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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

ever [piggy bank shaken. confetti falls out]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

trophy land. well they depreciate 40 million dollars in

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

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

million bucks in depreciation from their smelting machine against their hundred

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

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

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

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

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

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

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

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

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

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

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

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

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

surprisingly tasteful.