Tax Considerations for Individuals

Exclusions from Taxable Income

Statutorily, taxpayers may exclude certain money from taxable income. The most common exclusions are described below.

Gifts: A gift is generally not considered taxable income for the recipient.

Personal injury damages: Damages paid for personal physical injury that are due to pain and suffering, reimbursed medical expenses, future medical expenses stemming from the personal physical injury and lost wages are excludable.

Sale of main home: Generally, gains from the sale of your home may be excluded from taxable income.

1. The home must have been your principal residence, and you must have met the required ownership and use tests. The ownership test is met when you own the home for at least two years. The use test is met when you use the property as your main home for at least two years. Some factors in the use test are:
   • Whether the home’s address is used for tax returns, auto and voter registrations, driver’s license and general mail
   • The location of the home relative to your place of employment, banks, clubs and other organizations
   • Whether other family members reside at the home
2. The sale is for the main home.
3. The amount realized on the gain is up to $250,000 single or $500,000 married and filing a joint return.
4. The gain from the sale of another home has not been excluded within the previous two years.

Cancellation of debt: Forgiveness, cancellation or discharge of debt is usually considered taxable income but exceptions to this rule may exist in the case of a nonrecourse loan, bankruptcy, farm debt or foreclosure.

Flexible spending arrangements: Under these employer-provided benefit plans, contributions employers make to the plan may be excludable from an employee’s taxable income. Essentially, the employee is voluntarily reducing an agreed amount of salary, which the employer then contributes into the plan. When the employee makes distributions from the plan for qualified expenses, the amount covering the expense is usually not taxable income to the employee. If the contributions are not used within a specified amount of time, the employee forfeits any balance in the plan.

Tax Credit

A tax credit is a dollar-for-dollar offset that reduces the amount of tax. Common tax credits include:

• Child and dependent care expenses: Allows qualifying taxpayers to credit up to $3,000 for one child or up to $6,000 for two or more children when certain conditions are met.
• Earned-income credit: Designed for low-income families and individuals, this credit can result in a tax refund if the credit amount is greater than the amount of taxes owed.

Educational Credits

Provided that a taxpayer falls within certain income and tax limits, the Hope Scholarship Credit and the Lifetime Learning Credit may help the taxpayer offset some of the cost for post-secondary educational expenses incurred by the taxpayer, a spouse and dependents claimed on the taxpayer’s return. Both credits may be available if the taxpayer incurred more than one student’s expenses during the year, but both may not be taken for the same student in the same year.

• Hope Scholarship Credit: The Hope Scholarship Credit is available for up to $1,650 per eligible student for the first two years of the student’s post-secondary education. To claim the credit, students must be enrolled at least half time, be seeking an undergraduate degree or similar education credential and have no felony drug convictions on record.
• Lifetime Learning Credit: The Lifetime Learning Credit is available for up to 20 percent of the first $10,000 incurred in expenses for a maximum of $2,000 per family for each of the years the eligibility requirements are met. Students are not required to pursue a degree in order to qualify for the credit, the credit is available for one or more courses and no felony drug conviction restrictions apply.

Tax Deduction

A tax deduction reduces the amount of income subject to tax. Common deductions include:

• Mortgage interest: Generally, this deduction is allowable for the interest paid on the taxpayer’s main or second home for a home mortgage, home improvement or home-equity loan.
• Real estate: Real estate tax that is charged by state and local governments can be deducted provided that the taxing authority uniformly applied the tax in the jurisdiction, based the tax on the assessed real property value, and the tax itself was for the general public welfare.
• Charitable contributions: Contributions made to qualifying charities may be deducted up to certain limits.

Other Tax Considerations

• Employment taxes for household employers: Also known as the “nanny tax,” this tax may apply if a taxpayer pays someone to work in the taxpayer’s home and the individual worker is not self-employed or was not placed there by an agency that exercises control over the person as an employee. If the taxpayer is a household employer, then the taxpayer may be required to pay Social Security, Medicare, federal unemployment tax and federal income tax withholding for that employee.
• Alternative Minimum Tax: This alternative tax computation avoids taking deductions to the point where the taxpayer would pay little or no tax.
• Tax consequences of divorce: Alimony that meets statutory requirements that a taxpayer pays to a former spouse is deductible for the one paying it and includable income for the one receiving it. Child support, however, is not deductible. If there is a child from the dissolved marriage, only one parent may claim the child as a dependent.

Last update: Sept. 29, 2008