Never underestimate the staying power of a popular tax break. A deduction that was excised from the tax code by 1986’s landmark tax legislation was “termorarily” reinstated five years ago. It’s still on the books.
The resurrected law, which has been continued through the 2009 tax year, allows taxpayers to deduct state and local sales tax they pay in lieu of state income taxes.
The deduction is particularly welcomed by taxpayers in the seven states that do not collect state income taxes but do levy state sales taxes: Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. It also could benefit some Alaskans who, although they pay no state income or sales taxes, do face local sales taxes.
Even some residents of states with both types of taxes might find the sales-tax deduction is more valuable to them than the income tax write-off. For those keeping tax-collection score, New Hampshire has neither a sales nor an income tax, but Granite State officials do collect taxes on dividend and interest income.
But regardless of your state’s tax collection practices, to take full advantage of the sales tax deduction you have to know exactly how to file for it and just which taxes you can claim.
The process begins with your answers to two filing questions. First, do you plan to itemize? If so, then which write-off — sales taxes or income taxes — will give you the biggest break?
Deciding whether to itemize deductions or claim the standard amount is always a key tax-time choice. The Internal Revenue Service says that most people take the standard deduction. It’s easy to claim; there are no forms or work sheets to fill out and the amount is printed right there on your return near the line where it should be entered.
Plus, each year the standard deduction increases, thanks to inflation adjustments. For 2008 filing purposes, the standard deduction is $5,450 for single filers or married couples filing separately, $8,000 for head of household filers and $10,900 for married couples who file a joint return.
But if you use the standard deduction, you can’t take the sales tax break. To claim the sales taxes you paid, you must itemize.
If you have deductions such as mortgage interest, property taxes, charitable donations, and medical and miscellaneous expenses to add to your sales taxes, then the new deduction should help you push your Schedule A total well above your standard deduction amount.
However, if sales taxes are your only deductible expense, then it’s not worth it to itemize. This one itemized deduction will likely be much less than your standard deduction, and you always want to take the largest tax deduction amount you’re allowed.
For example, couples who file jointly and don’t have other things to itemize will be better off using the standard deduction. Otherwise, they would have had to have gone on a major spending spree last year (and kept all the receipts) to accumulate more than $10,900 in sales taxes to exceed their standard deduction amount.
Some taxpayers, though, do find the sales tax deduction worthwhile enough to warrant itemizing and claiming the added amount. And that means a bit of extra, and possibly unfamiliar, tax work.
“Some people, especially in states with no income tax, might find that this is the first time they’ve ever had to go to the long form and Schedule A to file,” says Bob D. Scharin, senior tax analyst from the Tax and Accounting business of Thomson Reuters.
These itemizers must now also answer question No. 2: Should you deduct your sales taxes or income taxes? In its pre-1986 incarnation, filers could claim both of these tax amounts. Now it’s an either-or decision; you cannot take both deductions and must note on Schedule A which tax you’re claiming.
“If you live in a state with no income tax, you’re clearly better off claiming the sales tax,” says Scharin.
And if you do pay both types of taxes, don’t automatically assume that your income tax break is going to be bigger. “If you live in a state with both, you can — should — look at both,” says Scharin. “Some states offer generous income tax exclusions for retirement income. In New York, for example, pensions for state and city employees are not taxed at the income tax level. It’s the same situation for disability pensions. You need to look and see exactly how much state income tax you’re paying.”
In some cases, the sales taxes paid could actually be more than state income taxes collected, says Mark Luscombe, principal tax analyst at CCH Inc., a Riverwoods, Ill.-based provider of tax law information and software.
“Yes, it could happen,” says Luscombe. “Here in Illinois, for example, we have a 6.25 percent sales tax rate and it’s higher in some counties, while there is a maximum income tax rate of 3 percent. And the income tax allows for some deductions and credits. So in an individual case, especially in a year with significant purchases, an Illinois resident could find that they could save more by claiming sales taxes.”
Then there’s the issue of just how much in sales taxes you can claim. If you have the documentation, there is no limit on the deduction amount.
Even if you don’t have all your receipts, you still might be able to recreate many of your sales tax payments. William Abrams, a partner in the law firm Abrams Garfinkel Margolis Bergson LLP, with offices in California and New York, notes that many types of records, such as credit card statements, are available online. By accessing them, he says, taxpayers could improve the accuracy of their annual sales-tax computations.
Most filers, however, will claim the amount that the IRS has figured for them in special sales-tax tables; one for each applicable state. The deduction amounts are based on the average consumption by taxpayers, taking into account filing status, number of dependents, adjusted gross income and rates of state and local general sales taxation.
But even with the tables, it’s not quite that simple. In using the data, you need to keep a couple of things in mind to get the biggest deduction.
First, don’t rely solely on your 1040 information when you read the table. The figure you enter on your federal return is taxable income, but Scharin says that the sales tax table amounts are based on total income, not just your adjusted, taxable income. You should take nontaxable income amounts into account for sales tax deduction purposes, he says, because the larger your total income, the larger your sales tax deduction.
These other types of income include municipal bond or other tax-exempt interest, workers’ compensation, nontaxable combat pay, the nontaxable portion of Social Security and other retirement benefits, as well as the nontaxable parts of an IRA, including a Roth IRA distribution.
Also, most of the tables only cover the state rates. “If you have a local sales tax, which many people don’t realize, you could be sacrificing some of the deduction if you use only the table amount,” says Scharin.
To account for local sales taxes, you’re going to have to do some extra calculating. If you’re not using tax software, a work sheet, also in the Schedule A instructions, will help you determine the correct number.
You also could have some extra math to do if you lived in different states that collected sales taxes. In this case, you must determine each state’s sales tax amount to arrive at your appropriate, combined deduction.
While all these considerations will definitely mean more work for some taxpayers, Scharin says, “If you went this far and you’re itemizing, you might as well get your full deduction.”
There’s also another add-on, and it could be quite sizable. Sales taxes you paid on the purchase of motor vehicles, boats, aircraft and, in some cases, building materials for a substantial addition to or renovation of an existing structure can be counted on top of your sales tax table and local tax amounts.
And if you think the IRS deduction tables are too stingy, don’t automatically rule out totaling up your receipts, even if you don’t have every single one from January through December 2008. “If you made large expenditures, you might find you still have enough to use instead of the tables,” says Scharin.
Some scenarios involving costly and taxable expenditures could produce a hefty deduction.
- You bought lots of electronic equipment.
- You moved to your first or a new home and furnished it.
- You bought expensive jewelry, such as an engagement ring.
- You paid for the wedding that followed that ring purchase.
“You’re more likely to have kept receipts for these items for insurance purposes or because they were mind-boggling,” says Scharin. “Basically, you’re looking for spending that’s disproportionate to your income. The tables are only looking at your income and the average amount spent by people making that much.”
Finally, there’s the issue of just what constitutes a state sales tax. Your monthly cell phone bill includes numerous service charges; do at least a portion of these added phone fees count as deductible sales taxes? Unfortunately no, says Bankrate.com’s tax adviser George Saenz. The Miami-based CPA notes that while many states impose a sales tax (often at a higher rate) on communications such as mobile phones, it’s not a general sales tax because it doesn’t apply to a broad range of products at a similar rate.
Also, says tax attorney Abrams, these bills include several layers of taxes. “The federal government governs the airways and cell phones have federal taxes, FCC charges. Federal taxes are never deductible.”
And some states apply sales taxes to utilities, such as electricity or cable services. Again, if you’re planning on deducting these costs, check with your state tax officials to make sure the amounts are the same as the state’s general sales tax rate.
Most taxpayers, however, are probably not going to worry about these extra taxes and fees and tracking down year-old receipts. They’ll likely opt instead to use the sales tax tables, especially because they provide some tax relief for relatively little effort.
“The tables are based on your income level, and built into that is your ability to spend,” says Abrams. “There’s probably not going to be that much of a difference between the tables and receipts.”