Tax Deduction
What it is:
A tax deduction reduces the amount of income that is subject to tax. A tax deduction is not the same as a tax credit.
How it works/Example:
For example, let's assume that John paid $10,000 in mortgage interest last year. He and his wife earned $150,000 from their jobs last year. Based on their circumstances, they can deduct the mortgage interest from their taxable income, meaning that they only have to pay federal income tax on $150,000 - $10,000 = $140,000.
Tax deductions have financial value. In our example, without the mortgage interest deduction, John would have paid income tax on that additional $10,000 of income. If he's in the 28% tax bracket, that could amount to $2,800. Thus, the mortgage interest deduction of $10,000 saves him $2,800 in taxes.
Why it matters:
Tax deductions obviously lower a person's tax bill, which is why taxpayers invest time in seeking out deductions and structuring transactions to maximize those deductions. There are hundreds of different types of tax deductions, though some deductions are only available to people in certain income brackets or companies in certain industries.