Taxation of Canadians in America:

8

Common Deductions

US taxpayers are able to deduct certain expenses on their US income tax returns. Expenses can result in adjustments, deductions, exemptions, or credits, all of which are treated in different ways to reduce your US tax liability. As Canadians, you may recognize some similarities to reductions available for Canadian tax returns. Unfortunately, not all of your expenses can reduce taxable income, but the expenses that do reduce your tax or taxable income are benefits for you. Some of these beneficial expenses may not result from expenditures that you have made. In most cases, however, you actually paid out-of-pocket money for specific items that are described in the Internal Revenue Code as available to reduce your taxes. The tax benefit that you receive is often limited to a percentage of your total actual cost or has a maximum threshold.

As you go through this chapter, we have categorized the expenses based on how they are used in calculating net taxable income or the tax calculation. This chapter focuses on deductions, exemptions, and credits.

Table 8 is the format for the US Individual Income Tax Return (Form 1040).

Table 8: THE FORMAT OF THE US INDIVIDUAL INCOME TAX RETURN (FORM 1040)

1. Above-the-Line Deductions

In determining US taxable income, there are “above-the-line deductions” and “below-the-line” deductions. So, what is the line? It is the taxpayer’s Adjusted Gross Income (AGI). AGI is an important subtotal because it is used in computing the percentage limitations on itemized deductions and in other areas in the tax computation. So, not only do above-the-line deductions simply reduce taxable income, they can lower the thresholds by which other deductions are determined.

A similar calculation methodology is used for nonresident aliens filing a US Nonresident Alien Income Tax Return (Form 1040-NR). Nonresident aliens can claim deductions to figure their effectively connected taxable income. They cannot claim deductions related to income that is not connected with their US business activities. Except for personal exemptions and certain itemized deductions, a nonresident alien can only claim deductions to the extent they are connected with US income.

2. Trade or Business Expenses

You can deduct all ordinary and necessary expenses for the operation of a US trade or business operated as a sole proprietor or as the single member of a limited liability company, on Schedule C, attached to your Form 1040 or 1040-NR. If you operate a business that is organized as a corporation, a multimember limited liability company, or a partnership, separate tax returns must be filed for those entities.

Ordinary and necessary expenses include reasonable salaries paid for services, expenses for use of business property, one-half of self-employment taxes, and other business expenses customary for your type of business. It does not include charitable contributions, gifts, illegal bribes or kickbacks, or fines and penalties. Other expenses that are not allowed include political contributions or lobbying expenses, unless the lobbying expenses are used for influencing local legislation such as your city or county government.

It is sometimes difficult to determine whether or not an expenditure is deductible as a trade or business expense. The expenditure must be both “ordinary” and “necessary” to be deductible. The courts have held that an expense is necessary if a prudent businessperson would incur the same expense and the expense is appropriate and helpful in the taxpayer’s business. It is ordinary if it is usual or customary in the type of business. Capital expenditures are not deductible as ordinary or necessary, but depreciation is deductible.

Allowable business expenses include legal expenses in defense of a civil or criminal claim or penalty, as long as the taxpayer can show that the claim or penalty was directly related to the trade or business; an income producing activity; or the determination, collection, or refund of a tax. Personal legal expenses are not deductible.

A bad business debt can be a deduction for Adjusted Gross Income (AGI). A bad debt results when a taxpayer sells goods or services on credit, and the accounts receivable subsequently becomes worthless. A bad debt deduction can only be taken if the income arising from the creation of the accounts receivable was included in the taxable income. A bad debt can also result from the non-repayment of a loan made by the taxpayer or from purchased debt instruments.

A nonbusiness bad debt is not a deduction for AGI but is a short-term capital loss. Loans to relatives or friends are the most common type of nonbusiness bad debt.

A bad debt can result from a deposit in an insolvent financial institution. There are specific rules if you have an ownership interest in the financial institution; however, generally, a bad debt results from this type of loss.

If you do not have a trade or business but merely have a hobby, which is an activity that may not have been engaged in for profit, you may still be able to deduct expenses, but only to the extent there is income from the hobby. How do you know if you have a hobby or a business? Generally, there is a presumptive rule that an activity is profit-seeking if it has made a profit for three of the last five years, or, if it involves horses, the activity would be a trade or business if it has made a profit for at least two of seven consecutive years. See Table 9.

Table 9: TRADE OR BUSINESS EXPENSES

Expenses That Are Deductible	Expenses That Are Not Deductible
Transportation expenses in the course of business, including taxi fares, automobile costs, tolls, and parking.	Commuting between one’s home and one’s place of business.
Travel expenses including transportation expenses and meals and lodging while away from home. The deduction for meals is limited to 50%.	Travel expenses for a spouse unless the spouse serves a bona fide business purposes.
Moving expenses.	Moving from one house to another without making a business location change that is more than 50 miles from the previous location.
Education expenses that improve your current skills.	Education expenses that train you for a new job.
Expenses for entertainment and entertainment-related meals, limited to 50%
Taxes, including social security taxes paid by an employer, state and local income taxes, unemployment insurance taxes, real estate taxes, and foreign taxes attributable to the business.	Federal income taxes paid are not deductible in determining taxable income.
Compensation paid for reasonable salaries or other compensation for personal services.	Compensation paid to a spouse who does not perform services for the business commensurate with the compensation paid.
Business gift expenses, limited to $25 per recipient per year.
Employee achievement awards, limited to $400 per employee, generally.
Interest expenses.	Personal credit card and auto loan interest.
Employees’ expenses, including reimbursed expenses.	The cost of regular clothing.
Home office expenses, for a portion of the home that is used exclusively, on a regular basis, as the principal place of business for your business.	An office in your home that is used by your children and other members of your family for personal use.
Contributions to employees’ qualified retirement plans.
Vacation home rental expenses.	Expenses for personal use of a vacation home.
Other business expenses.
Expenses of professional persons including dues to professional organizations.	Expenses for membership in clubs organized for business, pleasure, recreation, or other social purposes, generally.
Landlord or tenant expenses.	Expenses incurred in connection with a land purchase contract.
Employee benefits and health insurance expenses for employees and their dependents.	Health insurance coverage for an employee’s child who is older than age 27.
Life insurance premiums on an officer or employee.

There are many rules about what constitutes trade or business expenses; your tax accountant can help guide you through the rules to determine whether or not you can deduct expenses.

3. Vacation or Rental Home Expenses

If you own a home in the US and receive rental income, there are a complex set of rules that you must follow, but you are able to deduct expenses as long as they are related to the rental of the home and are not personal expenses. Rental activities are typically reported on Schedule E and attached to your US tax return. If the home is used solely for rental purposes, then the expenses related to that home, including depreciation, are fully deductible. For a home that you use as a personal residence during part of the year and rental for part of the year, you are only allowed a deduction to the extent of the income generated.

If the residence is rented for less than 15 days, then it is considered a personal residence, and you cannot deduct expenses, except for mortgage interest and real estate taxes which are allowed as itemized deductions, as with any personal residence.

If the residence is rented for more than 15 days in a year and is not used for personal purposes for more than the greater of 14 days or 10 percent of the total days rented, then the residence is treated as rental property. The expenses must be allocated between personal and rental days if there are any personal-use days during a year. Often, the deduction of expenses allocated to rental days can result in your expenses exceeding your income, or a rental loss. The loss may be deductible under the passive activity loss rules.

If the residence is rented for 15 days or more in a year and is used for personal purposes for more than the greater of 14 days or 10 percent of the total days rented, then it is treated as a personal/rental use residence. Expenses must be allocated between personal days and rental days, but expenses are allowed only to the extent of rental income. In other words, you cannot generate a passive activity loss from a personal/rental use residence.

If a residence is classified as personal/rental use, then expenses that are normally deductible as itemized deductions (e.g., real estate taxes and mortgage interest) must be allocated between personal days and rental days, based on the total days of use. If the house sat vacant for a period of time, those days cannot be used in the calculation. For example, if you rent your home for 100 days and you use your home for personal use for 120 days, then your mortgage interest and real estate taxes must be allocated 100/220 to rental expenses, and 120/220 of the expenses can be deductible as itemized deductions if you elect to itemize.

Other types of expenses that can be deducted are also allocated on the basis of total days used if the residence is classified as personal/rental use. These include operating expenses, utilities and maintenance expenses, and depreciation. It does not include any type of personal living or family expenses. It also does not include any amounts paid out for capital expenditures which are any amounts paid out for new buildings or permanent improvements or betterments made to increase the value of any property. Capital expenditures are subject to depreciation, and the depreciation is generally deductible over the life of the capital asset as determined by how the IRS classifies property. Depreciation is only allowed for a personal/rental use property to the extent that there is net income after deducting other expenses. See Table 10.

Table 10: VACATION/RENTAL HOME

4. Depreciation, Amortization, and Depletion Expenses

Canada uses capital cost allowance as its cost-recovery system for capital investments. In the US, we use similar systems that allow for a deduction, they are depreciation, amortization, or depletion. For purposes of understanding what is depreciated and what is amortized, tangible property is any property with physical substance, and intangible property is property that lacks substance, such as goodwill or patents. Tangible property, other than natural resources is depreciated. Intangible assets are amortized. Depletion is the method of accounting for the use of natural resources, such as oil, gas, coal, and timber. Land is not subject to any cost-recovery method.

The IRS has classified property among tangible, non-tangible, realty (real property), and personal (personal property). It further classifies property into categories based on recovery periods such as three-, five-, and ten-year property. The purpose of this discussion is not to give you all of the details of depreciation methodology; it is instead to provide you with a primer on how expenses for depreciation are available for capital assets. You should note that there are alternative depreciation methods, and if you have property that will be subject to depreciation, you should seek guidance from a tax accountant. Table 11 provides a brief list of property and classes of property subject to depreciation. Note that there are more classes of property; we are only showing the most common.

There are no capital cost-recovery deductions allowed for personal use capital assets; only for business use assets.

Table 11: CLASSES OF DEPRECIATION PROPERTY

Class of Property	Examples
3-year	Any qualified rent-to-own property
5-year	Automobiles Light and heavy general-purpose trucks Calculators, copiers, and duplicating equipment Any computer or peripheral equipment Appliances, carpets, furniture, etc. used in a rental activity
7-year	Office furniture and equipment Any property that does not have a class life and is not otherwise classified
15-year	Leasehold improvements placed in service before January 1, 2012
27.5 years	Residential rental property
39 years	Nonresidential real property

5. Individual Losses to Property

If you suffer damage to a personal asset or nonbusiness property, you can only deduct those losses attributable to certain events such as fire, storm, shipwreck, or other casualty or theft. These are generally known as casualty losses. The rules are that a casualty loss must result from an event that is identifiable; damaging to property; and sudden, unexpected, and unusual in nature. You can take a deduction for a casualty loss from an automobile accident only if the damage was not caused by your willful act or willful negligence. There must be damage to your property to qualify as a casualty loss.

Not all acts of God are treated as casualty losses. For example, progressive deterioration, such as erosion due to wind or water, is usually not a casualty because it does not meet the suddenness test.

Casualty losses are deducted in the year the loss occurs. No casualty loss is permitted if a reimbursement claim has a reasonable prospect of full recovery. If you have a partial claim, then only part of the claim can be deducted in the year of the casualty, and the rest is deducted when the claim is settled. If you later collect more than was expected and you are reimbursed for the amount that you deducted in a previous year, then you must report the reimbursement in gross income on the return for the year when it is received to the extent that the previous deduction resulted in a tax benefit.

The amount of the loss is calculated as the lesser of the adjusted basis of the property, or the difference between the fair market value of the property before the event and immediately after the event. Generally, an appraisal is needed to measure the loss, but the cost of repairs to the damaged property is acceptable as a method of establishing the loss in value as long as the following criteria are met:

• The repairs are necessary to restore the property to its condition immediately before the casualty.

• The amount spent for such repairs is not excessive.

• The repairs do not extend beyond the damage suffered.

• The value of the property after the repairs does not, as a result of the repairs, exceed the value of the property immediately before the casualty.

The amount of the loss for personal-use property must be reduced further by a $100 per event floor and a 10 percent of Adjusted Gross Income (AGI) aggregate floor. If the loss is spread between two taxable years, the loss in the second year is not reduced by the $100 floor but is still subject to the 10 percent of AGI floor.

Sometimes, the President of the US will declare an area as a designated disaster area, and casualties sustained in such areas can be deducted, by making an election, in the taxable year immediately preceding the taxable year in which the disaster actually occurred. This helps provide immediate relief to disaster victims in the form of accelerated tax benefits. If the disaster occurs after the previous year’s tax return was filed and the taxpayer wants to make the election to claim the disaster area loss to get the accelerated tax benefit, then an amendment to the previous return should be filed.

Losses from theft are computed like other casualty losses, but the timing for recognition of the loss is different. A theft loss is deducted in the year the theft was discovered, and if there is reasonable expectation of recovering any amount from an insurance company, then no deduction is permitted. When there is a settlement, then a deduction can be taken if the recovery is less than the asset’s adjusted basis. If there is a gain greater than the adjusted basis, then a gain may be recognized. If at any time a taxpayer has both a personal casualty gain and a casualty loss in the same year, the two are netted together.

6. Alimony and Child Support

Alimony payments are deductible from gross income in the year they are paid. They are a deduction for the party who pays the alimony and are reported as income for the party who receives the alimony payment.

Payments for child support are neither taxable nor deductible.

7. Contributions to Individual Retirement Accounts (IRAs)

There are several types of Individual Retirement Accounts (IRAs) available to individuals, and contributions to IRAs can be deductible or nondeductible. If you made contributions to a traditional IRA, you may be able to take an IRA deduction. However, you must have taxable compensation effectively connected with a US trade or business to do so.

There are complicated rules for IRAs and qualified retirement plans, and we do not intend to explain the complications in any detail. In a very general sense, there are traditional IRAs and Roth IRAs. To be eligible to make a contribution to an IRA, you must have earned income in the US, which includes alimony and wage payments from a US taxpayer employer. Generally, amounts held and earned in traditional IRAs are not taxed until a distribution is made, so when a contribution is made to a traditional IRA, a deduction is allowed. Amounts contributed to Roth IRAs are not deductible, and the amounts, including earnings and profits that are accumulated in a Roth IRA, are usually tax free when they are withdrawn. In very simple terms, traditional IRAs are generally tax free when contributed and are taxed when distributions are paid out, and contributions to Roth IRAs are taxed when contributed and distributions are tax free. There are limitations on when distributions can be made.

In 2012, the maximum annual combined contribution that can be made to all of an individual’s IRAs is $5,000. If an individual is age 50 or older, he or she can contribute an additional catch-up contribution of $1,000 per year. The person has until the due date of his or her return to make contributions. This means that he or she has until April 15 of the year following the tax year to make a contribution to his or her IRA.

If either you are or your spouse is active participant in an employer-sponsored qualified retirement plan such as a 401(k) or a 403(b), then the amount of your deduction for a contribution to an IRA can be limited. When a single person or a head of household is an active participant in an employer’s retirement plan, the IRA deduction begins to phase out when the taxpayer’s AGI reaches $58,000 and completely phases out when AGI reaches $68,000 (in 2012). For married individuals who file a joint return, the phase out range is $92,000 to $112,000.

You can only make contributions to a traditional IRA if you are younger than age 70.5, and upon reaching age 70.5, you will be required to make minimum required distributions annually from a traditional IRA.

It is very easy to create an IRA account with a bank or custodian. Before you do so, however, you should seek advice from a tax accountant or retirement plan specialist if you are interested in contributing to an IRA. There can be penalties for contributing funds to an IRA that are in excess of what you are permitted.

8. Moving Expenses

Employees or self-employed persons can deduct reasonable expenses for moving themselves and their families if the move is a result of a work-related relocation. For the expenses to be deductible, a distance test and a length-of-employment test must be met.

The new principal place of work must be at least 50 miles farther from your former home than the old job location was. If you have no former job location, the new job location must be at least 50 miles from your former home. You cannot deduct the moving expense when you are returning to your home in Canada or moving to a foreign job site, these expenses would have to be deducted in the foreign country, if allowed. The rules are specific to eliminate a moving deduction for taxpayers who purchase a new home in the same general area without changing their place of employment.

To meet the length-of-employment test, an employee must be employed on a full-time basis at the new location for 39 weeks in the 12-month period following the move. If the taxpayer is self-employed, he or she must work in the new location for 78 weeks during the next two years.

If you deduct moving expenses to the US, you cannot deduct travel expenses. Moving expenses result from a change in your principal place of business, and travel expenses are based on a temporary absence from your principal place of business. You can only deduct moving expenses that are not reimbursed or paid by your employer.

9. Health Savings Accounts (HSA)

For US resident taxpayers who have US health coverage, there are several types of medical savings accounts that typically link a high deductible health plan with a tax favored account, such as a health savings account (HSA), an Archer medical savings account (MSA) or a health reimbursement arrangement (HRA). These accounts are tax favored because the contributions to these accounts can be tax deductible, and distributions to pay qualified medical expenses are not taxable.

An HSA can be created if an individual has a high deductible health plan, is not covered by another other medical plan that is not a high deductible plan, is not enrolled in Medicare, and is not claimed as a dependent on somebody else’s tax return. If you meet these requirements in 2012, you can make tax-deductible contributions of up to $3,100 if you are covered under a self-coverage plan or $6,250 if you are covered under a family coverage plan. Different limits apply for MSAs. If you make contributions in excess of these limits, there is a 6 percent excise tax in addition to the deductions being nondeductible. If you are older than age 55, you can increase your annual contribution by an additional $1,000 per year.

A high deductible health plan is a plan that has a minimum annual deductible of $1,200 per year for self-coverage plans and $2,400 for family coverage plans for 2012. There are limits on how much your out-of-pocket expenses can be for these plans. For example, the annual out-of-pocket expenses for a self-coverage plan cannot exceed $6,050 ($12,100 per family) in 2012.

Qualified medical expenses include medical, dental, and vision care, as well as prescription drugs and premiums for long-term care. Generally, premiums for insurance are not qualified medical expenses unless they are for insurance coverage during periods of unemployment.

10. Qualified Education Expenses and Student Loan Interest

There are several deductions available for taxpayers who have qualified education expenses. Through 2011, taxpayers can deduct interest paid on any qualified education loan. The debt must be held by the taxpayer and must have been used solely to pay for qualified higher education expenses. This deduction is above the line for Adjusted Gross Income (AGI) and is limited to a maximum deduction of $2,500. It is phased out when a single taxpayer’s AGI is between $50,000 and $75,000 (double that for joint taxpayers).

Deductions can be taken above the line for AGI for tuition and related expenses paid for enrollment or attendance at an accredited postsecondary institution for his or her own expenses or a spouse’s or dependent’s expenses. The maximum allowed deduction, through 2011, is $4,000, and is phased out for single taxpayers with AGI between $65,000 and $80,000 (double for joint taxpayers).

Education expenses that improve skills required in your present job or meet the express requirements of your employer may be deductible below the line from AGI as education expenses. Generally, these expenses are allowed as business expenses for the employer, even if you are self-employed. If you are self-employed, you will want to report the expenses as business expenses. If your employer does not pay for these expenses and you are not self-employed, then you can generally deduct the unreimbursed education expenditures related to your job as itemized deductions, subject to 2 percent of AGI.

11. Exemptions

The US tax system uses exemptions in part based on an idea that a taxpayer with a small amount of income should be exempt from taxation. Exemptions free a specified amount of income from tax ($3,800 for 2012). The Internal Revenue Code allows a personal exemption for the taxpayer and for the spouse if a joint return is filed. Dependency exemptions can also be claimed for dependents who meet certain tests.

A resident alien can claim a personal exemption deduction from Adjusted Gross Income (AGI) on his or her tax return. In addition, if he or she has any dependents, then an additional exemption can be claimed for each dependent. For resident alien taxpayers who are filing a joint return with their spouse, exemptions can be claimed for both spouses.

Note: Dependents and spouses MUST have either an ITIN or SSN in order to be claimed as dependents.

Nonresident aliens engaged in a trade or business in the US can only claim one personal exemption. For Canadians, you can also claim a personal exemption for your spouse if your spouse had no gross income for US tax purposes and is not claimed on another US taxpayer’s return. You can also claim exemptions for your dependents.

There are several rules for determining who qualifies as a dependent. In its most simplest sense, a qualifying child dependent is generally a child younger than age 19, or younger than age 24 if he or she is a full-time student, who has lived with you for more than one half of the year, except if he or she is away for school, and who has not provided for more than one-half of his or her own support for the year. Certain qualifying relatives can also be claimed as dependents including siblings, parents, grandparents, aunts, or uncles. These individuals must meet minimum income requirements and support tests in order to be claimed as dependents.

The exemption amount is adjusted annually for inflation. For 2012, the exemption is $3,800 per exemption. The exemption amount is reduced for taxpayers whose AGI exceeds a threshold amount.

12. Standard Deductions or Itemized Deductions

Generally, a taxpayer has the choice of taking a standard deduction, which is an amount determined each year by Congress, or itemized deductions, which are several expenses that can be “itemized” on Schedule A. Taxpayers whose total aggregate itemized deductions are less than the standard deduction can choose to take a standard deduction amount instead of the itemized deduction. Either itemized deductions or the standard deductions are subtracted from a taxpayer’s Adjusted Gross Income (AGI) to determine taxable income.

12.1 Standard deductions

The standard deduction is made of up two components, a “basic standard deduction” as shown in Table 12 and an “additional standard deduction” as shown in Table 13. Only taxpayers who are age 65 or older or blind qualify for the additional standard deduction.

Table 12: STANDARD DEDUCTION AMOUNTS

Filing Status	Standard Deduction Amounts
	2011	2012
Single	$5,800	$5,950
Married, Filing Jointly	$11,600	$11,900
Head of Household	$8,500	$8,700
Married, Filing Separately	$5,800	$5,950

Table 13: ADDITIONAL DEDUCTION AMOUNTS

Filing Status	Standard Deduction Amounts
	2011	2012
Single	$1,450	$1,450
Married, Filing Jointly	$2,300	$2,300
Head of Household	$1,450	$1,450
Married, Filing Separately	$1,150	$1,150

For a taxpayer who is both blind and older than age 65, he or she can claim two additional deduction amounts, and if a couple is both older than age 65 and are both blind, they can claim four additional deduction amounts of $1,150 each.

Nonresident aliens are not eligible for the standard deduction. Dual-status taxpayers (taxpayers who change status between nonresident and resident during the year) also cannot use a standard deduction. Nonresident aliens and dual-status taxpayers can, however, report certain itemized deductions. You should also note that nonresident aliens and dual-status taxpayers cannot file using either a head of household or a married filing jointly status.

12.2 Itemized deductions

Generally, personal expenses are disallowed; however, Congress has allowed certain personal expenses to be deductible as itemized deductions. These include medical expenses, certain taxes, mortgage interest, investment interest, and charitable contributions. Itemized deductions include, but are not limited to the following:

• Medical expenses in excess of 7.5 percent of Adjusted Gross Income (AGI)

• State and local income taxes

• Real estate taxes

• Personal property taxes

• Interest on home mortgage

• Investment interest, subject to a limit

• Charitable contributions, subject to limits

• Casualty and theft losses in excess of 10 percent of AGI, plus $100

• Miscellaneous expenses such as the following, to the extent they exceed 2 percent of AGI:

• Union dues

• Professional dues and subscriptions

• Certain educational expenses

• Tax return preparation fees

• Investment counsel fees

• Unreimbursed employee business expenses, subject to limits.

Resident aliens can claim the same itemized deductions as US citizens using Schedule A of Form 1040. Nonresident aliens can deduct certain itemized deductions if you receive income effectively connected with a US trade or business. The deductions available to nonresident aliens include state and local income taxes, charitable contributions to US organizations, casualty and theft losses, and miscellaneous deductions. Nonresident aliens can claim itemized deductions on Schedule A of Form 1040NR.

13. State and Local Taxes

State, local, and foreign taxes paid on real property are deductible. Taxes on personal property are generally not deductible unless they are assessed in relation to the value of the property. Special assessments are also not deductible. Instead, any payments for special assessments such as sidewalks, sewers, or streets are added to the adjusted basis of the property.

State and local income taxes are deductible as itemized deductions. If you overpay state income taxes and receive a refund in a year following the year the deduction was taken, then the refund is included in your gross income for Adjusted Gross Income (AGI) in the year the refund was received.

14. Interest Expenses

Personal (consumer) interest is not deductible. This includes credit card interest, interest on vehicle loans, other interest that is not investment interest, home mortgage interest, or business interest.

When a resident taxpayer borrows money to acquire investments, the interest paid on the borrowed funds is deductible, but is limited to the net investment income for the year. Investment income is gross income from interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business, and not from a passive activity such as real estate. This does not include capital gains as investment income, unless an election is made. However, if the election is made, it can result in your capital gains being taxed at higher ordinary tax rates instead of capital gains rates. Interest on debt incurred to purchase or carry tax exempt securities is not deductible.

If you do not have enough investment income during a year to fully deduct all of the investment interest paid, then you can carry it over to future years, without a limit on the length of the carryover period.

If the interest is related to rental or royalty property, then the deduction is allowed as a deduction from rental income on Schedule E — above the line for Adjusted Gross Income (AGI). Interest on debt in relation to a business is allowed as an expense of the business on Schedule C — above the line for AGI. Otherwise, all investment interest that is not related to rental, business, or royalty property is an itemized deduction on Schedule A.

Qualified residence interest for US resident taxpayers can be deductible. This is interest paid or accrued during the taxable year on an indebtedness that is secured by any property that is a qualified residence of the taxpayer. Qualified residence interest is either interest on acquisition indebtedness or interest on home equity loans.

There are limits to the amount of qualified residence interest that can be deducted. A qualified residence includes the taxpayer’s principal residence and one other residence of the taxpayer or spouse. If a taxpayer has more than one second residence, he or she can make the selection each year of which one is the second qualified residence. A residence is a house, cooperative apartment, condominium, mobile home, or boat or motor home that has living quarters, which is described as having sleeping accommodations and toilet and cooking facilities. The interest deduction is also limited to interest paid on aggregate qualified residence indebtedness of $1,000,000 (or $500,000 for a married individual filing a separate return) plus $100,000 of home equity indebtedness (or $50,000 for a married individual filing a separate return).

Points paid to purchase or improve a home can be deducted as interest in the year the points are paid. Points paid to refinance an existing home cannot be immediately expensed but must be capitalized and amortized as interest expense over the life of the new loan, unless the proceeds are used for improvements. If the points are paid by the seller, they are not deductible by the buyer.

Prepayment penalties resulting from paying off a loan in full or in a lump-sum before its term can be deductible as qualified mortgage interest expense, as long as the general rules for deductibility of interest are followed.

A taxpayer cannot deduct any interest paid on behalf of another individual. Interest is generally deductible in the year it is paid.

15. Medical Expenses

Medical expenses are deductible for the care of the taxpayer, his or her spouse, and dependents, as long as the medical expenses have not been reimbursed. However, the medical expense deduction is limited to the amount that those expenses exceed 7.5 percent of the taxpayer’s Adjusted Gross Income (AGI). This threshold will increase to 10 percent of AGI for tax years beginning after December 31, 2012, except for taxpayers and their spouses who are age 65 or older before the close of the tax year, in which case the 7.5 percent of AGI threshold will continue to apply for tax years 2013 through 2016.

Deductible medical expenses include expenditures for the “diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure of function of the body.”

The following is a partial list of deductible medical items:

• Medical care including dental, mental, and hospital

• Prescription drugs

• Special equipment such as wheelchairs, crutches, artificial limbs, eyeglasses (including contact lenses), hearing aids

• Transportation for medical care

• Medical and hospital insurance premiums

• Cost of alcohol and drug rehabilitation

The following is a partial list of nondeductible medical items:

• Funeral, burial, or cremation services

• Nonprescription drugs (except insulin)

• Bottled water

• Toiletries or cosmetics

• Diaper service, maternity clothes

• Programs for the general improvement of health including weight reduction, health spas, stop-smoking clinics, and social activities such as dancing or swimming lessons

• Unnecessary cosmetic surgery

Amounts paid for cosmetic surgery can only be deducted if deemed necessary. It is necessary when it corrects a deformity arising from a congenital abnormality, a personal injury, or a disfiguring disease.

The cost of care in a nursing home or home for the aged, including meals and lodging, can be included in deductible medical expenses if the primary reason for being in the home is medical care. If the primary reason for being there is personal, costs for medical or nursing care can be included, but the costs of meals and lodging must be excluded.

Tuition expenses of a dependent at a special school may be deductible as a medical expense. The deduction for the costs of the special school is allowed if a principal reason for sending the individual to the school is because of a special education system for physically or medically handicapped persons. The costs of lodging and meals resulting from going to the special school may also be deductible as medical expenses.

Some capital improvements can qualify as medical expenses, such as the cost of home-related capital expenditures incurred to enable a physically handicapped person to live independently and productively in the home. This could include ramps, widening hallways and doorways, installing support bars, and adjusting electrical outlets and fixtures. Typically, improvements increase the cost basis of the home, but when the expenses are used as medical expense deductions, there is no increase in the cost basis of the home.

The costs for transportation, meals, and lodging for medical treatment can also be deductible as medical expenses. These include bus, taxi, train, air fare, ambulance services, and out-of-pocket expenses for the use of an automobile. An allowance of 23 cents per mile can be used instead of actual out-of-pocket automobile expenses. This is the rate in effect as of January 1, 2012. This allowance includes the transportation expenses of a parent who must accompany a child who is receiving medical care or a nurse or other person giving assistance to someone who is traveling to get medical care and cannot travel alone. The deduction for lodging while away from home can be taken only when the lodging is primarily for and essential for the medical care. The deduction cannot exceed $50 per night for the patient and another $50 if a person must travel with the patient. Meals for persons who are not the patient are generally not deductible.

Medical insurance premiums, paid by you, can also be deducted as medical expenses. This is only if the costs are paid by you and are not reimbursed or paid for by any other person, entity, or your employer. Long-term care insurance premiums can also be deductible, but there are dollar limits on the amount that can be deductible; those limits are shown in Table 14.

Table 14: LIMITS ON MEDICAL DEDUCTIONS

(This table lists the limits of the long-term care premiums that can be deducted as medical deductions)

Taxpayers Age at End of Tax Year	2012 Limit
40 and younger	$350
Older than 40 but not older than 50	$660
Older than 50 but not older than 60	$1,310
Older than 60 but not older than 70	$3,500
Older than 70	$4,370

Medical expenses must be deducted in the year the expenses were paid, except for when a taxpayer dies. If the medical expenses of a deceased person are paid within one year following the date of death, they can be treated as being paid at the time they were incurred. This means that these expenses may be reported on the final income tax return of the decedent or on earlier returns if the expenses were incurred before the year of death.

16. Employee Educational Expenses

If education expenses for US resident taxpayers are incurred in the pursuit of maintaining or improving skills required in a taxpayer’s employment or other trade or business, even if they lead to a degree, then they may be deductible as non-reimbursed employee expenses. They cannot be deductible if they are not required to meet minimum education requirements for a taxpayer’s current job or to qualify the taxpayer for a new trade or business. If the expenses are paid for or are reimbursed by an employer, then they cannot be deducted by the employee.

17. Charitable Contributions

Generally, any contributions made to qualified US charitable organizations can be deductible as itemized deductions in the year the payment is made, subject to several qualifiers and limitations. A charitable contribution must have a donative intent with the absence of consideration. The transfer must be made with the motive of disinterested generosity.

Contributions of services are not deductible. However, unreimbursed expenses involved for providing your contribution of services, including out-of-pocket transportation costs, may be deductible. In lieu of out-of-pocket transportation costs in 2012, a standard mileage rate of 14 cents per mile can be deducted, plus parking fees and tolls. Deductions for reasonable costs of lodging and meals can be deductible for time spent away from home for performing donated services.

Nondeductible items include dues to clubs, lodges, costs of bingo or lottery tickets, costs of tuition, the value of your blood given to a blood bank, donations to homeowners’ associations, gifts to individuals, and rental values of property used by a charity. Qualified organizations include states or possessions of the US, organizations situated in the US organized and operated for religious, charitable, scientific, literary, or education purposes, or for the prevention of cruelty to children or animals, veterans’ organizations, fraternal organizations, or cemetery companies. Contributions to foreign organizations are not deductible; however, you may be able to deduct contributions to US charitable organizations that transfer funds for foreign charitable needs. The IRS publishes a list of organizations that have applied for and received tax exempt status as charitable organizations.

If your total charitable contributions are less than $250 in any year, you do not need to include written substantiation of the contributions. However, if the deductions are greater than $250, you will need to specify the amount of cash and a description of any property other than cash contributed. You must have a written statement from the charitable organization confirming the contribution.

For noncash contributions of property, you should refer to Publication 526 for details on what you will need for substantiation of the contribution. If the value of the contribution is more than $500, then you will have to complete and attach the Noncash Charitable Contributions (Form 8283) to your return. If the value of the donated property is $5,000 or more, you will have to get a qualified appraisal. Taxpayers who donate a vehicle, truck, boat, or aircraft valued at more than $500 must obtain a Contributions of Motor Vehicles, Boats, and Airplanes (Form 1098-C) from the charity, and if the charity sells the property, then the deduction may be limited to the proceeds that the charity was able to receive from the sale.

If ordinary income property is donated, the deduction is equal to the fair market value of the property less the amount of ordinary income that would have been reported if the property was sold. Ordinary income property is any property that, if sold, would result in the recognition of ordinary income. This can be inventory in the taxpayer’s trade or business, a work of art created by the donor, or a manuscript prepared by the donor, or short-term capital gain property. In most instances, the charitable deduction for ordinary income property is limited to the adjusted basis of the property.

The contribution of long-term capital gain property generally results in a deduction equal to the fair market value of the property at the time of contribution. Special rules apply if property is contributed to a private foundation. There are also special rules for tangible personal property, which is property that is neither realty, nor intangible property such as stock or securities. If tangible property is contributed to a public charity, such as a museum, church, or university, the charitable deduction may have to be reduced if the property is put to a use that is unrelated to its purpose. For example, if you donate a piece of artwork to a museum, and it is not kept by the museum but is instead immediately sold at a fund-raising auction, it was not used for its intended purpose as a piece of artwork. If the art is retained in the museum’s collection, then it would be considered to be used for its intended use and would be fully deductible.

Each taxpayer has limits on the amounts that can be deductible in any year for charitable contributions. Contributions made to public charities cannot be deducted if they exceed 50 percent of an individual’s Adjusted Gross Income (AGI) for the year. A 30 percent ceiling applies for contributions made to private nonoperating foundations, except for long-term capital gain property contributed to private nonoperating foundations, in which case it is subject to a 20 percent of AGI ceiling. All excess contributions can be carried over for five years.

Note: The Treaty allows for a charitable deduction to Canadian Charities as long as the contribution meets two criteria:

• The charity would have met the tax exempt criteria if it were in the US.

• You must have income from Canada that equals or exceeds the deduction claimed.

Because this deduction is permitted under the Treaty, you must file Treaty-Based Return Position Disclosure under Section 6114 or 7701(b) (Form 8833) for the deduction to be valid.

18. Miscellaneous Itemized Deductions

The following expenses are a partial list of items that can be deducted as miscellaneous itemized deductions:

• Gambling losses up to the amount of gambling winnings.

• Impairment-related work expenses of a handicapped person.

• Federal estate tax on income in respect of a decedent.

• An unrecovered investment in an annuity contract when an annuity ceases as a result of death.

The following is a partial list of items that can be deducted if, in total, they exceed 2 percent of the taxpayer’s Adjusted Gross Income (AGI):

• Professional dues to membership organizations.

• Uniforms or other clothing that cannot be used for normal wear.

• Fees for preparing tax returns or fees for tax litigation before the IRS or the courts.

• Job hunting costs.

• Fees paid for a safe deposit box used to store papers and documents relating to taxable income-producing investments.

• Investment management expenses for the management of taxable US investments.

• Appraisal fees to determine the fair market value of the property involved in a casualty loss or a donation.

• Hobby losses up to the amount of hobby income.

• Unreimbursed employee expenses.

You may be able to deduct ordinary and necessary travel expenses while you are working in the US if you are on a temporary assignment that is realistically expected to, and does last for one year or less. These expenses would be miscellaneous itemized deductions subject to 2 percent of your AGI. If you qualify, you may be able to deduct expenses for your transportation, lodging, and 50 percent of the cost of your meals. If you are reimbursed by your employer for these expenses, or if your employer pays these costs, then you would not be able to deduct the expenses. You would be able to deduct your expenses only and not the expenses for anyone else, including members of your family.

Note that most, if not all of the itemized deductions reported on Schedule A are for personal expenses only and not for expenses related to the production of income, in connection with a trade or business, unless they are unreimbursed expenses that you paid out of your own pocket. If the expense is incurred as a result of a passive or rental activity, it is generally a deduction for AGI and reported on Schedule E, and if the expense is incurred in connection with a trade or business, it is a deduction for AGI and is reported on Schedule C. Also, expenses that are reimbursed or paid by an employer are not deductible by the employee.

19. Credits

Congress has often used tax credits to achieve social or economic objectives to promote equity among different types of taxpayers. Tax credits should not be confused with income tax deductions. Tax credits are not affected by the tax rate of the taxpayer; they are a direct reduction of the tax.

Certain credits are refundable, meaning that if the amount of the credit exceeds the taxpayer’s tax liability, the excess is paid to the taxpayer. However, nonrefundable credits are not paid if they exceed the taxpayer’s tax liability.

Some nonrefundable credits, such as the foreign tax credit, are subject to carryover provisions if they exceed an allowable amount during the year. The foreign tax credit is not discussed here because a full chapter is dedicated to it (see Chapter 5).

Like every other aspect of the US Federal income tax system, the rules can be complicated. If you want to use any of the credits available to you, you should seek advice from a qualified tax accountant. We are merely introducing you to the concepts.

19.1 Child and dependent credit

A nonrefundable credit may be available to taxpayers who incur employment-related expenses for child or dependent care, for children under age 13. The credit is based on a percentage of actual dependent care expenses that were incurred so that the taxpayer could work.

The maximum credit $1,050 for one qualifying dependent or $2,100 if two or more qualifying dependents are involved is available, and is available for taxpayers with Adjusted Gross Income (AGI) of less than $15,000. The credit starts to get reduced when AGI exceeds $15,000 and is capped when AGI reaches $43,000. For taxpayers with AGI of greater than $43,000, they can claim the minimum credit of $600 for one dependent or $1,200 for two or more dependents. Married taxpayers must generally file a joint return to claim this credit, and because the credit is per dependent, there is no additional allowance for a couple filing jointly.

19.2 Credit for the elderly or disabled

A nonrefundable credit is available to taxpayers who are 65 years old or are permanently disabled. This credit is 15 percent of an initial amount which is $5,000 for single individuals and $7,500 for married couples filing jointly. For married couples filing separately, the amount is $3,750. The amount is reduced by amounts received as pension, annuity, or disability benefits that are excludable from gross income, and then reduced by one-half of the taxpayer’s AGI in excess of $7,500 for single taxpayers or $5,000 per each married taxpayer.

The eligibility requirements and the tax computation for this credit are complicated. An individual may elect to have the IRS compute his or her tax and the amount of tax credit.

19.3 Child tax credit

A credit is available for taxpayers who have one or more qualifying children that they also claim as dependents. This is separate from the child and dependent care credit. The credit is $1,000 per child through 2012, and decreases to $500 per child beginning in 2013. The credit is phased out when modified Adjusted Gross Income (AGI) reaches $110,000 for joint taxpayers and $75,000 for single taxpayers. The credit is reduced by $50 for every $1,000 of modified AGI in excess of those thresholds. The credit can be partially refundable.

19.4 Earned income credit

This credit is a refundable credit that is available to low-income individuals who have an Adjusted Gross Income (AGI) below a certain level, have a valid Social Security number, and use a filing status other than married filing separately. You must be a US citizen or resident alien and have no foreign income to be eligible for this credit.

The determination of the amount of the credit and the phaseout limits for this credit depend on how many dependent children you have. The credit is based on earned income, and the maximum credit for taxpayers with one qualifying child, for example, is $3,169 in 2012. A maximum credit in 2012 for three or more children is $5,891. If you have no qualifying dependent children, your maximum credit is $475.

19.5 Education credits

There are credits available to help qualifying low- and middle-income individuals defray the costs of higher education. These credits are generally nonrefundable and are available for qualifying tuition and related expenses incurred by students seeking college, graduate degrees, or vocational training. These credits are not available for nonresident alien taxpayers.

The American Opportunity Credit is a credit for 100 percent of the first $2,000 of qualified tuition and related expenses plus 25 percent of the next $2,000, for a total maximum credit of $2,500 per eligible student per year. Forty percent of the credit is refundable, which means that you may be able to receive up to $1,000, even if you owe no taxes. The credit phases out for taxpayers with modified Adjusted Gross Income (AGI) between $80,000 and $90,000 (double for married taxpayers who file joint returns). The credit cannot be taken by married taxpayers who file separate returns. This credit is available for tax years 2009 through 2013. This credit replaced a Hope Scholarship Credit which was available in previous years.

A Lifetime Learning Credit is available for qualified tuition expenses paid on the first $10,000 of tuition. It is a one-time credit and is limited to $2,000. The credit is phased out for single taxpayers when modified AGI reaches $52,000 in 2012 and completely phases out when modified AGI exceeds $62,000 in 2012. For joint taxpayers, the phase out is $104,000 and $124,000 in 2012.

19.6 Retirement savings contributions credit

In cases of low-income taxpayers, a nonrefundable credit is available for taxpayers who make a contribution to a qualified retirement savings plan. This includes contributions made to a traditional or Roth IRA, elective deferrals to a 401(k) plan or 403(b) plan, or other qualified plan. The credit is available for taxpayers whose 2012 Adjusted Gross Income (AGI) is less than $57,500 for joint returns, $43,125 for heads of household, and $28,750 for single filers. The maximum credit amount is $1,000 and is calculated as a percentage multiplied by the contributions, up to $2,000 per year, to qualified retirement plans during the year. This credit is available to residents and nonresident aliens.

19.7 Other credits

In addition to the credits that we discussed above, there are several credits available for very specific circumstances. (Foreign tax credits are discussed in Chapter 5.) The following is a partial list of other credits that may be available:

• A first-time home-buyer credit was available for qualified homeowners who purchased a home before May 1, 2010, to be their principal residence. This type of credit has been available, in different forms, many times and may be reintroduced at some point. This credit would not be available to nonresident aliens.

• A refundable adoption credit for qualified adoption expenses. In 2012, the credit reverts back to being nonrefundable.

• Health insurance premium assistance refundable credit for very low-income individuals and families. This credit will begin for tax years ending after December 31, 2013, and is meant to help with the cost of federally mandated insurance costs for very low-income persons. This credit will be available for lawful resident aliens who are not eligible for Medicaid; however, the credit is for households whose income is below the federal poverty level.

• There are nonrefundable credits available for energy efficient nonbusiness property and improvements, such as residential doors and windows, insulation, heat pumps, furnaces, air conditioners, and hot water heaters. The credit is available for qualified energy efficiency improvements installed between January 2008 and January 1, 2012.

• There are nonrefundable credits available for alternative motor vehicles. Various vehicles qualify for credits, and the credits are different for each type of vehicle. The credits have been available for plug-in electric drive motor vehicles, hybrid vehicles, alternative fuel vehicles, and alternative fuel refueling property.

• Businesses have several credits available, including the alternative motor vehicles credits and energy efficient property credits. There is an extensive list of credits available for special situations. For example, a commonly used business credit is a work opportunity credit, which is available to businesses for hiring hard-to-employ individuals.