Tax Basics

Personal finance experts Ken and Daria Dolan help you get an early jump on your taxes with simple steps you can take right now that will take some of the stress out of tax season.

The National Taxpayer Advocate recently announced that Americans spend 6.1 billion hours a year on tax prep. That's almost as many hours that 3 million full-time employees work in a year.

You can easily cut down the number of hours you spend preparing your 2011 taxes by taking a few simple steps now. Trust us, tackling tax season in bite-size chunks will make the whole process less daunting.

Here are seven simple, painless tips to save time, money, a headache and hassle down the road:

The good news: You survived an audit. So what now?

If you're audited and the result is that there are no adjustments to your return (or if you get a refund), it decreases your odds of being audited in subsequent years. If you're audited on the same items two years in a row with no additional taxes due, the IRS manual actually recommends that you not be audited for the same items for another year.

But what if you're audited and the IRS finds that you owe additional tax? You'll want to resolve those outstanding tax liabilities as soon as possible in order to avoid further interest and penalties.

If you can afford to pay the tax due in full, you'll prevent any future penalties and interest from piling up. If you can't afford to pay the tax due in full from your regular operating account, consider dipping into savings accounts or money markets. The IRS goes so far as to suggest that you consider a home equity loan, personal loan or credit card, since penalties and interest for your taxes may cost you more over the long run.

Some parts of the country are still digging out from the recent nor'easter -- and winter is only a few weeks old. With heating costs soaring as the temperatures dip, it's a great time to think about ways to become more energy efficient, which may even include the purchase of home improvements meant to help you stay cozy this winter.

Under current law, taxpayers may be eligible for a federal income tax credit for the purchase of a new energy-efficient water heater, air conditioner or furnace. But it doesn't stop there. The credit also applies to such improvements as windows and doors, roofs and insulation. You can find a detailed list of qualifying purchases on the Energy Star website.

It's no secret that the IRS is ramping up the number of audits in an attempt to close the "tax gap." That's the term the IRS is using to account for the difference between the taxes it believes it should have collected and what it actually managed to collect. For 2001 (the last year for which data is available), the tax gap was $350 billion.

While the chances of being chosen for an audit are still generally low, your chances of being selected are on the rise. Don't get caught by surprise. Here's what you need to know in order to be prepared.

The most basic question is what kind of audit the IRS is seeking. Audits can be divided into two general categories: paper audits and people audits.

For the fiscal year 2009, about 1.4 million taxpayers were chosen for audit. This represents about 1% of the 140 million tax returns filed in 2008 -- pretty good odds. Of those, about 75% were correspondence, or "paper" audits, and the remaining 25% were field or "in person" audits. Even though the numbers of taxpayers audited are fairly low, anxiety about tax audits remains high.

Here, we tackle some of the most frequently asked tax audit questions:

The Homebuyer Assistance and Improvement Act of 2010, signed into law by President Obama in July 2010, modified the terms of the existing first-time homebuyer's credit. The new law extended the closing deadline for home purchases from June 30, 2010, to Sept. 30, 2010; binding contracts for the sale of the home must have been entered into by April 30, 2010.

For purposes of the credit, a first-time homebuyer is defined as someone who has not owned a principal residence during the last three years. For married taxpayers, you have to consider the history of both the homebuyer and the homebuyer's spouse. If one spouse is disqualified, neither can claim the credit. This means, so long as you are considered married (even if you weren't married to your spouse for the entirety of the past three years), you don't qualify for the first-time homebuyer credit if your spouse doesn't qualify.

The same rule doesn't apply for unmarried individuals who purchase a home together. The law allows those taxpayers to split the credit or allocate the amount to any buyer who qualifies as a first-time buyer. See Notice 2009-12 for more details.

The credit is equal to 10% of the home's purchase price up to a maximum of $8,000. A taxpayer who purchased a home for $75,000 would be entitled to 10%, or $7,500. A taxpayer who purchased a home for $80,000 would be entitled to the maximum credit, or $8,000. But a taxpayer who purchased a home for more, say, $150,000, would still only be entitled to the maximum credit, or $8,000.

Taxpayers often use the terms "deduction" and "credit" as though they're the same thing. They are not. They're actually very different terms, and being aware of the distinctions between the two can help you make good choices at tax time -- and maybe put some extra money back in your pocket.

A deduction is a reduction in your taxable income, while a credit is a reduction in your taxes due.

Deductions are calculated as part of your taxable income (you'll find taxable income on line 43 on your form 1040). They are subtracted from gross income, including wages, interest and dividends, and may even be listed on a separate form, such as a Schedule A. Maximizing those deductions allows you to reduce your overall taxable income. Your tentative tax due is calculated from your taxable income.

Credits are applied to your tentative tax and reduce the overall tax due on a dollar for dollar basis. Popular credits for 2010 include the Making Work Pay Credit, the American Opportunity Credit and the Earned Income Tax Credit.

It's rare that the decision to itemize or take the standard deduction hinges on some of the smaller deductions that you can claim on your federal form 1040, Schedule A. This is because the deduction thresholds are fairly high. For 2010, the standard deduction for married couples filing a joint return is $11,400. The standard deduction for individual taxpayers and married couples filing separate returns is $5,700. The standard deduction for heads of household is $8,400.

With numbers like those, big ticket items tend to drive the decision of whether to itemize. To help you figure out whether itemizing makes sense for you, here's a list of five of the most common itemized deductions:

1. Home Mortgage Interest. You can generally claim the home mortgage interest deduction for interest you pay on a loan secured by your home. The loan must be on your main home or a second home and includes a mortgage, a second mortgage, a line of credit or a home equity loan. You must have an ownership interest in the home (meaning that you can't take the deduction for paying the mortgage for a home owned by someone else) and you must be obligated to pay the loan.

If you pay $600 or more of mortgage interest during the year on a mortgage, your lender will generally issue a form 1098, which shows the total interest paid during the year, the amount of any mortgage insurance premiums paid and, if you bought your home during the year, the deductible points paid during the year, including seller-paid points. Those amounts are generally deductible to you. Be aware, however, that income limits and other restrictions may apply.

If you keep good records, deductions can be a great way to reduce your taxable income. Increasing your allowable deductions means the less tax you owe and the more money you get to keep.

To maximize your deductions, it's a good idea to familiarize yourself with tax rules -- there are likely many deductions you're missing out on.

A number of deductions that get overlooked quite a bit are called "deductions subject to the 2% limit." These deductions are only deductible to the extent that they are more than 2% of your adjusted gross income (AGI). You figure your total deductions subject to the 2% limit on Schedule A by subtracting 2% of your AGI from the total amount of these expenses. For example, if your AGI is $40,000, your deduction would be limited to those expenses over $800 (2% of $40,000).

To get you started, here's a list of eight commonly overlooked tax deductions subject to the 2% limit:

Each year, taxpayers have the option of claiming the standard deduction or the itemized deduction. For the tax year 2010, the standard deduction remains unchangedat $5,700 for single taxpayers or for those married filing separately; it also remains unchanged for married taxpayers or qualifying widow(er)s at $11,400; and for head of household, the standard deduction increased to $8,400.

Most taxpayers will choose the standard deduction -- about two out of three taxpayers make this choice. It's quick, it's easy and it allows taxpayers to file what's referred to as a short form, the form 1040-EZ. You may not file a form 1040-EZ if you itemize.