businessman
Banned
Taxpayers who itemize can now choose between deducting state income tax and deducting sales tax.
Congress eliminated the itemized deduction for sales tax in 1986, but now it's back, at least temporarily, in a modified form. For 2004 and 2005, taxpayers who itemize will be allowed to claim this deduction, but only if they do not claim an itemized deduction for state or local income tax. You can deduct one kind of tax or the other, but not both. (See below for a possible trap in making this choice.)
Itemizers Only
To claim this deduction, you have to itemize. Taxpayers who claim the standard deduction (a majority of taxpayers) don't benefit from this change. However, some taxpayers who previously claimed the standard deduction will find that they come out better with itemized deductions now that this deduction is available.
HOW IT WORKS
Apart from the requirement to choose between deducting sales tax or income tax, the new rule will work the way the old one did, for those old enough to remember it. You have a choice between two different ways to claim the deduction.
One way is to collect receipts for all your purchases when you pay sales tax, and then add up the sales tax on all those receipts. Most people find that's more work than it's worth, but you're allowed to do this if you think it will provide a better result.
The other way is to use tables appearing in IRS Publication 600. The table will tell you how much sales tax to deduct based on your income level and the state where you live. You can increase that amount by any sales tax you pay on the purchase of an automobile, aircraft, boat or home (including home building materials).
Using the IRS table is a lot easier, but you may suspect you're getting cheated when you take this approach. The the tables used back in the 1980s were reasonably generous, so that shouldn't be a concern unless your spending on items subject to sales tax is unusually high for someone with your income level (for example, when you're living off savings). I suspect most people will do just as well or better using the table amount even if they collect all their sales tax receipts.
The deduction is not allowed for sales tax you incur as part of your business. That cost should be deducted (to the extent allowed) as part of your business expenses.
Hidden Trap?
In most cases, the best choice is to claim whichever tax gives you the greater deduction. But suppose you're in this situation:
Example: If you claim the sales tax deduction it will be $900. If you claim the state income tax deduction it will be $950, and you will receive a state income tax refund next year of $150.
If you claim the state income tax deduction, you'll have to report the state income tax refund as taxable income in the year you receive it. The extra tax you'll pay on this income is probably more than the tax you save by claiming the income tax deduction instead of the sales tax deduction, because the amounts are so close.
Some experts have suggested that you would only have to include $50 of the $150 state income tax refund in income because your benefit from choosing to deduct your state income tax instead of sales tax is only $50. The IRS has not ruled on this issue yet, but it seems unlikely they will interpret the tax benefit rule in this manner. It is more likely they will say you have to include the entire refund in income because it was your choice to deduct state income tax. Bottom line: in a situation like this it's probably better to deduct the sales tax, even though it provides a smaller deduction.
Planning
If your sales tax and income tax are roughly the same, you may benefit from "bunching." Try to pay more income tax in one year (for example, by paying your fourth quarter estimated payment before or after the end of the year), and consider the tax effect when you decide whether to buy a new car this year or next. And if Congress allows this deduction to expire at the end of 2005, you may want to replace that jalopy before 2006.
Welcome to AMT
This deduction isn't allowed in figuring alternative minimum tax (AMT), and that means many taxpayers will lose some or all of the benefit. We haven't seen any projections on this point, but it's likely that thousands of taxpayers who previously did not pay AMT will have to do so when they begin claiming this deduction. Welcome to our world. (Click here for our free online guide to AMT.)
How Fair?
Residents of states that have sales tax but no income tax see this change as a welcome move toward fairness. There's another way to look at it though. Residents of those states can now deduct all the taxes they pay to state and local governments (sales tax and property tax). Residents of states that have only and income tax (no sales tax) are also able to deduct 100% of the tax they pay to state and local governments.* Taxpayers in the rest of the country deduct only part of the tax they pay to state and local governments, because they must choose between income tax and sales tax. When Congress turns to this issue again (as it must, because the deduction expires in two years), it should level the playing field by allowing taxpayers to deduct both taxes. That's the only way to permit states to choose between sales tax and income tax without affecting the federal tax burden of their citizens.
Congress eliminated the itemized deduction for sales tax in 1986, but now it's back, at least temporarily, in a modified form. For 2004 and 2005, taxpayers who itemize will be allowed to claim this deduction, but only if they do not claim an itemized deduction for state or local income tax. You can deduct one kind of tax or the other, but not both. (See below for a possible trap in making this choice.)
Itemizers Only
To claim this deduction, you have to itemize. Taxpayers who claim the standard deduction (a majority of taxpayers) don't benefit from this change. However, some taxpayers who previously claimed the standard deduction will find that they come out better with itemized deductions now that this deduction is available.
HOW IT WORKS
Apart from the requirement to choose between deducting sales tax or income tax, the new rule will work the way the old one did, for those old enough to remember it. You have a choice between two different ways to claim the deduction.
One way is to collect receipts for all your purchases when you pay sales tax, and then add up the sales tax on all those receipts. Most people find that's more work than it's worth, but you're allowed to do this if you think it will provide a better result.
The other way is to use tables appearing in IRS Publication 600. The table will tell you how much sales tax to deduct based on your income level and the state where you live. You can increase that amount by any sales tax you pay on the purchase of an automobile, aircraft, boat or home (including home building materials).
Using the IRS table is a lot easier, but you may suspect you're getting cheated when you take this approach. The the tables used back in the 1980s were reasonably generous, so that shouldn't be a concern unless your spending on items subject to sales tax is unusually high for someone with your income level (for example, when you're living off savings). I suspect most people will do just as well or better using the table amount even if they collect all their sales tax receipts.
The deduction is not allowed for sales tax you incur as part of your business. That cost should be deducted (to the extent allowed) as part of your business expenses.
Hidden Trap?
In most cases, the best choice is to claim whichever tax gives you the greater deduction. But suppose you're in this situation:
Example: If you claim the sales tax deduction it will be $900. If you claim the state income tax deduction it will be $950, and you will receive a state income tax refund next year of $150.
If you claim the state income tax deduction, you'll have to report the state income tax refund as taxable income in the year you receive it. The extra tax you'll pay on this income is probably more than the tax you save by claiming the income tax deduction instead of the sales tax deduction, because the amounts are so close.
Some experts have suggested that you would only have to include $50 of the $150 state income tax refund in income because your benefit from choosing to deduct your state income tax instead of sales tax is only $50. The IRS has not ruled on this issue yet, but it seems unlikely they will interpret the tax benefit rule in this manner. It is more likely they will say you have to include the entire refund in income because it was your choice to deduct state income tax. Bottom line: in a situation like this it's probably better to deduct the sales tax, even though it provides a smaller deduction.
Planning
If your sales tax and income tax are roughly the same, you may benefit from "bunching." Try to pay more income tax in one year (for example, by paying your fourth quarter estimated payment before or after the end of the year), and consider the tax effect when you decide whether to buy a new car this year or next. And if Congress allows this deduction to expire at the end of 2005, you may want to replace that jalopy before 2006.
Welcome to AMT
This deduction isn't allowed in figuring alternative minimum tax (AMT), and that means many taxpayers will lose some or all of the benefit. We haven't seen any projections on this point, but it's likely that thousands of taxpayers who previously did not pay AMT will have to do so when they begin claiming this deduction. Welcome to our world. (Click here for our free online guide to AMT.)
How Fair?
Residents of states that have sales tax but no income tax see this change as a welcome move toward fairness. There's another way to look at it though. Residents of those states can now deduct all the taxes they pay to state and local governments (sales tax and property tax). Residents of states that have only and income tax (no sales tax) are also able to deduct 100% of the tax they pay to state and local governments.* Taxpayers in the rest of the country deduct only part of the tax they pay to state and local governments, because they must choose between income tax and sales tax. When Congress turns to this issue again (as it must, because the deduction expires in two years), it should level the playing field by allowing taxpayers to deduct both taxes. That's the only way to permit states to choose between sales tax and income tax without affecting the federal tax burden of their citizens.