12,750 for most couples, there is no benefit to having tax deductible expenses.

Mortgage Interest: Mortgage interest on your primary residence works just like charitable contributions to offset income if the sum of eligible deductions exceeds the standard deduction. Interest on a second home is not usually deductible. Mortgage interest on an investment property is deductible on another form; it isn’t impacted by the standard deduction threshold.

Medical Expenses: Medical expenses are only deductible to the extent that they are more than 7.5% (1. Usa. Gov/2DQ4Q5) of your income; you can only deduct the portion that exceeds 7.5%. They, together with charitable contributions and mortgage interest must exceed the standard deduction in order to be done deductible.

Business Expenses: If you have a small business you may deduct customary business expenses on your tax return. If you manage a day care center in your home, for instance, you may be located in a position to deduct food and other supplies used by the children in your care against the income you generate with the business. Under some circumstances, you can deduct depreciation on the space in your home dedicated to the business. If the business loses money, you may be located in a position to offset other income of business losses (this won’t work if the IRS thinks your business is a hobby).

Understanding these basic concepts won’t make it easy for you to produce your personal tax return—especially if you make a business. Knowing how tax deductions work, however, may allow you to make better spending decisions during the year. If you are positioned in a situation where you can deduct your charitable contributions, for instance, you now understand that charitable contributions are effectively cheaper for you because of the tax savings.

Before you file your tax return, seek help form an experienced CPA.