What Are Tax Deductions, Credits, And Deferrals?
Tax Deductions
A tax deduction is a reduction in the amount of taxable income that you have. Tax deductions can be claimed for various expenses, such as mortgage interest, charitable donations, and medical expenses. When you claim a tax deduction, you reduce the amount of income that is subject to tax, which means you pay less tax overall. The amount of tax you save depends on your tax rate and the amount of the deduction.Let's say you earned $50,000 in income for the year and you made a $5,000 charitable donation to a qualified nonprofit organization. When you file your taxes, you can claim a tax deduction for your donation.
Assuming you are in the 22% tax bracket, your tax deduction will reduce your taxable income by $5,000. This means that instead of being taxed on $50,000 of income, you will be taxed on $45,000 of income.
Here's how the math works:
$50,000 (income) - $5,000 (charitable donation) = $45,000 (taxable income)
$45,000 (taxable income) x 22% (tax bracket) = $9,900 (tax liability)
Without the tax deduction, your tax liability would have been $11,000. So by claiming the tax deduction for your charitable donation, you were able to reduce your tax liability by $1,100.
Tax Credits
A tax credit is a dollar-for-dollar reduction in the amount of tax you owe. Tax credits are often more valuable than tax deductions because they reduce your tax liability directly. There are two types of tax credits: refundable and non-refundable. Refundable tax credits can reduce your tax liability below zero, which means you could receive a refund from the government. Non-refundable tax credits can only reduce your tax liability to zero, but they cannot result in a refund.Let's say you install a new solar panel system in your home and it costs you $10,000. Assuming you meet all eligibility requirements and the solar panel system meets all necessary standards, you can claim a tax credit of up to 26% of the cost of the system, which would be $2,600 in this case.
Here's how the math works:
$10,000 (cost of solar panel system) x 26% (credit rate) = $2,600 (maximum credit amount)
The credit is non-refundable, which means that it can only be used to offset your tax liability. So if your tax liability before the credit was $5,000, your tax liability after the credit would be reduced to $2,400 ($5,000 - $2,600).
Tax Deferrals
A tax deferral allows you to delay paying taxes until a later date. This can be beneficial because it allows you to keep the money you would have paid in taxes and earn interest on it instead. The most common type of tax deferral is a retirement account, such as an IRA or 401(k). Contributions to these accounts are tax-deductible, which means you can reduce your taxable income by the amount you contribute. You don't pay taxes on the money in the account until you withdraw it, which could be years or even decades later. Another example of a tax deferral option is the like-kind exchange, also known as a 1031 exchange. This is a tax code provision that allows real estate investors to defer paying taxes on the gain from the sale of one property by using the proceeds to purchase another "like-kind" property.
Here's a simple scenario to illustrate how a like-kind exchange works:
Let's say you are a real estate investor and you sell a rental property for $200,000 that you originally purchased for $100,000. This means you have a $100,000 capital gain on the sale.
Under normal circumstances, you would owe taxes on that $100,000 capital gain in the year that you sell the property. However, if you use a like-kind exchange, you can defer paying taxes on that gain by using the proceeds from the sale to purchase another "like-kind" property.
Let's say you use the $200,000 from the sale to purchase another rental property that is also worth $200,000. Because this is a like-kind exchange, you can defer paying taxes on the $100,000 capital gain from the sale of the first property until you sell the second property.
So in this scenario, you have effectively deferred paying taxes on the $100,000 capital gain by using a like-kind exchange. This can be a valuable tool for real estate investors who want to reinvest their gains into other properties without incurring a large tax bill.
