6.2 State and local taxes

State and local taxes can significantly impact your federal tax return. Understanding which taxes are deductible and how to optimize your deductions within the $10,000 SALT cap is crucial for effective tax planning.

The Tax Cuts and Jobs Act of 2017 changed the game for many taxpayers, especially in high-tax states. Knowing how to navigate these changes, including state workarounds and IRS guidance, can help you maximize your deductions and minimize your tax liability.

Deductible State and Local Taxes

Types of Deductible Taxes

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• State and local income taxes paid or withheld during the tax year become deductible on federal tax returns
• Real estate taxes imposed by state and local governments on personal property qualify for federal tax deductions
• Personal property taxes assessed by state or local governments based on the value of personal property typically qualify for deductions (vehicles, boats)
• State and local general sales taxes may qualify for deductions, but taxpayers must choose between deducting income taxes or sales taxes
• Foreign income taxes paid to a foreign country or U.S. possession may qualify for deductions if the taxpayer does not claim the foreign tax credit
• Special assessments for local benefits, such as sidewalks or sewer lines, generally do not qualify as deductible taxes

Considerations for Deductions

• Taxpayers must itemize deductions on Schedule A of Form 1040 to claim state and local tax deductions
• The choice between deducting state and local income taxes or sales taxes depends on which provides the greater tax benefit
  • Income tax deduction benefits taxpayers in high-income tax states (California, New York)
  • Sales tax deduction benefits taxpayers in states with no income tax (Florida, Texas)
• Timing of tax payments can affect deductibility
  • Prepayment of future year's taxes may not be fully deductible in the current year
• Documentation requirements include keeping records of tax payments and receipts for sales taxes if claiming the actual sales tax paid

Limitations on State and Local Tax Deductions

SALT Deduction Cap

• Tax Cuts and Jobs Act of 2017 imposed a cap of $10,000 ($5,000 if married filing separately) on the total deduction for state and local taxes (SALT)
• SALT deduction limit applies to the combined total of state and local income taxes, real estate taxes, and personal property taxes
  • Example: If a taxpayer pays $8,000 in property taxes and$4,000 in state income taxes, their deduction is limited to $10,000
• Excess state and local tax payments above the $10,000 limit cannot be carried forward to future tax years
  • Example: If total SALT payments are $15,000, the$5,000 excess over the cap is permanently lost as a deduction

Additional Limitations

• SALT deduction becomes subject to the overall limitation on itemized deductions for high-income taxpayers, known as the Pease limitation
  • Reduces itemized deductions by 3% of the amount by which AGI exceeds a threshold amount
• State and local taxes paid in connection with a trade or business are not subject to the $10,000 SALT deduction limit
  • Example: Property taxes paid on rental properties can be deducted in full on Schedule E

Tax Cuts and Jobs Act Impact on State and Local Taxes

Changes to Deduction Benefits

• TCJA significantly reduced the benefit of the SALT deduction for many taxpayers, particularly in high-tax states (New York, California, New Jersey)
• $10,000 SALT deduction cap is not indexed for inflation, meaning its real value decreases over time
  • Example: $10,000 cap in 2018 is worth less in 2023 due to inflation
• TCJA nearly doubled the standard deduction, reducing the number of taxpayers who itemize and claim the SALT deduction
  • 2023 standard deduction: $13,850 for single filers,$27,700 for married filing jointly

State Responses and IRS Guidance

• Some states implemented workarounds to mitigate the impact of the SALT deduction cap
  • Establishing charitable funds (New York, New Jersey)
  • Pass-through entity taxes (Connecticut, Wisconsin)
• IRS has issued guidance and regulations to address state attempts to circumvent the SALT deduction cap
  • Disallowed full charitable deductions for contributions to state-run charitable funds
  • Provided safe harbor for certain pass-through entity taxes
• SALT deduction cap is scheduled to expire after 2025, unless extended by future legislation
  • Creates uncertainty for long-term tax planning

Strategies for Claiming State and Local Tax Deductions

Optimizing Deductions

• Compare potential itemized deductions, including SALT, to the standard deduction to determine which method results in a lower tax liability
  • Example: Single taxpayer with $9,000 SALT and$5,000 charitable contributions might still benefit from the standard deduction
• Time tax payments strategically to maximize deductions within the $10,000 limit for taxpayers in high-tax states
  • Pay property taxes in December instead of January to claim in current tax year
• Married couples filing separately should consider the impact of the $5,000 SALT deduction limit per return on their overall tax situation
  • May benefit some couples but could increase overall tax liability for others

Advanced Planning Techniques

• Calculate whether deducting state and local income taxes or sales taxes provides the greater benefit
  • Use IRS sales tax tables or actual receipts for large purchases
• High-income taxpayers should consider the interplay between the SALT deduction, other itemized deductions, and potential alternative minimum tax (AMT) liability
  • AMT can reduce or eliminate the benefit of the SALT deduction for some taxpayers
• Business owners may benefit from allocating a portion of their state and local taxes to their business activities, as these are not subject to the $10,000 limit
  • Example: Deduct home office expenses, including a portion of property taxes, on Schedule C
• Stay informed about potential changes to tax laws that may affect the SALT deduction in future years
  • Consider flexible tax planning strategies that can adapt to legislative changes