It's decision time: Do you itemize deductions on Schedule A or take the zero bracket amount (ZBA) -- what once was called the standard deduction? For most people, this is a relatively simple decision. If the total amount you can claim by itemizing is greater than the ZBA for your filing category, you should itemize. If the total is the same or less, use the ZBA.
The zero bracket amounts for 1985 tax returns are increased slightly over the 1984 numbers because of indexing:
*$2,390 for filing status 1 (single) and status 4 (head of a household).
*$3,540 for categories 2 (married filing a joint return) and 5 (qualifying widow or widower with dependent child).
*$1,770 for filing status 3 (married filing a separate return).
The tax tables and tax rate schedules already incorporate the appropriate ZBA deductions, so you have no calculations to make if you use the ZBA. For that reason, if you itemize, a special deduction -- taking out the ZBA that's already accounted for in the tables and schedules -- is required on line 25 of Schedule A (after you have added up your various deductions). Only the net amount on line 26 of Schedule A is carried to line 34a of the 1040.
(Caution: If your state tax return requires the use of the federal Schedule A deduction, be sure to carry the total amount from line 24 to the state form, not the reduced amount from line 26.)
Schedule A includes five major areas of deductions -- medical and dental expenses, taxes, interest, contributions and casualty losses -- plus a sixth section titled "Miscellaneous Deductions" for whatever doesn't fit anywhere else.
Overlooked deductions are a major reason for overpayment of taxes, and thus fertile ground in which to search for ways to reduce the tax bite. Let's take a detailed look at each of the six categories. Medical Expenses
Qualifying medical expenses may be claimed on Schedule A to the extent that the total exceeds 5 percent of your adjusted gross income (line 33 of Form 1040).
This includes all payments you made in 1985 to medical practitioners, such as physicians, dentists, osteopaths, chiropractors, nurses and acupuncturists; to pharmacies for prescription drugs and insulin, but not for other over-the-counter medications; and to such medical organizations as hospitals, clinics, free-standing emergency centers, laboratories and ambulance services.
The cost of a legal abortion or a procedure for sterilization is a qualifying expense, but illegal drugs or any procedure that is against the law in your state or under federal regulations cannot be included. Organ donors may deduct all related surgical, hospital and transportation expenses.
Include the cost of prosthetics, such as false teeth, hearing aids and batteries, glasses and contact lenses, orthopedic shoes, crutches, canes and similar aids; purchase or rental of special equipment for the handicapped; the cost of acquiring and maintaining a guide dog for the sightless or hearing-impaired; and medical insurance premiums, including such things as replacement insurance for contact lenses and supplementary (Part B) Medicare.
Medical expenses include the cost of transportation to obtain medical care -- bus, taxi, train or plane fare, or 9 cents a mile plus tolls and parking fees if you use your car. Expenses of a parent traveling with a child or of a nurse accompanying a patient also may be claimed. You may deduct the actual cost, up to $50 per day, for lodging (but not food) while away from home at least overnight to obtain medical treatment.
In addition to your own medical expenses, you may count those expenses paid by you on behalf of any person claimed as a dependent on your return, including a dependent you claim under a multiple support agreement. You also may include expenses you paid for a person you would have been permitted to claim as a dependent except that he or she had taxable income of $1,040 or more or is filing a joint return.
New this year: Both divorced parents may claim medical expenses each paid for a child, regardless of which parent has custody or gets the dependent exemption.
If you charge medical expenses on a bank credit card, the deduction should be claimed in the year of the charge rather than in the year the account is paid. But if the health practitioner simply delays billing or defers the due date of your payment, then the deduction belongs in the year of the payment. Taxes
Despite a lot of talk about cutting back, you still may deduct just about the same state and local taxes on your 1985 return as you did for 1984. But first, let's set the record straight on those taxes you may not deduct: excise taxes on liquor, cigarettes, gasoline, utility bills or transportation; hunting or fishing licenses; car tags or driver's licenses; and traffic fines or penalties for underpayment of federal or state income tax.
With those out of the way, we can take a look at the major kinds of tax payments you may deduct.
*State and local income taxes actually paid or withheld from wages during 1985, whether more or less than your actual tax bill. If you itemized deductions for 1984, and then in 1985 received a refund of a part of your 1984 state income tax, that refund should not be offset against your 1985 state income tax payments. Instead, report the refund as income on line 10 of your 1985 Form 1040, and claim on Schedule A the full amount of taxes paid or withheld.
*Personal property taxes paid in 1985, regardless of the year to which the tax applied.
*Real estate taxes paid in 1985 on your home or other nonbusiness property. (Taxes paid on property held for rental to others go on Schedule E as an expense against rental income, rather than on Schedule A.) If the institution that holds your mortgage pays the real estate tax, deduct only the amount paid on your behalf in 1985 as shown on the annual statement, not the monthly tax payments you made into the escrow account.
*General sales tax -- either the amount allowed in the table in the IRS instruction booklet, or the total actually paid if you kept a record. In addition to the amount authorized by the table, if you use that option, you may claim sales tax paid on certain major purchases, such as a car, boat or trailer.
If you use the sales tax table, add to your adjusted gross income all nontaxable income, such as municipal bond interest, the deduction for a two-earner couple and the untaxed part of Social Security benefits. You also may add in the excluded portion of long-term capital gains; fairness requires that you then deduct the excluded portion of any net long-term losses.
Instead of simply looking up the sales tax allowance for your adjusted gross income, use this true "spendable income" figure. In the "Taxes You Paid" box on Schedule A write "includes X nontaxed income" (entering the dollar amount) to explain the seeming discrepancy. Interest Expense
You may deduct on Schedule A interest paid on a mortgage on your home or other nonbusiness property, on a car or other personal loan, on charge accounts and on federal or state tax deficiencies (but not any penalty charges).
Banks and other mortgage institutions are required this year to send you a new form (1098) showing the amount of interest expense paid on your mortgage during 1985. If there are others on your mortgage (other than your spouse), attach a statement to your return with the name and address of any collateral mortgagor.
If you bought a home with "creative financing" that provided you with a mortgage at less than market rates, you may be entitled to a Schedule A deduction at a higher rate than that stated. For a principal residence at a purchase price of up to $250,000, the "trigger" market rate is 9 percent and the imputed interest rate 10 percent. For a higher-priced home or for other types of property, you should consult a professional.
Interest on a life insurance loan is deductible if paid in cash, but not if the interest charge is added to the principal amount of the loan.
The amount of any "points" paid by you in connection with the purchase of a home normally is considered interest. But if you didn't pay the points in cash, and the amount was subtracted instead from the loan proceeds, the deduction may not be allowed because you didn't actually "pay" the charge.
If you sold your home, points you paid to induce a lender to provide financing to the buyer (mortgage "buydown") are not considered interest. The amount you paid, however, is a selling expense that may be used to reduce any gain on the sale.
Prepaid or discounted interest may not be deducted when paid if the loan extends beyond the 1985 tax year. Instead, the interest cost must be prorated over the life of the loan, with only the amount applicable to each year's payments allowed as a deduction on that year's tax return.
If the loan document doesn't specify, and you don't know how much of each payment is interest, divide the total amount of interest evenly over the scheduled number of payments. Multiply the resulting interest per payment by the number of payments due and made during the year.
Interest paid on money borrowed to buy tax-exempt bonds or a single-premium life insurance policy is not an authorized deduction. And there is a ceiling on the deduction for interest paid in connection with investments. See IRS Publication 550 for details. Contributions
All taxpayers, whether they itemize or not, are eligible in 1985 for a deduction for contributions to qualifying organizations. The IRS instruction booklet that accompanied your tax forms provides a comprehensive list of the types of religious, charitable and educational institutions that qualify, along with the major kinds of contributions that may not be claimed.
Cash is the most common form of contributions to one of the qualifying organizations. In addition to routine payments to various religious and charitable organizations, "cash" includes any excess over the normal market value paid for cookies or candy, dinners, theater admissions, etc.; and amounts added by customers to their utility bills when the utility company is acting as an agent to collect funds for low-income, elderly or handicapped people in need of emergency energy assistance.
You also may deduct the fair market value of property donated to a qualifying organization if the property is used by that organization in connection with its tax-exempt functions. New for 1985: You must document donations of property on Form 5283 if the total value of all non-cash contributions exceeds $500.
If you donate property you have owned for more than six months that has appreciated in value, you may claim the higher market value at the time of the donation without having to report any realized capital gain.
But there are restrictions on the deduction for contributions of property -- particularly property that now is valued at more than your cost basis. Among the new rules: A professional appraisal is required to support a claim for property (other than publicly held securities) valued at $5,000 or more. The appraisal fee itself may not be added to the value of the contribution, but may be taken as a miscellaneous deduction on Schedule A. See IRS Publication 526 for further details.
Unreimbursed expenses incurred while donating services to a qualifying organization are deductible, such as postage and phone calls, meals while contributing your services, the purchase and upkeep of specialized uniforms not suitable for general wear.
You also may deduct local transportation expenses and the cost of travel to attend a convention as an official delegate of a qualifying organization, including meals and lodging if away from home overnight.
If you use your own car, you may claim either the actual out-of-pocket cost of operating the vehicle (fuel and maintenance, but not depreciation or insurance), or the new optional standard rate of 12 cents a mile, up from 9 cents last year. Add tolls and parking fees with either method.
You may not deduct the value of your contributed services, even if you normally are paid for the same type of work. Similarly, the value of temporary use of your property by a qualifying organization is not deductible, even if the property is normally rented for income; but actual expenses such as utilities or custodial services may be claimed.
Taxpayers who itemize deductions should claim their contributions on Schedule A. Nonitemizers using any one of the three tax forms also may claim 50 percent of qualifying charitable contributions, with no ceiling other than the statutory limitations explained in Publication 526. The deduction is taken on line 16 of Form 1040A or line 4 of the 1040EZ. Casualty Losses
You may be eligible for a Schedule A deduction in the event of the destruction of or damage to nonbusiness property resulting from a sudden, unexpected or unusual occurrence.
Gradual deterioration, such as a termite infestation, doesn't qualify, nor does preventive action, such as removing a dead tree before it falls. The event must occur suddenly -- a hurricane or tornado, earthquake or flood, fire, theft, vandalism or accident.
Only an unreimbursed loss is deductible. Any amount recovered from an insurance company or from another individual must be subtracted from the total loss.
The first $100 of net loss from each separately identifiable event must be subtracted. Nonbusiness casualty losses are deductible only to the extent that the total of all losses (after deducting the $100 exclusion for each loss) exceeds 10 percent of your adjusted gross income.
Report casualty losses on IRS Form 4684, using a separate form for each separate event, then summarizing on lines 13 through 18 of a single 4684. The net deductible loss from that summary 4684 goes on line 19 of Schedule A.
Expenses associated with establishing a loss -- photographs or professional appraisals, for example -- may not be added to the amount of the loss itself but may be claimed as a miscellaneous deduction. Employee Deductions
Certain business expenses may be taken in the "miscellaneous deductions" section of Schedule A if they were incurred in the course of your employment and you were not reimbursed by your employer.
These include union dues, professional publications and societies, small tools and supplies, entertainment expenses, cost of purchases and maintenance of specialized uniforms not suitable for wear away from work and protective clothing, such as hard hats and safety shoes.
If your employer requires that you have a medical examination and doesn't reimburse you, the cost may be claimed as either an employe expense or a medical deduction. Unless other medical expenses already have put you over the required minimum, a miscellaneous deduction is the smart way to go.
Military people on active duty may not deduct the cost of regular uniforms, but may claim items such as insignia and ribbons, and both the purchase cost and upkeep of work clothing that may not be worn off duty. Reservists and guardsmen not on extended active duty may deduct the unreimbursed cost of all uniforms.
Other than transportation, unreimbursed expenses for qualifying education related to your work are deductible on Schedule A. Transportation costs for qualifying education may be claimed as an adjustment to income, even if you don't itemize deductions.
To qualify, the education must have been taken to meet the requirements of your employer or of the law to keep your present job, or to maintain or improve your skills on that job. Education to qualify for a job initially, to train for a new profession or for your own pleasure does not qualify.
Expenses related to a search for a job in the same trade or business may be deducted even if the search was unsuccessful. But such expenses may not be claimed if they were incurred in a search for employment in a new trade or business.
If the job-hunting qualifies under this rule, you may deduct such things as preparation and mailing of a resume, fees paid to an employment agency, long-distance phone calls and travel expenses (for an interview, for example).
You may not claim the cost of a certifying examination or of a license to practice; but these may be included as expenses on Schedule C if you were self-employed and were already in business when the costs were incurred. Office at Home
If you were self-employed and used a part of your home for business, you may deduct certain expenses if the space used meets these tests:
*The area must be used exclusively for business. It may be a separate room or just part of a room, as long as that part is used only for business purposes.
*It must be the principal place for operating the business for which you claim the deduction, or be regularly used by clients or customers.
The business for which you claim the office deduction need not be your principal occupation. The deduction qualifies even if the space was used for a secondary or part-time business, as long as the tests are met.
If you are an employe rather than self-employed, there is a further requirement: Use of the space in your home must be for the convenience of your employer, not for your own convenience.
If the space qualifies, you may deduct two kinds of expenses:
*Those costs directly attributable to the business use, such as a desk, filing cabinet, telephone or stationery.
*A proportionate share of the general expenses of the home, such as utilities, rent, insurance and depreciation (if you owned the home). The fraction to be used may be derived either from the number of rooms in the home or by a square-footage calculation.
Property purchased for use in the business may qualify for the investment tax credit and accelerated depreciation methods; and up to $5,000 worth of business property may be "expensed" in the year of purchase -- that is, written off in full rather than being depreciated over a period of years.
To qualify for these special tax breaks, however, the property must be used predominantly for business; that is, business use must exceed 50 percent of total use. If it does not, depreciation must be taken using the straight-line method over the useful life of the property, for the part of the cost that corresponds to the percentage of business use.
If you are claiming expenses for an office in your home, IRS Publications 334, "Tax Guide for Small Business," and 587, "Business Use of Your Home," will be very helpful.
The deduction for an office in the home may not be used to shelter other income from tax. After subtracting the allocable portion of property taxes and mortgage interest (which could be claimed on Schedule A in any case), the deduction for the remaining expenses may not exceed your net income from the activity for which the deduction is claimed. Adoption Expenses
A miscellaneous deduction is allowed for up to $1,500 of expenses in connection with adoption of a "child with special needs," one who has been so designated under the laws of your state and who is eligible for adoption assistance payments under the Social Security Act.
Qualifying expenses include adoption fees, court costs and attorney fees. Total expenses must be reduced by any reimbursement received under a federal, state or local government program. But adoption assistance payments from Social Security are considered "maintenance payments" rather than expense reimbursements, and need not be offset. Investment Expenses
In general, you may claim as a Schedule A deduction any personal expense related to the production of taxable income. Under this rule, you may include the cost of a safe-deposit box if it held corporate stocks or bonds or the deed to investment property, but not if it contained only the deed to your residence, other personal papers and tax-free bonds.
Fees for investment advisory services and subscriptions to investment periodicals may be deducted even if you lost money on your investments. The cost of transportation to your broker's office may be included; but travel expenses to attend a stockholder meeting are not deductible, even if you own or contemplate buying shares in the company.
You may not claim a deduction for office space in your home that is used to manage your investments, no matter how extensive those investments are. Although there is an obvious profit motive, an investment portfolio does not constitute a trade or business, and you may not claim home office expenses.
However, you may deduct reasonable costs directly attributable to management of your investments, such as a calculator and accounting pads. You also may deduct the cost of computer software dedicated to portfolio management; but the computer itself doesn't qualify for the investment tax credit or accelerated depreciation unless it is used more than 50 percent for qualifying business purposes.
You may deduct fees paid to your bank or broker for the collection of taxable interest on notes or bonds; and a custodial fee on your IRA or Keogh account is deductible if you paid the fee in cash, but not if it simply was deducted from your account. Other Deductions
Legal fees associated with the production of taxable income, such as attempts to collect alimony or back wages, qualify as miscellaneous deductions. Legal costs for a divorce proceeding are not deductible; but a separately identified fee for investment or tax counseling in connection with a divorce is a valid deduction.
This is the place to deduct your losses from all kinds of gambling, but only to the extent that you have reported gambling winnings as income. Winnings and losses must be reported separately; you may not offset one against the other to come up with a net figure.
Finally, don't forget to include a fee paid for having your personal tax return prepared, as well as the cost of any tax books and of trips to your tax preparer and to an IRS office for forms or tax assistance. Even if you prepared your own return, you may deduct the cost of legal or accounting assistance needed in the event of an audit of your return.