Free Lunch: Deducting Expenses You Never Paid

In certain situations, you can claim tax deductions for expenses that someone else paid.

By BILL BISCHOFF

In a 2010 decision, the U.S. Tax Court concluded that a daughter could deduct medical expenses and real estate taxes on her Form 1040 -- even though they were paid by her mother. This outcome may surprise you, because you probably think a taxpayer can never deduct expenses that were paid by someone else. As this Tax Court decision proved, that is not necessarily true. Here are some cases where you can claim tax deductions for expenses you didn't pay.

Medical Expenses

You can deduct medical expenses to the extent they exceed 7.5% of your adjusted gross income. In the 2010 Tax Court decision, the Internal Revenue Service argued that the daughter could not deduct the expenses because she did not pay for them with her own money. The Tax Court disagreed. The facts of the case demonstrated that the mother intended the payments, which were paid directly to the medical-service providers and local government, to be gifts. Therefore, the Tax Court characterized the transactions as gifts from the mother to the daughter, followed by payment of the expenses by the daughter using those gifted funds. The daughter was allowed to count nearly $25,000 of medical expenses that were actually paid by the mother, plus some expenses the daughter paid with her own funds, in calculating her medical-expense deduction.

Thanks to the tax-law exemption for gifts that are made in the form of direct payments to medical-service providers, the mother's payment of the medical expenses had no federal gift tax consequences for her.

Important Point: When you directly pay medical expenses for a person who is your dependent (meaning you pay over 50% of that person's total support), you can add the expenses you pay for the dependent to your own expenses and claim a deduction for the total to the extent it exceeds 7.5% of your adjusted gross income. In the Tax Court case, the daughter was evidently not the mother's dependent, so the deduction for the daughter's expenses belonged to the daughter rather than the mother.

Real Estate Taxes

The daughter in the 2010 Tax Court decision was also allowed to claim an itemized deduction for more than $5,500 of local real estate taxes that were actually paid by the mother, plus some taxes that the daughter paid with her own funds. Thanks to the annual federal gift tax exclusion (currently $13,000), the mother's payment of the real estate taxes had no federal gift tax consequences because it was less than the $12,000 gift tax exclusion that applied for the year in question (2006).

Seller-Paid Points for Home Mortgage

Assuming you itemize deductions, you can write off points (including loan origination fees) that you pay to take out a mortgage to buy your principal residence. Surprisingly enough, you can also deduct mortgage points paid by the seller on your behalf to sweeten the deal. In fact, IRS Revenue Procedure 94-27 actually requires you to claim the deduction. Don't ask questions. Just follow directions and claim that deduction, even though the seller paid for it.

The Moral of the Story

When it comes to deductions for certain expenditures, the question of who actually paid for them may not decide who is entitled to deduct them. Do not automatically assume you can't deduct expenses that were actually paid by someone else. Sometimes there is such a thing as a free lunch. Contact your friendly tax pro when you have questions about who is allowed to claim write-offs in various circumstances. You may be surprised by what you hear.