How Do Tax Deductions Work?

Tax deductions are a way to help you pay less taxes each year. They lower the amount of income you report to the IRS to calculate your income taxes. 

Not all tax deductions are created equal, and some are much easier to obtain than others. Tax law can get confusing, but knowing which tax deductions you can take advantage of and how they work can save you hundreds (or even thousands) of dollars. 

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What Is a Tax Deduction?

Tax deductions are expenses that you can subtract from your income to lower the amount of taxes you pay. 

You use these deductions when you prepare your tax return for the year, and they allow you to subtract certain costs from your income.

There are several types of tax deductions for both personal and business expenses. And how you apply your tax deductions can vary depending on your specific circumstances. 

The U.S. has a very complicated tax code, so it’s a good idea to work with a licensed tax professional (CPA or EA) who can help you optimize your taxes each year.

READ MORE: Do I Need to File Taxes? A Basic Checklist

How Tax Deductions Work

Tax deductions are applied to your tax return based on expenses you’ve had throughout the year. 

Different deductions have different rules and limitations placed on them by the IRS. You may need to meet a minimum expense, or you may be capped on the total you can deduct.

There are two main ways to apply tax deductions:

• The standard deduction is an amount that anyone can use to reduce their taxable income. For individual taxpayers, it is $14,600 in 2024. If you’re married and filing jointly, you have a standard deduction of $29,200 in 2024.
• Itemized deductions allow you to add up individual deductions in different categories to find your total deduction number. If this number is less than the standard deduction, you will simply use the standard deduction amount. But if it is more than the standard deduction, you will file your itemized deductions using the IRS Schedule A form.

In addition to standard and itemized deductions, there are also “above-the-line” deductions that lower your taxable income no matter which method you choose. This includes: 

• Retirement plan contributions
• Student loan interest
• Tuition and fees
• Contributions to HSA plans

Types of Tax Deductions

There are several types of tax deductions, both for personal and business tax returns.

Personal tax deductions

Personal tax deductions are either applied “above the line” and reduce your AGI, or they are itemized. 

Here are a few common personal tax deductions:

• Mortgage interest: If you have a mortgage on your personal residence or second home, you can deduct the interest paid throughout the year.
• Student loan interest: You can deduct the interest paid on those loans, whether they are private or federal loans.
• Medical expenses: You can deduct medical expenses that are over 7.5% of your AGI. This includes medical insurance premiums, doctor appointments, prescriptions, non-elective medical procedures, and contacts or eyeglasses.
• Property taxes: If you own a home, you can deduct the amount paid in property taxes on your personal residence or second home.
• State and local taxes: You can deduct state and local income taxes or sales tax paid on items throughout the year. You can keep receipts and deduct actual amounts, or use the IRS sales tax estimate calculation instead.
• Retirement contributions: If you contribute to a traditional IRA or 401(k), you can deduct the amounts contributed. Note: Roth 401(k) or Roth IRA contributions are not tax-deductible.
• Charitable contributions: You can deduct charitable contributions made to qualifying non-profit organizations (such as church tithing). 

There are many more deductions available depending on your personal tax situation.

Self-employment tax deductions

If you are self-employed or work as a contractor, there are some self-employment tax deductions you can claim on Schedule C. 

Here are a few common deductions for self-employed folks:

• Work-related expenses: Any expenses related to your self-employment can be deducted from your business income. But you may need to split your deductions between personal and business use, depending on the expense.
• Home office deduction: If you use a home office for your self-employed income, you may be able to deduct a portion of your mortgage and utility costs based on the square footage of the room and business use percentage.
• Health insurance premiums: You may be able to deduct health insurance premiums from your business income.
• One-half self-employment taxes: You can deduct one-half of your self-employment taxes (Social Security and Medicare taxes) each year.

READ MORE: How to Do Taxes as a Freelancer

Small business tax deductions

Small businesses only pay taxes on profits from the business, but you can lower your reported business profit with business tax deductions. 

Here are a few small business tax deductions that can help lower your tax burden:

• Advertising expenses 
• Car and truck expenses
• Charitable contributions
• Club dues and membership fees
• Credit card convenience fees
• Damages recovered
• Demolition expenses or losses
• Education expenses
• Franchise, trademark, trade name
• Impairment-related expenses
• Internet-related expenses
• Interview expense allowances
• Legal and professional fees
• Tax preparation fees
• Licenses and regulatory fees
• Moving machinery
• Outplacement services
• Penalties and fines

There are hundreds of possibilities for deductions when you own a small business, so work with a licensed tax professional to set up your business structure and prepare your business tax returns. This may save you hundreds (or even thousands) per year in taxes.

READ MORE: Do I Need a Business Bank Account?

Rental property tax deductions

If you own a rental property, you will need to report your income and expenses on Schedule E. 

There are many deductions available to help lower the taxes owed on your rental income. Here are a few of the most common ones:

• Mortgage interest: If you have a mortgage on your rental property, you can deduct the interest paid.
• Property taxes: You can deduct the property taxes paid.
• Property management: If you pay a property management company to handle tenant screening and placement, as well as other activities, you can deduct the cost of the service.
• Rental property depreciation: This one is huge, as you can deduct a portion of the value of your rental property annually, which can be thousands of dollars. In general, you take the cost basis of the property and deduct it over a 27.5-year period, though other methods may be available.
• Repairs and improvements: Any repairs to the property can be deducted, but improvements can be depreciated over time. 
• Other expenses: You can deduct other miscellaneous expenses related to renting a property, including advertising, lawn care, insurance premiums, and more.

Tax deductions for homeowners

As a homeowner, there are several tax deductions available to you. While most of these require itemization, it’s still a good idea to keep track of these for years when you qualify for itemized deductions. 

Here are a few common tax deductions for homeowners:

• Mortgage interest: If you have a mortgage on your personal residence or second home you can deduct the interest paid throughout the year.
• Property taxes: You can deduct the amount paid in property taxes on your personal residence or second home.
• Home equity loan interest: If you take out a home equity loan and use it for improvements to your current home, you can deduct the interest paid.
• Points: If you paid for discount points on your home mortgage, you can deduct them in the year paid.
• Capital gains exclusion: If you sold a home that you’ve lived in for two out of the last five years, you can deduct up to $250,000 in capital gains made on the sale. If you’re married-filing-jointly, the deduction is up to $500,000!

Standard Deduction vs. Itemized Deduction: Which Is Better?

When choosing between the standard deduction or itemizing your deductions, it’s simply a matter of adding up your total qualifying deductions for the year. 

Since the standard deduction is set at a flat rate each year, that is your benchmark for itemizing. If your itemized deductions are more than that amount, then itemized deductions are better.

	2023 Standard Deduction	2024 Standard Deduction
Single	$13,850	$14,600
Married Filing Separately	$13,850	$14,600
Heads of Household	$20,800	$21,900
Married Filing Jointly	$27,700	$29,200
Surviving Spouse	$27,700	$29,200

The standard deduction works for most taxpayers, but if you think you might have enough expenses to itemize, it’s worth it to track your deductions. If you’re unsure, you can work with a licensed tax professional to review your tax situation to see if you can itemize.

No matter which method you choose, be sure to report those “above-the-line” deductions. They will reduce your taxable income no matter what, which can save you hundreds of dollars (or more).

FAQs

What is the difference between tax credits and tax deductions?

A tax credit is a dollar-for-dollar refund of taxes paid, and sometimes tax credits even pay you back when no taxes were paid. 

A tax deduction simply reduces your taxable income, lowering the amount of income tax you pay. 

In general, tax credits are a better deal because you get 100% of your money back for the credit, while tax deductions are only worth a discount at your current tax rate.

What is required to claim tax deductions or credits?

To claim tax deductions or credits, you will need to report the qualifying expenses or details on your tax return. You may also need to submit a copy of any official tax forms you received regarding the expenses paid. 

For example, if you plan on deducting mortgage interest, you will need to attach a copy of IRS Form 1098 to your tax return. 

Even if no forms are required, keep digital copies of itemized receipts for any expenses that are deducted in case of an IRS audit.

TL;DR: How To Maximize Tax Deductions

Maximizing your tax deductions starts with learning what deductions you are able to take throughout the year. 

As you make spending decisions, you can be intentional about what you spend money on and take advantage of any tax deductions you may qualify for.

But even more important may be working with a licensed tax professional. Look for a licensed Certified Public Accountant (CPA) or Enrolled Agent (EA) who specializes in your type of tax situation. 

Whether you're just a regular taxpayer, a business owner, or own a few rental properties, you might be leaving thousands on the table each year. So find a reputable tax professional you can trust and maximize every tax deduction you qualify for.

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