A tax exemption is an allowance that reduces or eliminates the taxes owed by an individual or organization. Exemptions can apply to many different types of taxes, including income tax, property tax, and sales tax.
Knowing what a tax exemption is and which types of tax exemptions you may qualify for could help you reduce your tax liability and save money.
Definition and Examples of Tax Exemptions
A tax exemption enables individuals or organizations to avoid paying some or all taxes in situations that would generally incur a tax liability if the exemption did not exist.
For example, some nonprofits apply for federal tax exemptions with the IRS so that they don’t have to pay federal income tax. Tax exemptions can also apply at the state or local level, such as when a qualifying religious organization is exempt from paying property taxes.
Individuals can qualify for exemptions from different types of taxes depending on their circumstances. Foreign students with income from a part-time job on campus, for example, may be eligible for an exemption from paying Social Security or Medicare taxes. Diplomats from other countries may be exempt from sales tax when they make purchases in the U.S.
And perhaps most commonly, many individuals qualify for property tax exemptions through their state, county, or municipality. However, these exemptions often reduce rather than eliminate the amount of property tax owed. For example, the Homestead Exemption (or Homeowners’ Exemption) often allows homeowners to reduce the assessed value of their primary residence, meaning they’re taxed on a lower amount, though the specific rules vary based on local tax regulations.
How Tax Exemptions Work
A tax exemption works by either reducing or waiving tax liability, and the details depend on factors such as who’s receiving the tax exemption and where it’s being applied.
In many cases, receiving a tax exemption requires an individual or organization to apply for that status. For example, you may have to initially apply to receive a property tax exemption based on your age or veteran status. That exemption might continue automatically for as long as you live in that home, depending on local laws, or you may need to reapply periodically.
Organizations also typically have to apply for tax exemption. To receive tax-exempt status from the IRS, for example, a nonprofit has to complete an application. They may also have to apply for state or local tax exemptions.
In some situations, a tax exemption could apply automatically. During a tax holiday, for instance, some types of purchases might automatically be exempt from sales taxes. That means you can buy items as you normally would and simply avoid paying sales tax on their value.
What Tax Exemptions Mean for Individuals
Understanding tax exemptions can help individuals save money by reducing how much tax they may owe. It’s often worth looking into whether any tax exemptions apply to your situation for any type of tax you may owe, whether that’s property taxes, payroll taxes, or other types of taxes.
A tax professional can help you properly claim tax exemptions so you can legally reduce what you owe in taxes.
Keep in mind that tax exemptions can change over time. Prior to 2018, for example, many people were eligible to claim what was known as the personal exemption on their federal income taxes, which reduced their taxable income. The Tax Cuts and Jobs Act (TCJA) removed the personal exemption, though it’s possible that it will return if the TCJA expires as scheduled after 2025.
Also, if you’re considering starting a business, you may want to look into potential tax exemptions to see if you could save money. Some types of environmentally friendly businesses, for example, may be eligible for tax credits and tax exemptions that could incentivize you to start a company in a certain area. New York state, for instance, allows for a sales and use tax exemption for selling and installing commercial solar energy systems. That alone might not be enough of a reason to start a business in the state, but it’s a factor worth considering if you were already leaning toward that location.
- A tax exemption can reduce or eliminate the amount owed in certain types of taxes, such as income tax, property tax, or sales tax.
- Many different types of tax exemptions exist, some of which apply to individuals and some to organizations.
- To receive the benefits of a tax exemption, you’re often required to apply for it. However, in some cases, a tax exemption may automatically kick in.