The Mysterious Miscellaneous Deductions

When filing your tax return, you can generally choose between itemizing your deductions and taking the standard deduction. It all depends on which method provides you with the greater tax benefit. Taxpayers that choose to itemize will find that itemized deductions are broken down into several categories, which include medical, taxes, interest, charity and miscellaneous deductions.

Of all the categories, miscellaneous deductions may be the most mysterious because it is broken down into two sub-categories, one of which has limitations based upon income. In addition, since it is a catch-all category, many of the deductions themselves have special rules and limitations. On top of all this, one of the sub-categories is further limited by the alternative minimum tax (AMT).

This may all seem too complex, but we will attempt to shed enough light on the mysteries to give you a better understanding of this deduction and how it can or cannot benefit you.

First of all, the deductions are broken down into two sub-categories, often referred to as tier I and tier II deductions in tax lingo. The tier I deductions are not limited by income or the AMT and include the following infrequent deductions:

o Gambling losses – A deduction for gambling losses (not to exceed gambling winnings).

o Impairment-related work expenses – A deduction for impairment-related work expenses for taxpayers having a physical or mental disability that limits their activities.

o Claim of right deduction – A deduction is allowed when a taxpayer has repaid income that was taxable in a prior year.

o Federal estate deduction – A deduction is available when inherited income is subject to inheritance tax and is also taxed to the beneficiary (double taxed).

o Amortizable bond premium – Not applicable to most taxpayers.

All other deductions fall under the tier II sub-category. The tier II category is deductible for regular tax purposes only to the extent the deduction exceeds 2% of your adjusted gross income (AGI) for the year. In addition, to the extent you might be subject to the AMT, this sub-category is not deductible at all. Let’s say your AGI (generally your income for the year) is $75,000. 2% of $75,000 is $1,500. Thus, your first $1,500 of tier II itemized deductions would not be deductible. If it exceeds $1,500, then you are only allowed to deduct the amount that exceeds the $1,500. So, if your tier II miscellaneous deductions are clearly less than 2% of your AGI for the year, there is no need to spend time on this deduction. If you are subject to the AMT, there is a chance that even the amount that exceeds the 2% might not be deductible, since tier II deductions are not allowed in the AMT computation. So what deductions are included in the tier II sub-category? Tier II deductions generally include:

o Employee business expenses – Tools, uniforms, supplies, travel, occupational licenses, etc., not reimbursable by the employer and required as part of employment. It does not include commuting expenses.

o Investment expenses – Includes certain investment fees, custodial fees, trust administration fees, and other expenses paid for managing investments that produce taxable income.

o Home office deduction - If the taxpayer uses part of his home regularly and exclusively for business purposes and meets the stringent IRS requirements for this deduction, he or she may be able to deduct part of the operating expenses and depreciation of the home.

o Employee education expenses - To be deductible, educational expenses must be closely related to the taxpayer’s present job and must either maintain or improve skills required in the taxpayer’s present job, or be required by the employer to retain the taxpayer’s position.

o Legal expenses - For the protection or production of taxable income (generally excludes divorce issues).

o Tax preparation fees – Includes costs for planning, consultations and representation, as well as the actual return preparation.

How much these deductions will save you in taxes depends upon your tax bracket. If you are in the 25% tax bracket, you will save 25 cents for every dollar of deductible deduction. Another way to look at it is that you recoup 25 cents for every deductible dollar spent as a reduction in your tax. However, because of the various limitations and AMT you may not benefit as you might think for your tax bracket. Therefore, where possible, attempt to have employee business expenses reimbursed by your employer under an accountable plan, even if it means reducing your salary slightly to pay for the tax-free reimbursement. Your employer may also be able to reimburse you for all or a portion of your education expenses.

If you have significant miscellaneous deductions that are being lost to the various limitations listed above, it may be appropriate to schedule a consultation to see if there are tax scenarios that can help your specific situation.

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