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The Myth of the Tax Write-Off

ReachMD Healthcare Image
03/02/2024
themotivatedmd.com

“It’s a write-off for them.” (Kramer)

“How is it a write-off?” (Jerry)

“They just write it off.” (Kramer)

“Write it off what?” (Jerry)

“Jerry, all these big companies, they write off everything.” (Kramer)

“You don’t even know what a write-off is.” (Jerry)

“Do you?” (Kramer)

“No, I don’t.” (Jerry)

“But they do, and they’re the ones writing it off.” (Kramer)

The above scene from Seinfeld encapsulates what most people believe: that a tax write-off is a magical tool corporations and wealthy individuals use to wipe out expenses and get ahead.  I’ve heard people dismissively say, “You can just write it off,” in a variety of situations, from dining out to sporting events, travel, charitable giving, automobiles, and more.  Some healthcare professionals unironically justify buying a bigger house because “you can write off the mortgage interest payments.”  However, nearly 90% of Americans take the standard deduction on their federal income taxes, leaving them unable to claim individual deductions. 

Clearly, there are a lot of misconceptions surrounding this topic.  What is tax deductible, and what isn’t?  Who can take these deductions, and who can’t?  This article will help clear the air around the myth of the tax write-off.  Read Taxation: The Inescapable Bane of Medical Professionals for a primer on how taxes work. 

The Myth of the Tax Write-Off

Calculating Taxable Income

Let’s review how income tax is calculated in order to understand tax deductions.     

Step One:

Gross Income – Adjustments = Adjusted Gross Income (AGI)

Gross Income is your income from all sources:  Wages, self-employment income, rental income, capital gains, retirement distributions, dividends, and other income.

Adjustments, or above-the-line deductions (don’t get confused), are subtracted from gross income to calculate AGI:  Student loan interest, retirement account contributions, alimony payments, and HSA contributions. 

Adjusted Gross Income is an important intermediate because it is the starting point for step two, and it will determine your eligibility for many deductions and credits.  

Step Two

Adjusted Gross Income – Standardized OR Itemized Deductions = Taxable Income

The Standard Deduction is a specified dollar amount allowed by the government that taxpayers can subtract from their AGI to reduce their taxable income. 

Itemized Deductions are qualified expenses that reduce your taxable income:  Charitable donations, SALT (state and local taxes), home mortgage interest, specified business expenses, and unreimbursed medical expenses that exceed 7% of AGI.  

Taxable Income is the amount of income subject to tax.  The U.S. uses a graduated tax system to calculate the total tax due.   

Tax Deductions

The IRS allows below-the-line deductions, which lower taxable income.  Taxpayers can choose to take the standard deduction or to itemize their deductions.  The standard deduction for the 2024 tax year is $14,600 if you are filing as a single person and $29,200 if married filing jointly.  Itemized deductions, or write-offs, are qualified expenses the government allows based on specific rules.  Taxpayers should only itemize their deductions if they collectively exceed the standard deduction amount.

Another way to think about a tax deduction is that you save your marginal tax rate multiplied by the deductible amount.  The higher your marginal tax bracket, the more valuable tax write-offs become.  For example, if you make a charitable donation of $5,000 and your marginal tax rate is 37%, you will save $1,850 in taxes (5000 * 0.37).  However, if your marginal tax rate is 25%, the deduction is only worth $1,250.  This is how many people conceptualize a tax write-off. 

Don’t confuse a tax deduction and a tax credit.  A tax credit differs because it is not subtracted from AGI and has nothing to do with your marginal tax rate.  If you qualify, a tax credit reduces dollar-for-dollar the taxes you owe.   

The Myth

People erroneously believe that if you own a business, you can deduct anything you want: meals & entertainment, travel, automobiles, and clothes.  Social media posts and YouTube videos promoting schemes where you can “write off” everything perpetuate this common misconception.  While some of this may be true for certain professions, it doesn’t apply to most medical professionals, even if they own their own business.  The IRS has strict rules concerning itemized business deductions.

The fact is that most healthcare professionals are employees, and there are far fewer eligible deductions if you don’t own a business.  The most common avenue for which an employed taxpayer will be eligible are SALT (state and local taxes), home mortgage interest payments, and charitable donations.  Let’s explore these deductions individually to determine if they are actually useful for the average medical professional or just a potentially harmful myth.

State and Local Taxes (SALT)

No one enjoys paying taxes; this deduction helps you avoid paying them twice on the same income.  Through the SALT deduction, the IRS allows you to deduct the state and local taxes you have already paid from your federal AGI.  Several state and local taxes potentially qualify:  State income tax, sales tax, home property taxes, and personal property taxes (cars, boats, R.V.s).  Of course, there are many rules and exceptions around what qualifies and what doesn’t, so please consult your accountant. 

If you live in a state with a high state income tax or own an expensive home with high property taxes, the SALT deduction can really add up.  However, there is currently a cap of $10,000 on SALT deductions, scheduled to expire at the end of 2025.  This cap applies equally to both single and married taxpayers. 

Although I live in Texas, which has no state income tax, the property taxes in Austin average 2.3%.  A median-priced home in Austin is around $550,000.  If the house was assessed at $500,000 by the city, the annual property taxes would be $16,500 before any homestead exemptions.  Second homes, if not used as rental property, are allowed the same tax treatment as the primary.  High property taxes cause the $10,000 SALT cap to be reached fairly easily, even in states with no state income tax. 

Mortgage Interest

Mortgage interest is deductible for both residential and commercial real estate.  While most medical professionals are not real estate investors, the vast majority will own their own home, which is why this particular deduction garners so much attention.  This deduction leads to a whole host of bad advice.  ‘High-income medical professionals should take out the largest loan possible because of the mortgage interest deduction.’  ‘You should never pay off your loan early because you will lose the deduction.’  

The interest paid on loans for rental real estate is always deductible, regardless of whether you take the standard deduction or itemize.  Interest paid on personal mortgages (primary and secondary homes) is deductible only if you itemize. 

Annual Amount of Mortgage Interest Paid At Varying Interest Rates

30-Year Fixed Rate Loan

The utility of the mortgage interest deduction depends on how much money you borrow, your interest rate, whether you reach the SALT deduction cap, and your marital status.  The recent change in interest rates can have a profound effect.  A $600,000 mortgage financed at 3% interest carries a payment of $2,530 a month, while at 8% it is $4,403.  Over a year, you would pay $22,476 more towards the loan, but the difference in mortgage interest paid is $29,990!

Charitable Giving

Charitable contributions can be a win-win; the donor gets to make a tax-deductible contribution while the charity benefits from the generosity.  The charity recipient must be a qualified organization recognized by the IRS, and, you guessed it, the donor must itemize deductions to benefit.  Additionally, as my charity auction article outlined, “quid pro quo” rules apply.  If you get anything in return for your contribution, you may only deduct the amount of your donation that exceeds the fair market value of the item or service received.  

There are different types of donations.  Most commonly, you simply donate cash.  In 2024, the IRS limits contributions to 60% of the taxpayer’s AGI.  So, if you win the lottery and want to give it all away, you can’t, or you’ll face quite the tax bill.  You can also donate non-cash gifts, such as securities with appreciated capital gains.  You can give money directly to the charity or use an account such as a donor-advised fund (DAF).  When donating appreciated securities to a donor-advised fund, the IRS limits contributions to 30% of the taxpayer’s AGI. 

The Reality

Tax write-offs are of limited value for most employed medical professionals, especially if they are married.  Unless you own your home with a mortgage, the high standard deduction amount coupled with the cap on SALT has limited the utility of itemizing deductions.  If you hit the $10,000 SALT cap, you still have a $19,200 gap before you reach the standard deduction.  The ideal candidate for itemizing is a single homeowner with a large, high-interest mortgage living in a high-income tax state that is very charitable.  Excepting the charitable part, the rest isn’t an ideal financial demographic.

Tax Saving Strategies

You can change from taking the standard deduction to itemized deductions from year to year, allowing you to maximize your deductions by grouping them within a single tax year.  For instance, some municipalities appraise your property taxes and send the bill before January 1st.  You can potentially pay two property tax bills during the same year if you pay one in January and prepay the following year in December.  This can increase your SALT deduction if you are below the cap.  You cannot do the same for mortgage interest payments, which must be deducted in the year they are due.

More impactfully, you can stack charitable donations by making a large, concentrated payment in one tax year rather than spreading them out.  For example, donating $250 each week to your church totals $13,000 annually.  Alternatively, you could save the donations for a year, donating all $13,000 for the previous tax year in January, then another $13,000 for the current tax year in December, totaling $26,000 in one calendar year. 

Another option is to make one large donation to a donor-advised fund and then use the fund to donate to charity over time.  Instead of donating $10,000 per year as a one-time gift, you can contribute $50,000 to a DAF and give $10,000 each year from the fund.  This allows you to maximize your deduction in one year and take the standard deduction in the other years.

Here is an example of two identical families, married and filing jointly. Each family is subject to the same state and local taxes, but their total itemized deduction varies based on how they perform their charitable donations over the course of 3 years.

Each option produces a standard deduction of $29,200 in each of the first two years.  In year 3, option 1 yields the same standard deduction, while option 2 produces a $42,886 itemized deduction, saving $5,064 in taxes at a 37% marginal rate.  If you are concerned that the charity is getting the money later, you can assuage your fears by donating the tax savings.

Take Home Points

Hopefully, I have debunked the myth surrounding the tax write-off.  Tax deductions are a powerful tool for a small minority, typically business owners.  However, most U.S. medical providers are now employees.  Because the standard deduction is so high, especially for married couples, most doctors and APPs will take it.  This renders nearly all discussions of tax deductions moot.  If you take the standard deduction, you can’t write anything off.

If you are an employee, there are only a few things you can do around the edges to save on taxes, short of moving to a no income tax state.  The most important is to fund your retirement plan to maximize your above-the-line adjustments.  You can also group itemized deductions into one tax year under certain circumstances.  However, if you want more tax write-offs, the best option is to start a business.  While we are fans of medical entrepreneurship here at Business is the Best Medicine, forming a business just to save taxes is not advised.   

The saying “don’t let the tax tail wag the dog” means don’t let tax decisions determine what you do with your money.  Don’t buy something you don’t want just to pay less taxes.  You still end up spending more money.  Two clear examples are starting a business to try to save on taxes and buying a larger house than you need because you can write off the mortgage interest.  Instead of obsessing over the mythical tax write-off, focus on what you can control: earning more money, spending less, and investing the difference

[Disclaimer: I am not an accountant or a tax expert.  I do not know your specific circumstances and am not giving tax advice.  You should talk with your accountant to verify the tax implications of any financial decision you consider.  One word of advice: pay the taxes you owe.  Read The Legend of Doc J to find out what happened to one medical professional who didn’t.]

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Schedule26 May 2024