Getting Ready for Your 2021 Tax Return

2020 Draft 1040-T

Hello Client,

Welcome to November! With two months left in the year and the holidays around the corner, the count down to tax season begins. I will be sending two emails before the end of the year. This one covers various topics for individual taxpayers. After Christmas, I will send another email to cover any last-minute tax legislation passed by Congress, how to use the new TaxDome file portal, and discuss other ways you can prepare for an accurate tax return.

Due to the enactment of legislation to offset the economic burden wrought by COVID-19, there are new regulations and tax issues for you to consider. Pandemic-related tax breaks include expanded dependent care assistance, payroll tax credits for self-employed individuals, substantial increases in the child tax credit and the earned income tax credit, $1,400 recovery rebates for many taxpayers, and an exclusion from income student loan forgiveness (in specific circumstances), to name just a few.

Presently, Congress is engaged in negotiations on a tax and spending bill that would likely result in significant tax changes beginning next year. Should such a bill pass, we will want to factor such changes into our year-end planning. For now, we’ll need to base our planning on existing law.

The following are some of the tax issues you should consider and the strategies we can employ to help minimize your taxable income and resulting federal tax liability. There is much to review in this email. I suggest skimming the issues, and when you see a topic of interest, go back and read the section carefully. Send me an email or schedule a meeting (link is at the end of this email) if you want more information or an explanation related to your specific tax situation.

2021 Recovery Rebate

Under American Rescue Plan (ARP) Act, passed in March, individuals with income under a certain level are entitled to a recovery rebate tax credit. These are direct payments (sometimes referred to as “stimulus checks”) to individuals by the government.

Single individuals and joint filers are entitled to a payment of $1,400 for each eligible individual. An eligible individual is any individual other than (1) a nonresident alien, (2) a dependent of another taxpayer, and (3) an estate or trust. For these purposes, the term “dependent” includes not just children but also qualifying relatives. The amount of the recovery rebate phases out for income over a certain level. The 2021 recovery rebate began phasing out starting at $75,000 of adjusted gross income (AGI) for an individual ($112,500 for heads of household and $150,000 in the case of a joint return or surviving spouse). It was completely phased out where an individual’s AGI is $80,000 ($120,000 for heads of household and $160,000 in the case of a joint return or surviving spouse).

The government began issuing the rebates based on 2019 income tax returns, or 2020 returns for individuals who filed their 2020 returns in time. The calculation for the correct amount of the rebate will be part of your 2021 tax return. If your 2021 tax return indicates a rebate larger than your stimulus check (because, for example, your income went down or you had another child), any additional amount will be claimed as a credit against your 2021 tax bill. On the flip side, if the 2021 rebate calculation shows an amount above what you were entitled to, you do not have to repay that excess.

Filing Status

Your tax return filing status can impact the amount of taxes you pay. For example, if you qualify for head-of-household (HOH) filing status, you are entitled to a higher standard deduction and more favorable tax rates. To qualify as HOH, you must be unmarried or considered unmarried (i.e., legally separated or living apart from a spouse) and provide a home for your child, children, or other dependents. If you are in such a situation, we need to review whether you qualify for HOH filing status.

If you are married, you’ll either be filing your return using the married filing jointly or married filing separately filing status. Generally, married filing separately is not beneficial for tax purposes. Still, in some unique cases, such as when one party earns substantially less or when one party may be subject to IRS penalties for issues relating to tax reporting, it may be advantageous to file as married filing separately. Additionally, if one spouse was not a full-year U.S. resident, an election is available to file a joint tax return, which may help reduce a couple’s tax liability.

Income, Deductions, and Credits

Standard Deduction versus Itemized Deductions

The Tax Cuts and Jobs Act of 2017 (TCJA) substantially increased the standard deduction amounts, making itemized deductions less attractive for many individuals. For 2021, the standard deduction amounts are:

  • $12,550 (single);
  • $18,800 (head of household);
  • $25,100 (married filing jointly); and
  • $12,550 (married filing separately).

An additional standard deduction amount of $1,350 applies for taxpayers who are 65 or older or blind. This additional amount is increased to $1,700 if the individual is unmarried and not a surviving spouse. If the taxpayer is 65 or older and blind, the deduction is doubled.

The TCJA capped the amount of State and Local Taxes (SALT) that can be deducted on Schedule A to $10,000 (single and married filers) and $5,000 for clients filing married filing separately. With the SALT limitation, many clients pay less tax with the standard deduction than itemizing their medical expenses, taxes, mortgage interest, and charitable contributions.

Most of the provisions in the TCJA will expire after the 2025 tax return year. Some members of Congress are trying to remove the SALT provisions before the expiration date. I encourage you to continue submitting your property tax, mortgage interest, and charitable contribution documents to see if you may benefit by itemizing your deductions. However, don’t be surprised if you see the standard deduction on your tax return.

Medical Expenses, Health Savings Accounts, and Flexible Savings Accounts

As a result of the COVID-19 pandemic, many individuals have incurred more medical expenses than usual. For 2021, out-of-pocket medical expenses you have paid in 2021 are deductible as an itemized deduction to the extent they exceed 7.5 percent of your adjusted gross income. Deductible medical care expenses must be primarily to alleviate or prevent a physical or mental disability or illness. They don’t include expenses that are merely beneficial to general health, such as vitamins or a vacation. Deductible expenses include hospitalization expenses and health insurance premiums, and the amounts you pay for transportation to get medical care. Medical expenses also include amounts paid for qualified long-term care services and limited amounts paid for any qualified long-term care insurance contract. Depending on what your taxable income is expected to be in 2021 and 2022 and whether itemizing deductions would be advantageous for you in either year, you may want to accelerate any optional medical expenses into 2021 or defer them until 2022. The right approach depends on your income for each year, expected medical expenses, as well as your other itemized deductions.

If you don’t already have one, you may also want to consider health savings accounts (HSAs). These are tax-advantaged accounts that help individuals who have high-deductible health plans. If you are eligible to set up such an account, you can deduct the amount you contribute to the account in computing adjusted gross income. These contributions are deductible whether you itemize deductions or not. Distributions from an HSA are tax-free to the extent they are used to pay for qualified medical expenses (i.e., medical, dental, and vision expenses). For 2021, the annual contribution limits are $3,600 for an individual with self-only coverage and $7,200 for an individual with family coverage.

In addition, if your employer offers a Flexible Spending Account (FSA), consider setting aside some of your earnings tax-free in such an account so you can pay medical and dental bills with pre-tax money. The maximum amount that the IRS will allow to be set aside for 2021 is $2,750. Since you don’t pay taxes on this money, you’ll save an amount equal to the taxes you would have paid on the money you set aside. FSA funds can be used to pay deductibles and copayments, but not for insurance premiums. You can also spend FSA funds on prescription medications, as well as over-the-counter medicines, generally with a doctor’s prescription. Reimbursements for insulin are allowed without a prescription. And finally, FSAs may also be used to cover medical equipment costs (e.g., crutches), feminine hygiene and medical supplies, and diagnostic devices like blood sugar test kits.

Charitable Contributions

While the tax benefits of making charitable contributions and taking an itemized deduction for such contributions were reduced due to the increases made to the standard deduction amounts, a law passed at the end of 2020 modified the charitable contribution rules for 2021 tax returns. As a result, eligible individuals can claim a deduction of up to $300 ($600 in the case of a joint return) for qualified cash charitable contributions made during 2021. An eligible individual is an individual who does not elect to itemize deductions. A qualified charitable contribution is a cash contribution paid in 2021 to an eligible charitable organization (e.g., a 503(c)(3) non-profit, schools, and hospitals). Go Fund Me and political campaign contributions are not eligible. Also, contributions of non-cash property, such as securities or items to Goodwill, are not qualified contributions. Look for a question about your contributions on the 2021 Tax Return Checklist you will be asked to compete.

If you are itemizing your deductions, you can reap a more significant tax benefit by donating appreciated assets, such as stock, to a charity. Generally, the higher the appreciated value of an asset, the bigger the potential value of the tax benefit. Donating appreciated assets not only entitles you to a charitable contribution deduction but also helps you avoid the capital gains tax that would otherwise be due if you sold your stock.

For example, if you own stock with a fair market value of $1,000 that was purchased for $250 and your capital gains tax rate is 15 percent, the capital gains tax you would owe if you sold that stock is $113 ($750 gain x 15%). If you donate that stock instead of selling it and you are in the 24 percent tax bracket, your ordinary income deduction is worth $240 ($1,000 FMV x 24% tax rate). You also save the $113 in capital gains tax you would otherwise pay if you sold the stock; that amount goes to the charity. Thus, the after-tax cost of the gift of appreciated stock is $647 ($1,000 - $240 - $113) compared to the after-tax cost of a donation of $1,000 cash which would be $760 ($1,000 - $240).

Finally, if you have an individual retirement account and are 70 1/2 years old and older, you are eligible to make a charitable contribution directly from your IRA. This is more advantageous than taking a distribution and donating to the charity that may or may not be deductible as an itemized deduction. If your itemized deductions, including the contribution, are less than your standard deduction, then you receive no tax benefit from taking a taxable distribution and donating that distribution. You eliminate having the IRA distribution included in your income by donating directly from your IRA to a charity. The IRA donation reduces your adjusted gross income (AGI). Lower AGI can potentially increase your medical expense deduction, reduce the tax on social security income, and reduce any net investment income tax since these items are calculated based on your adjusted gross income.

Expenses Incurred While Working from Home

Although more people have been working from home this year due to the pandemic, related expenses are not deductible if you are an employee. You may want to ask your employer for reimbursements for new office equipment (e.g., desk, chairs, computers, etc.) Your employer can probably deduct the expense on their business tax return.

If you are self-employed and working from home during the year, tax deductions are still available. Thus, if you have been working from home as an independent contractor, we should discuss what expenses you have incurred that might offset that taxable income.

Mortgage Interest Deduction

If you sold your principal residence during the year and acquired a new principal residence, the deduction for any interest on your acquisition indebtedness (i.e., your mortgage) could be limited. The interest deduction on mortgages of more than $750,000 obtained after December 14, 2017, is limited to the portion of the interest allocable to $750,000 ($375,000 in the case of married taxpayers filing separately). If you have a mortgage on a principal residence acquired before December 15, 2017, the mortgage interest limitation applies to mortgages of $1,000,000 ($500,000 in the case of married taxpayers filing separately) or less. However, if you operate a business from your home and take the “home office deduction,” a portion of your mortgage interest is not subject to these limitations.

Interest on Home Equity Loans and Loan Refinancing

You can potentially deduct interest paid on home equity loans (HELOCs), but only if you used the debt to buy, build, or substantially improve your home. Thus, for example, interest on a home equity loan used to build an addition to your existing home is typically deductible, while interest on the same loan used to pay personal expenses, such as credit card debt, vacations, or a new automobile, is not.

The same concept applies if you refinanced your home in 2021. If all the proceeds from the new loan are applied to your home’s principal, all the mortgage interest is deductible. However, if you refinanced your home and used a portion of the proceeds for other purposes, a portion of your mortgage interest is not deductible. You will need to let me know if you refinanced your home mortgage in 2021 to determine whether all your mortgage interest is deductible.

Sale of a Home.

If you sold your home this year, up to $250,000 ($500,000 for married filing jointly) of the gain on the sale is excludible from income. However, this amount is reduced if part of your home was rented out or used for business purposes. Generally, a loss on the sale of a home is not deductible. But again, if you rented part of your home or otherwise used it for business, the loss attributable to that portion of the home is deductible.

Discharge of Qualified Principal Residence Indebtedness

If you had a qualified principal residence mortgage and the bank discharged (forgave) the loan in 2021, it is not included in gross income. (Usually, when a loan is forgiven, the IRS considers the amount of debt forgiven as taxable income.)

Deductions for Mortgage Insurance Premiums

You might be entitled to treat amounts paid during the year for any qualified mortgage insurance as deductible qualified residence interest if the insurance was obtained in connection with acquisition debt for a qualified residence.

Child Tax Credit

The ARP significantly increased the child tax credit (CTC) available in 2021. Many taxpayers received this credit as an advanced credit with direct deposit or check payments starting last July.

The CTC was increased from $2,000 to $3,000 or, for children under 6, to $3,600. The age of a child for which the credit is available was raised from 16 to 17. Further, the refundable amount of the 2021 CTC equals the entire credit amount instead of being based on an earned income formula.

Under modified phaseout rules, the modified adjusted gross income threshold, which determines if an individual qualifies for the CTC, was reduced to $150,000 in the case of a joint return or surviving spouse, $112,500 in the case of a head of household, and $75,000 in any other case. This special phaseout reduction is limited to the lesser of the applicable credit increase amount (i.e., either $1,000 or $1,600) or 5 percent of the applicable phaseout threshold range.

The payments taxpayers received for the CTC were based on their income in 2020 or 2019 if no tax return was filed by the CTC payment start date. Some taxpayers who had higher income in 2021 may lose some of the CTC and will have to pay back a portion of the advanced payments on their 2021 tax return.

Dependent Care Assistance Tax Benefits

The ARP provided several favorable changes to tax benefits relating to dependent care assistance, including (1) making the child and dependent care tax credit (CDCTC) refundable; (2) increasing the amount of expenses eligible for the CDCTC; (3) increasing the maximum rate of the CDCTC; (4) increasing the applicable percentage of expenses eligible for the CDCTC; and (5) increasing the exclusion from income for employer-provided dependent care assistance.

Generally, you may be eligible for a nonrefundable CDCTC for up to 35 percent of the expenses paid to someone to care for your child or your dependent so that you can work or look for work. For 2021, the dependent care credit is refundable for an individual living in the United States for more than one-half of the tax year. Under the ARP, the amount of child and dependent care expenses eligible for the credit was increased to $8,000 for one qualifying individual and $16,000 for two or more qualifying individuals. The maximum credit rate also goes up from 35 to 50 percent, and phaseout thresholds begin at $125,000 of adjusted gross income (i.e., household income). At $125,000, the credit percentage begins to phase out and plateaus at 20 percent. This 20-percent credit rate phases out for taxpayers whose adjusted gross income is more than $400,000. In addition, the amount of employer-provided dependent care assistance that may be excluded from income has been increased from $5,000 to $10,500 (from $2,500 to $5,250 in the case of a separate return filed by a married individual) for 2021.

Premium Tax Credit

A health insurance subsidy is available through a premium assistance credit for eligible individuals and families who purchase health insurance through insurance Exchanges offered under the Patient Protection and Affordable Care Act (PPACA). The premium assistance credit is refundable and payable in advance directly to the insurer on the Exchange. Individuals with incomes exceeding 400 percent of the poverty level usually are not eligible for these subsidies. However, the ARP eliminated that provision for tax years beginning in 2021 or 2022 and allows anyone to qualify for the subsidy. In addition, the provision limits the percentage of a person’s income paid for health insurance under a PPACA plan to 8.5 percent of income.

Education-Related Deductions and Credits

Certain education-related tax deductions, credits, and exclusions from income may apply for 2021. Tax-free distributions from a qualified tuition program, also referred to as a Section 529 plan, of up to $10,000 are allowed for qualified higher education expenses. Qualified higher-education expenses for this purpose include tuition expenses in connection with a designated beneficiary’s enrollment or attendance at an elementary or secondary public, private, or religious school, i.e., kindergarten through grade 12. It also includes expenses for fees, books, supplies, and equipment required for participation in apprenticeship programs and qualified education loan repayments in limited amounts. A special rule allows tax-free distributions to a sibling of a designated beneficiary (i.e., a brother, sister, stepbrother, or stepsister). As a result, a 529 account holder can distribute a student loan to a sibling of the designated beneficiary without changing the account’s designated beneficiary.

In addition, if your modified adjusted gross income level is below certain thresholds, the following are also available for 2021: an American Opportunity Tax Credit of up to $2,500 per year for each eligible student; a Lifetime Learning credit of up to $2,000 for tuition and fees paid for the enrollment or attendance of yourself, your spouse, or your dependents for courses of instruction at an eligible educational institution; an exclusion from income for education savings bond interest received; and a deduction from gross income for student loan interest of up to $2,500. In addition, under the ARP, certain discharges of students loans occurring in the years 2021 through 2025 are excludible from income.

Credit for Sick Leave for Self-Employed Individuals

As a result of the COVID-19 pandemic, notable income tax credits were enacted for self-employed individuals. If you are considered an eligible self-employed individual, you may qualify for an income tax credit for a qualified sick leave equivalent amount. You are an eligible self-employed individual if you regularly carry on any trade or business and would be entitled to receive paid leave during the tax year under the Emergency Paid Sick Leave Act added by the Families First Act. The calculation of the qualified sick leave equivalent amount is complicated but is generally equal to the number of days during the tax year that you could not perform services for which you would have been entitled to sick leave, multiplied by the lesser of two amounts: (1) $511, or (2) 100 percent of your average daily self-employment income. The number of days taken into account in determining the qualified sick leave equivalent amount may not generally exceed ten days. Your average daily self-employment income under this provision equals the net earnings from self-employment for the year divided by 260. In addition, if you have the appropriate documentation, the credit is refundable.

In simple terms, if you are self-employed and were so sick you couldn’t work, let me know. You may be eligible for this credit.

Credit for Family Leave for Certain Self-Employed Individuals

Another coronavirus-related income tax credit that may be available to you is a credit for a qualified family leave equivalent amount for wages paid before October 1, 2021. The qualified family leave equivalent amount is an amount equal to the number of days (up to 50) during the tax year that you could not perform services for which you would be entitled, if you were employed by an employer, to paid leave under the Emergency Family and Medical Leave Expansion Act, multiplied by the lesser of two amounts: (1) 67 percent of your average daily self-employment income for the tax year, or (2) $200. Your average daily self-employment income under the provision is an amount equal to your net earnings from self-employment for the year divided by 260. This credit is also refundable.

Like the previous credit, if you are self-employed and you couldn’t work because you had to take care of a member of your family, let me know. You may be eligible for this credit.

Retirement Planning

If you can afford to do so, investing the maximum amount allowable in a qualified retirement plan will yield a significant tax benefit. If your employer has a 401(k) or 403(b) plan and you are under age 50, $19,500 of income can be contributed to the plan in 2021. Catch-up contributions of $6,500 are allowed if you are 50 or over. If you have a SIMPLE 401(k), the maximum pre-tax contribution for 2021 is $13,500. That amount increases to $16,500 if you are 50 or older. The maximum IRA deductible contribution for 2021 is $6,000, and that amount increases to $7,000 if you are 50 or over.

Life Events

Life events can have a significant impact on your tax liability. For example, if your filing status last year was Head of Household or Surviving Spouse, and your filing status for 2021 is Single, then your tax rate will go up. If you married or divorced during the year and changed your name, you need to notify the Social Security Administration (SSA). Similarly, the SSA should be notified if you have a dependent whose name has been changed. A mismatch between the name shown on the tax return and the SSA records can cause problems in processing tax returns and may even delay tax refunds.

When you complete the 2021 Tax Return Checklist, let me know if you had any Life Events that may affect your tax return.


If you have questions about the tax issues presented in this email or would like to talk about your 2021 tax return, we can schedule a phone call or Zoom meeting. Use this link: Phone Call or Zoom Meeting to set up an appointment.

Let me know if you have any questions.
Best regards,