What Does It Mean to Be Tax-Exempt?

What It Means to Be Tax-Exempt Explained in Less Than 4 Minutes

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If something is tax-exempt it means it is not subject to taxation. Tax exemptions could apply to certain types of earnings, goods or services, or an organization as a whole such as a nonprofit.

Understanding what tax-exempt means and what qualifies for tax exemptions could help you improve how you file taxes to maximize your returns. Learn more about what qualifies for tax exemptions. 

Definition and Examples of What It Means To Be Tax-Exempt

Tax exemptions are essentially an exception to a taxation rule from a government. If something is tax-exempt, then it is not subject to taxation, or it’s subject to a lower tax rate or only partial taxation. Tax exemptions could apply to a number of situations. 

For example, income from government bonds is exempt from federal taxes. An organization, such as a charity, school, or religious institution, can also be classified as tax-exempt. For example, the Internal Revenue Service (IRS) exempts qualified charitable organizations, among others from federal income tax.

States might also designate an organization as tax-exempt. For instance, California has a separate application to designate an organization as exempt from income and franchise taxes. States can also designate an organization, such as schools, as being exempt from paying sales tax on purchases.

You can declare an exemption from tax withholdings on your paycheck if you don’t expect federal income tax liability for the year, but that doesn’t mean you’re actually tax-exempt. You could still end up owing taxes when it’s time to file. 

The IRS has eliminated the personal tax exemption as a part of the Tax Cuts and Jobs Act, and the lowest federal income tax rate was 10% for income of $10,275, or $20,550 for married couples filing jointly for the 2022 tax year.

How Does Being Tax-Exempt Work?

Tax-exempts can apply for different taxes, like federal or state. But just because there is a tax exemption under one jurisdiction, doesn’t mean that tax-exempt applies in another. For example, a nonprofit could be exempt from fees like property taxes on buildings it owns in one state, but not another. 

To be federally tax-exempt, organizations generally need to apply for tax-exempt recognition and meet requirements such as not being organized for private interests. But, as the IRS points out, “nonprofit status is a state law concept.”

Tax-exempt income varies widely. Income from investments in government bonds, for example, could be exempt from income taxes. Or income from renting out your home for less than 15 days can qualify as tax-exempt.

Many other things are tax exempt. For example, many states exempt regular groceries from sales tax.

What Does Being Tax-Exempt Mean for Individuals?

Understanding what it means to be tax-exempt can help you or your organization optimize your taxes. If you know what types of investment income are tax-exempt, for example, you may consider how those types of earnings can fit into your portfolio to try to minimize your tax burden.

Keep in mind that tax-exempt rules can vary significantly from jurisdiction to jurisdiction, so it’s important to confirm whether something that’s exempt at the federal level also applies in your state and any other local tax jurisdictions.

Individuals may also want to understand what it qualifies as tax-exempt when they make decisions about their charitable giving. 

Key Takeaways

  • Tax-exempt is when an item (or income, organization, etc.) is not subject to taxation.
  • Tax-exemptions can apply in many instances, such as when a charity is designated tax-exempt by the IRS or a purchased item is exempt from state sales tax.
  • Tax-exemption rules can differ by jurisdiction.