There has to be something wrong with the U.S. tax code if losing $500 dollars can raise your tax bill by $1,867. If I had not seen this travesty with my own eyes, I would not believe it, but unfortunately, the facts support this.
This winter, I prepared the tax return for a couple who are semi-retired and live in Washington, a state without an income tax. Like many of my older clients, these people have paid off their mortgage and no longer have the interest expense, which everyone assumes is a huge tax deduction. They have some medical expenses, which everyone assumes are deductible, but often turn out not to be. Other expenses which they have, which may be tax-deductible are their payment of property taxes, charitable contributions and some miscellaneous expenses which only count when they are more than two percent of the AGI.
The client's income consisted of $40,000 wages, Social Security benefits of $25,938 and finally investment income of $3,965. Their AGI was $60,959.The amount of Social Security benefits that are taxable income depends, on how much other income, plus tax-exempt interest, is on the tax return. For married taxpayers, the magic line between tax-free benefits is $32,000 plus half of the amount of benefits.
These clients were each over 65 years old and because of this, they had an additional $1,400 added to their standard deduction of $11,600. Furthermore, the wife is legally blind and received an additional $1,150 benefit which meant that their total standard deduction is $15,050.
The return was extremely simple to prepare and showed that the client's tax liability was $4,389, and they were due a refund. While discussing the return with the clients, the husband told me that they had one more additional document, a form W2-G, which is used to report gambling winnings. It turns out that on one of their jaunts to Reno, they had won $7,500 at the slots. The husband also showed me the yearly statement from the casino, showing that they had lost $8,000 and uttered the magic words, "I lost more than I won, so nothing is reportable, isn't that right?"
Unfortunately, the answer is no. Winnings are reported on page 1; line 21, "Other income" and the losses are reported on Schedule A as an "Other Miscellaneous Deduction - Not Subject to 2 Percent Threshold", in other words, the losses may count from the first dollar.
This changed the entire nature of the client's tax return. For starters, since the gross winnings are added to income, more of the Social Security benefits became taxable. Now, the maximum amount, which is 85 percent, of the Social Security benefits became taxable and the clients AGI went all the up to $73,512 or $5,053 more than just the gambling winnings.
Originally the client was taking the standard deduction, which was $6,304 more than the total of his itemized deductions. However, after the AGI increased, because of the winnings and additional taxable Social Security benefits, the value of his medical and miscellaneous deductions were reduced. When we added in the maximum gambling loss of $7500, because gambling losses are deductible only to the extent of winnings, his total deductions were $15,126, or only $76 more than his standard deduction.
His tax bill was now $6,256 or $1,867 more than originally calculated. The client was puzzled because obviously, no matter how you slice the cake, he had lost $500 gambling.
The lesson that needs to be learned is that adding any income to your tax return can have a greater impact than the amount of the deduction. Also, exercise caution when basing your decision on subscribing to a service or buying something because it is tax deductible. The item MAY be deductible under the law, but it is your own individual circumstances which dictate whether or not it is actually deductible on your return.
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- Social Security