Dictionary of Tax Deductions

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Edward A. Lyon, JD
TaxTuneup.com, Inc.
3416 Shaw Ave #5
Cincinnati OH 45208
513.321.2821
elyon@taxtuneup.com

Hardship Withdrawal (See Qualified Plan Withdrawal)

Handicapped Care Costs

Deductible Medical Expense, subject to the 7.5% floor (including payments to special schools or homes, special medical equipment, and home improvements to accommodate you or a handicapped dependent).

Deductible Medical Expense, subject to the 7.5% floor, if prescribed for a specific health condition.

Health Insurance

Today's health insurance costs are spiraling out of control faster than Britney Spears on a 3-day Starbucks bender. Fortunately, the Tax Code offers several provisions to ease that bite:

Employer-Provided Health Insurance

• Health insurance coverage and benefits you get from your employer's group plan are nontaxable. This is true whether your employer buys commercial coverage on your behalf or self-insures and pays claims directly.
   

• If you contribute to your employer's group plan through a Section 125 Plan, you'll avoid income and payroll taxes on the income you use to pay the premiums. In effect, the plan lets you deduct the part of the premium you pay yourself without regard to the 7.5% floor. You may have a premium-only plan, or "POP" plan, that eliminates tax on the premium. Or you may have a true Flexible Spending Account, or FSA, that lets you set aside money for unreimbursed expenses.

• Premiums that you pay out of your own pocket, without benefit of a POP plan or FSA, are a deductible Medical Expense subject to the 7.5% floor. Ask your employer if they can install a POP plan

Self-Employed Health Insurance

If you're self-employed as a sole proprietor, member of a Limited Liability Company, or 2%+ shareholder in an S Corporation, you can deduct 100% of your health insurance premium up to your earned income from self-employment as an adjustment to income.

If your premium exceeds your net income from self-employment, you can still deduct the excess as a Medical Expense subject to the 7.5% floor. If that's the case, and your other deductible medical expenses are high, you may save more by choosing to deduct your premiums as a regular Medical Expense. The only way to know which saves you most is to try them both.

If you're self-employed, consider establishing a Medical Expense Reimbursement Plan for deducting all your family's medical expenses without regard to the 7.5% floor.

Health Savings Accounts

Hearing Aid

Deductible Medical Expense subject to the 7.5% floor.

Heating Pad

Deductible Medical Expense subject to the 7.5% floor.

Hedge Funds

Hedge funds, along with their cousins, venture capital funds and private equity funds, are private investment partnerships. These are the glamorous and secretive celebrities of the managed money world. Managers like George Soros, John Meriwether, and John Paulsen capture headlines and move markets. They also catch the blame when markets fall and currencies collapse.

Hedge funds generally accept contributions of $1 million and up. The most coveted funds operating offshore or require as much as $10 million to join. Some funds let groups of smaller investors pool their money into partnerships of their own to reach these minimums.

Hedge funds are less liquid than publicly traded mutual funds. Usually, there's just one annual chance to redeem your investment. Managers can pay out over a period of time or even suspend redemptions entirely to protect remaining partners. And, you can't track your investment in the paper like you can with a publicly traded fund. Despite these disadvantages, hedge funds are estimated to manage close to $3 trillion.

Hedge funds use sophisticated strategies like options, futures, short sales, and arbitrage. Despite the implication that hedge funds aim primarily to reduce risk, many hedge funds have become high-octane speculators. These cowboys don't just try to beat the market. They want to kick its butt. And they're expensive: a typical fee is 2% of assets, plus 20% of profits; however, some funds charge as much as 4% of expenses plus 44% of profits.

To put a little perspective on how those fees add up, consider this. None of the Forbes 400 richest Americans made their fortune investing in hedge funds. But several, including Stephen Cohen (net worth $6.8 billion) and John Paulsen, who earned $3 billion in 2007 alone, made their money running them.

Hedge funds can trade furiously; so turnover can be high. That generally means taxes are high. You'll have to decide for yourself if the gains, after taxes and fees, justify the risk and illiquidity. But there are a few limited tax breaks if you choose to play this game:

• You can buy private-placement variable Life Insurance and Annuity contracts that invest in hedge funds. These also require super-high minimum investments.
   

• You can buy retail Mutual Funds marketed as hedge funds for the masses. Market neutral funds hold both long and short positions in an attempt to eliminate market risk. "Bear" funds use options and other derivatives to profit when the market falls. Most investors who use bear funds hold them briefly to profit from short-term drops. Both of these fund categories are best suited for your tax-deferred accounts.
   

• Venture capital investors can buy publicly traded stocks that invest much like venture capital partnerships. Hold these shares in tax-deferred accounts to avoid current taxes.

High Yield Bonds

High-yield bonds, or "junk bonds," are bonds without an investment-grade rating. (Feeling cynical? Think of them as "subprime" bonds.)

Junk bond issuers range from small and mid-sized companies looking to finance growth, to "fallen angels" experiencing financial difficulty that costs them their investment-grade rating. "Municipal" junk includes bonds from troubled issuers like New York City in the 1970s and Orange County in 1994 and bonds from issuers who don't want to pay the price for a rating. You can probably consider many foreign bonds, especially emerging markets bonds, to be junk as well.

What "junk" bonds all share are high current yields plus good potential for capital gains. Domestic corporate junk carries higher credit risk than investment-grade bonds. Maturities usually fall into the short-intermediate range, so interest-rate risk is low. As an asset subclass, junk can be an excellent choice for high total return with less volatility than stocks. Most investors who buy junk do so through funds-the market is just too specialized for individual investors to buy individuals.

Corporate junk is taxed the same as other corporate bonds. But since junk bonds pay the highest available interest, it naturally follows that they generate the highest tax bills as well. For this reason, junk bonds are best suited for tax-deferred retirement accounts and variable annuities. And junk bonds have another twist that makes them even less tax-efficient.

In many cases, a junk bond fund's total return will be lower than the interest income it pays. This is because a small percentage of the holdings will default, either missing payments or becoming worthless altogether. Junk's higher income compensates for this risk. But this has the effect of returning a portion of your original capital--the portion that defaults--in the form of taxable interest.

Junk bond issuers sometimes pay bondholders "consent money" in order to consent to changes in the bond's indenture--the debt agreement that governs the terms of the bond. This consent money is taxable as ordinary income. If you invest through funds, there's no need to worry about this treatment. The fund simply pays through your proportional share.

Hobby Losses

If your business loses money, you can use losses to offset income from wages, interest, dividends, and so forth. You can carry Net Operating Losses back two years (for a refund of taxes you’ve already paid) or forward 20 years, to offset future income. But, if your hobby loses money, your deduction is limited to your income from the hobby. You can’t use losses to offset other income or carry them backwards or forward.

The strategies in this Dictionary can easily turn real profits into paper losses. But the IRS is on the lookout for sham businesses established solely for tax breaks. (They're especially skeptical of network marketing businesses established to offset salary income -- so be especially careful documenting business intent here.) Don’t be afraid to report a loss—the IRS gets millions of Schedule Cs reporting losses each year. But if you’re new in the business, your income is low, or if you operate part-time, you need to know how to protect your breaks from the “hobby loss” rule.

The key is to prove that you started the business with the intent to make a profit. You don’t need to expect it—but you do need to intend it. If you profit in three out of five years, the IRS presumes you have that necessary intent. You might misinterpret this to mean you need profits 3 years out of 5 in order to claim losses. But you can lose money year after year, and still prove your business intent by operating in a businesslike manner. (In one recent case, a cattle farmer lost money for 24 years and still proved a profit motive!) Here’s how to preserve your deductions:

1. Investigate your business and profit potential before starting.
    

2. Write a business plan projecting realistic profits over time.
    

3. Run your business like a business. Keep appropriate records, including a diary for appointments and expenses. Set up separate bank and credit card accounts for your business. Print business cards. Put in a business phone line. Advertise.
    

4. Invest in yourself. Document how you educate yourself to improve your business.
    

5. Work your business regularly—at least one hour a day, four to five days per week—and document that work in your business diary or records.
    

6. Pay extra attention if your business involves popular hobbies like antiques, traveling, writing, raising show animals, and the like. The IRS knows you’ll engage in them just for the fun, and they’re more likely to reclassify these businesses as hobbies.

If your activity doesn't show an immediate profit, and you're worried that you'll run afoul of the hobby loss rule, you can file Form 5213 to postpone the profit motive determination until the fourth taxable year following the first year of the activity (six years for horses). File Form 5213 within three years of the due date for the return for the year you start the activity. But many advisors recommend not filing this form. Why tip your hand to the IRS if you don't have to?

Home Equity Interest

You can generally deduct interest you pay on up to $100,000 of loans or lines of credit secured by your primary residence and one additional residence. You can use home equity debt to pay off car loans, student loans, and any other nondeductible debt. This move converts nondeductible personal interest into deductible home equity interest.

Your home equity debt doesn't have to consist of an actual second mortgage. A single mortgage can include both acquisition indebtedness and home equity indebtedness. If you refinance an existing mortgage and take out equity (finance the new loan for more than the old loan balance), you can deduct the interest on the original balance, plus whatever you use to substantially improve your residence as acquisition indebtedness and interest on up to $100,000 more as home equity indebtedness.

Example: You buy your house with a first mortgage for $150,000, then pay down the outstanding balance to $120,000. Now you refinance with a "cash out" first mortgage for $180,000. Interest on $120,000 of the new first mortgage qualifies as acquisition indebtedness; interest on the remaining $60,000 qualifies as home equity indebtedness.

Here are some important considerations with this strategy:

• Make sure you compare after-tax rates before refinancing consumer debt with home equity debt. If you can buy a car with a special interest rate, your nondeductible personal interest may still cost less than deductible home equity interest. If you can transfer a credit card balance to a new card with a low introductory rate, you could save money and avoid the paperwork needed to refinance your home.

• You can use home equity interest to deduct otherwise nondeductible student loans. But avoid paying off loans while the student is still in college or qualifies for the student loan interest deduction. With many loan programs, the federal government pays or waives the interest while the student is still in school. It doesn't pay to use home equity interest to pay when no interest is due to begin with.
   

• There's no deduction for home equity debt you use to buy Life Insurance or Annuity contracts (because their earnings are tax-deferred).
   

• If you pay Points on a home equity loan, you have to deduct them over the term of the loan. If you pay off the loan early, deduct any remaining amount in the final year of the loan.

• Interest on home equity debt you don't use to buy or improve your home is an adjustment for the Alternative Minimum Tax.
   

• Finally, you can still deduct the interest you pay on more than $100,000 of home equity debt if you use it for a deductible purpose. For example, if you use home equity debt to buy stocks, deduct it as Investment Interest; if you use it to finance your business, deduct it as a Business Expense.

Home Improvements

Home improvements include room additions, decks, pools, garages, and the like. They don't include routine maintenance or repairs, such as new paint, a new roof, or a new furnace.

Home improvements are generally a nondeductible personal expense. However, they affect your income tax in these three circumstances:

• Include the cost of home improvements in your Basis for calculating your gain when you sell.
   

• If you claim Home Office Expenses, you can include home improvements in your home's Basis for calculating Depreciation deductions.

• Home improvements you make for medical reasons, such as elevators and stair lifts, may be a deductible Medical Expense, subject to the 7.5% floor, to the extent they cost more than they add to the home's value.

Home Office Expenses

Home office expenses are deductible for any space you use "regularly and exclusively" as your "principal place of business." This includes space where you conduct administrative and managerial activities if you have no other fixed location where you regularly do so. "Regularly and exclusively" means you use the space solely for business, not for personal activities. You can claim the deduction for a workshop, studio, or space you use to store samples and products. It doesn't even have to be an entire room.

If you use it for more than one business, both have to qualify to take the deduction. If you and your spouse both use the office, both of you have to qualify to take the deduction. If you claim the deduction for space you use as an employee, you'll have to show that your employer requires you to maintain the home office for the employer's convenience.

To claim the deduction:

1. Calculate the business use percentage ("BUP") of your home. You can simply divide by the number of rooms, if they're roughly equal. Or you can actually figure what percentage of the home's square feet you use. Exclude "common areas" like hallways and stairs to boost your deductible BUP.
    

2. Deduct the BUP of rent, mortgage interest, property taxes, utilities, repairs, insurance, plus incidental home expenses such as garbage pickup, lawn maintenance and security.
    

3. Finally, you can Depreciate the BUP of your home's purchase price.

Example: In 1995, you buy a house for $100,000. $20,000 of that price represents the value of the lot; while $80,000 represents the house. (Land isn't depreciable. Check your property tax valuation for the portion of the purchase price to allocate to the land.) In June 1995, you start a mail-order business that occupies 10% of your house. This gives you a "depreciable basis" of $8,000, or 10% of your $80,000 purchase price. Looking at the table below, you see that you can deduct 1.391% of your $8,000 depreciable basis, or $111. The next year, you can deduct the "full" $205.

You may also be able to write off various home office expenses even if you don't qualify for the full deduction. For example, if you use your Computer more than 50% for business, you can deduct part of those costs. You can also deduct a portion of the costs for household items you use for work. For example, if you use a recliner, television, and VCR 25% to watch videos for work, you can  write off 25% of the cost of those items. You can use First-Year Expensing if you qualify or Depreciate them if not.

If you're a sole proprietor, claim the deduction on Form 8829, then carry the total to Schedule C. If you're a member of a Limited Liability Company taxed as a partnership, claim home office expenses on Form 1065. If you're a shareholder in an S Corporation, claim the deduction on Form 1120S. Finally, if you operate your business as a C Corporation, claim home office expenses or your corporate return. You can use the deduction to shelter profits, but not to take a loss against other income. If your home office expenses exceed your income, carry that loss forward to next year.

For more information, see IRS Publication 587, "Business Use of Your Home."  

Home Health Care

Deductible Medical Expense, subject to the 7.5% floor, for skilled nursing care only (not unlicensed home health care attendants).

Home Sale

The Taxpayer Relief Act of 1997 made significant changes to the rules surrounding gain on the sale of your primary residence. The old system, effective for home sales before May 7, 1997, let you roll an unlimited amount of gain into a new residence and gave you a one-time $125,000 exclusion if you sold your home after age 55.

The new system lets you exclude up to $250,000 of gain ($500,000 for joint filers), with no requirement that you roll the gain into a new residence. Here are the rules:

• You can claim the exclusion as often as every two years.

• If you marry someone who's used the exclusion within two years of the marriage, you can exclude up to $250,000. Once two years has passed since you or your spouse have used the exclusion, you can exclude the full $500,000 on your next, combined, sale.
   

• If your spouse dies while you own the house jointly, their Basis is "stepped up" to half of the house's fair market value as of the date of their death (100% in community property states).
  
  Example: You and your spouse buy a house in a non-community property state for $80,000. The house is now worth $280,000 and your spouse dies. Your gain before the death would have been $200,000. However, your spouse's basis is stepped up from $40,000 (your spouse's half of the purchase price) to $140,000 (half of the fair market value). Your new basis in the house is now $180,000--your half of the $80,000 purchase price, plus your spouse's half of the $280,000 fair market value at death.
   

• If you sell your interest in your home to your spouse as part of a divorce, those payments won't increase your spouse's Basis in the home. This means, if your ultimate goal is to sell the house, your best bet may be to sell it to a third party before the divorce to claim the full $500,000 exclusion while you're still married.
   

• You can't take a deduction for selling your house at a loss.

Example: You and your spouse bought a house in 1960 for $70,000. The house is now worth $700,000. If you sell the house now, you'll pay tax on $130,000 of gain ($700,000 minus your $70,000 basis, minus the $500,000 exclusion). If your spouse dies, their basis in the house will be stepped up to $350,000. If you sell after your spouse's death, you'll pay tax on $65,000 of gain ($700,000, minus your spouse's basis of $350,000, minus your basis of $35,000, minus the $250,000 exclusion).

If you have to sell your house before the end of the two-year period, you can exclude a pro rata share of the $250,000 if your move is due to:

• Change in employment (you, your spouse, a co-owner of the house, or any other person whose principal abode is in the house accepts a job whose location is at least 50 miles farther from the home than their previous place of employment).
   

• Health (a qualifying person or their relative moves to treat a disease, illness, or injury, or to get or provide medical care for a qualified individual).
   

• "Unforeseen circumstances" (including, but not limited to, involuntary conversion, natural or man-made disaster, death, disability, divorce, or multiple births from the same pregnancy).

The IRS is actually quite liberal in defining "unforeseen circumstances," and has even granted an exception to an undercover police officer who moved because his cover was blown.

For more information, see IRS Publication 523, "Selling Your Home."

Hope Scholarship Tax Credit

The Hope Scholarship tax credit is a credit for parents of students (if the parents claim the student as a dependent), or credits for students themselves (if they can't be declared as someone else's dependents). Tax credits are more valuable than deductions because they cut your actual tax, not just your income. Here are the rules:

• The Hope Scholarship credit is available for qualifying tuition and related expenses of you, your spouse, or your dependent enrolled at least half-time in the first two years of postsecondary education. This generally includes any accredited school offering credit towards a bachelor's degree, associate's degree, or other recognized post-secondary credential. (The Lifetime Learning Tax Credit is available for any year of post-secondary or graduate education, plus any course of instruction at an eligible institution to acquire or improve job skills.)
   

• You can claim the credit for more than one qualifying student at a time.

• The Hope Scholarship credit is equal to 100% of the first $1,200 of costs, plus 50% of the next $2,400 of costs, for a maximum credit of $2,400 per year. (The Lifetime Learning Tax Credit is equal to 20% of qualifying expenses up to $10,000, for a maximum credit of $2,000 per student.)

• The credit phases out ratably for taxpayers with adjusted gross incomes between $48,000 and $58,000 ($96,000 and $116,000 for joint filers).

• You can't claim the credit during any year in which you withdraw money from an Education IRA account for that particular student.
   

• The credit isn't available for married couples filing separately.

For more information, see IRS Publication 970, "Tax Benefits for Higher Education."

Hospice

Deductible Medical Expense subject to the 7.5% floor.

Hospital

Deductible Medical Expense subject to the 7.5% floor.

Hydrotherapy

Deductible Medical Expense subject to the 7.5% floor.