ShmoopTube

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finance a la shmoop -what is a tax deduction ah taxes love them hate them

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you can't leave them. but you can lower them legally by being you know

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thoughtful about how you spend your earnings. all right how do we do this?

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well let's start with the largest tax deduction in America the home mortgage. [man stands in front of house]

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and you use a dentist who makes a hundred fifty grand a year for putting

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your fingers in wet mouths. well remember, that for individuals versus corporations [man sticks finger into open mouth]

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we pay a graduated or quote progressive unquote tax rate - like almost nothing on

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the first 15 grand we earned than about 10 percent from 15 to 30 grand, and then

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about 20 percent from 30 to 60 grand and so on. that's progressive. so on the last

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20 grand of earnings you make well you might pay say 40 percent in taxes and [chart shown]

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yeah we know the numbers aren't exact we're just illustrating a point here. you

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have a mortgage of $300,000 on a home you bought for $400,000 right so you put

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a hundred grand down and borrowed three hundred .the mortgage costs you 6% per

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year in interest, or eighteen thousand dollars to rent that three hundred

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thousand. before you owned the home the IRS thought of you as a hundred fifty

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grand a year earner, but a hundred percent of the interest on the home is fully [the number 100 on screen]

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tax-deductible .so what about that last 20 grand ie the money you earned from 130K to 150 K? well as far as the IRS is concerned, now that you have a

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home, you get taxed as if you earned just 132 grand,

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hundred fifty K you actually earned .why? because that eighteen thousand dollars

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in interest comes right off the top of your earnings. see? there's the math right

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there. 150 minus 132 in taxable earnings. it's as if you didn't earn that money

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ever [piggy bank shaken. confetti falls out]

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all right well if you'd had no deductions on that last $20,000 of

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earnings you'd have paid 40 percent or $8,000 in taxes. but now on that last

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$20,000 thanks to your mortgage deduction, well you only have taxable

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income of $2,000 and yes you pay 40 percent on that 2,000 or 800 bucks. and

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you mumble though thank you government for largely splitting the cost of my

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mortgage with me. the American Dream is alive and well yeah that's what you said. [ man in suit stands in fancy room]

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okay. and thank you Jay. there are other deductions beyond home mortgages of

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course but well you give the gist here of how they work. from a taxpayers

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perspective deductions like those from your home mortgages are a good thing.

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common personal deductions also include things like prepaid health care costs,

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and the cost of feeding quote dependent unquote children. ie those noisy things [kid jumps on a bed]

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sleeping in your spare bedrooms until they're 18. okay so those are personal

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deductions. things that individual citizens take. but what if you're a

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corporation? well in a way it's kind of easier. think of most corporations as

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having a flat 30% tax from the first dollar they make just to keep things

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simple. participation trophy company Inc made a hundred million dollars last year

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and paid 30 million in taxes. they netted 70 million after tax. the company really

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needs a new trophy smelting machine because with so much demand for [metal melts in a fire]

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participation trophies of late while the old one is running dull with mediocrity.

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the company spends 40 million bucks on the new machine knowing that it will be

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worthless in 10 years either because it wears out or because the country gets

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real. or you know simply remembers to you know have a nice day, yeah participation [smiley face]

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trophy land. well they depreciate 40 million dollars in

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equal parts of 4 million bucks each year over 10 years so that in the next year

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when they again earned a hundred million dollars well they now get to deduct 4

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million bucks in depreciation from their smelting machine against their hundred

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million dollars in earnings. so again as far as the IRS is concerned they didn't

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really earn a hundred million dollars even though they did. they earned quote

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only unquote 96 million. and yes they still pay their 30 percent tax only now [equation on screen]

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instead of paying it on a hundred million bucks it's paid on 96 million of

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earnings or 0.3 times ninety six or twenty eight point eight million in

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taxes. they deducted from their taxes the four million bucks ,expected value

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decline from their smelting machine. right it goes down four million a year

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in value from the 40 they paid. and they received essentially a credit on their

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taxes of 1.2 million dollars. so instead of that years depreciation costing the [equations shown]

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company four million bucks well it really cost them more like 2.8 million

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if you ignore a bunch of other things like the original capital cost of the

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machine and what else they might have done with that money other than the you

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know buy a smelting machine. think think corporate jet yeah those G-6 are [furnace shown]

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surprisingly tasteful.

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