When I graduated from college in 1999 several people advised me to purchase a house so I would have something to deduct on my taxes.
Without any deductions these well intentioned individuals felt I was exposing myself to an unnecessary amount of taxes and would be much better off if I bought some real estate.
I was single, I had no dependents to claim, and I was earning a decent income considering I was fresh out of college. To quote one of my buddies, “I was ripe for the picking in the eyes of the IRS!”.
Although their reasoning sounded legitimate, something just didn’t seem right about buying something to save money.
After doing a little research (and a few calculations of my own) I learned the truth behind tax deductions and how you can best use them to your advantage.
Here’s How Tax Deductions Work:
When you claim a tax deduction or “write something off” on your income taxes, you do not get a dollar for dollar reduction in the amount of taxes you are required to pay the government.
What actually happens is your total taxable income (the income you are required to pay taxes on) is reduced by the total amount of your deductions and that figure is used to calculate how much you owe in taxes
Let’s say you and your spouse had a combined income of $70,000 in 2009.
After applying all eligible deductions and exemptions your total taxable income was $47,000.
According to the 2009 IRS Tax Schedule you would owe $6219 in federal income taxes (married filing jointly).
But what if you had listened to my friends and bought a home at the beginning of 2009?
Let’s pretend you bought a home and paid $9000 in mortgage interest through the end of the year ($165,000 mortgage @ 5.5% interest).
Assuming you were already itemizing your deductions, your total taxable income would now be only $38,000.
According to the 2009 IRS Tax Schedule you would now “only” owe $4869 in federal taxes.
In other words, had you followed the advice of my friends you would have paid the bank $9000 in interest to save $1350 in taxes! That’s not a good deal!
The Tax Deduction Myth and Small Business Owners
Another time, a friend tried explaining to me why he had to buy a brand new pick-up truck for his plumbing business to replace an otherwise perfectly running two year old model.
He reasoned that he made “too much money” last year and needed a large tax write-off to ease his tax burden.
He ended up paying over $30,000 for a new truck so he could write the “depreciation” off on his taxes over the next few years.
This is FOOLISH! For every $1000 you are LOOSING in depreciation, you are only saving $150-380 in taxes (depending on how much you make)!
Whether you’re writing off mortgage interest, depreciation costs, or other tax deductible items, you’re not going to get ahead by chasing down tax deductions.
But Wait, Tax Deductions are Still A Good Deal!
Tax deductions are great if you were going to buy a tax deductible item anyway, but in almost every circumstance you’re fooling yourself if you think you’re getting ahead by purchasing something to get a tax break!
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