Deductibility of Taxes: State, Local, and Foreign Income Taxes, General Sales Taxes, and Real Estate Taxes
Many taxes can be deducted from federal income tax. Businesses can deduct taxes directly from their income by claiming them on Schedule C. Sales taxes on items that businesses buy are deductible only as an adjustment to the basis of the property. So if a business pays $5 for paperclips, and pays $.30 for sales tax, then it can deduct $5.30 for the cost of the paperclips.
Individual taxpayers can also reduce their income tax liability by claiming itemized deductions for property taxes, and either state, local, and foreign income taxes, or sales taxes. State, local, and foreign real property taxes are also deductible. However, most taxpayers will save more money on foreign income taxes by claiming the foreign tax credit, which is claimed on Form 1116, Foreign Tax Credit.
Transfer or excise taxes imposed on the sale of property are deductible by increasing the adjusted basis of the property for the buyer and as a sales expense for the seller.
Note, however, that state and local taxes cannot be deducted under the alternative minimum tax. Additionally, as itemized deductions, which are claimed on Schedule A of Form 1040, the deduction of taxes is subject to the same adjusted gross income (AGI) reduction rules that apply to itemized deductions in general, where up to 80% of the itemized deductions may be nondeductible. This deduction is only reduced, not completely phased out, so even the richest taxpayers will be able to deduct at least 20% of their itemized deductions.
Either State and Local Income Taxes or General Sales Taxes Are Deductible
Starting for the tax year 2018, the Tax Cuts and Jobs Act, passed by the Republicans at the end of 2017, the deductibility of income or sales taxes and property taxes is capped at $10,000 per return, and this is not indexed for inflation. As planned, this provision will hurt the taxpayers living in California or New York or other predominantly Democratic states, which generally have higher income or sales taxes, and higher property taxes.
The taxpayer can choose to deduct either state and local income taxes or general sales taxes. This was a time-limited option for a few years, that had to be periodically renewed by Congress. However, Congress made this choice permanent in 2016. This choice is offered because some states do not impose an income tax and some do not impose a general sales tax, but every state imposes one or the other. However, the taxpayer can choose to deduct only one or the other — not both.
If the taxpayer elects to deduct income taxes, then any tax paid during the tax year for state and local income taxes are deductible, including:
- overpayments from the previous year that are applied to the current year
- estimated tax payments for the next tax year, but only those paid during the tax year, which does not include the January payment paid in the following year
- back taxes paid for previous tax years
However, if the taxpayer receives any refund of taxes that were previously claimed as a deduction, then the income that created the tax benefit received by claiming the deduction must be added back to the taxpayer's income. The reason why a refund may have to be added back to income is because by claiming a larger deduction than what the taxpayer was entitled to, he paid less federal tax than what would otherwise be the case if the state tax was not deducted. However, only the amount that was subject to additional taxes needs to be included as income. This amount is found by calculating what the taxable income would have been without the tax deduction.
Example: State Refunds are Includible in Income to the Extent of their Tax Benefit in the Previous Tax Year
Suppose that, in the previous tax year, you had the choice of claiming either a deduction of $1200 of state income tax or $1000 for the state sales tax. Obviously, you would have chosen the larger of the deductions, which, in this case, would have been the $1200 of state income tax. Suppose, however, that there was a mistake in calculating your $1200 of state income tax and the actual tax owed turned out to be $900, so the state refunded $300 to you. Therefore, since you did have the choice of claiming $1000 for the state sales tax, the part of the refund that you would have to add in calculating your federal taxable income is $100 (= $1000 – $900).
Consider another scenario: with your deduction of $1200 of state income tax, your total itemized deductions was only $50 more than your standard deduction. Therefore, only $50 of the state refund would be includible as income, since you could have claimed the standard deduction instead of your itemized deductions.
Unlike individuals, businesses cannot deduct any state or local income tax from their income.
State and Local General Sales Taxes
There are 2 methods of determining the total amount of sales tax paid. The taxpayer can keep records of all personal purchases and apply the general sales tax rate to that amount to calculate the total sales tax paid. If the sales tax rate on food, clothing, medical supplies, and motor vehicles is lower than the general sales tax rate, they can still be added to the total to calculate the total deduction. However, if the sales tax rate on motor vehicles is higher, then only the general sales tax rate can be used in calculating the deductible tax.
Instead of keeping records, the taxpayer may also use optional tables and worksheets provided in Schedule A instructions or use the IRS's Sales Tax Deduction Calculator. Even if IRS tables are used, the actual sales tax paid on major purchases, such as motor vehicles, boats, airplanes, homes, including mobile and prefabricated homes, or even home additions or renovations, can be added.
Another way to save on sales taxes is to take advantage of sales tax holidays that many states offer for specific items, usually clothes and school supplies, but also for guns, rifles, ammunition, and energy-saving products. A list, updated periodically, of all states that offer tax holidays can be found at Sales Tax Holidays.
Regardless of the election to deduct either income taxes or general sales taxes, property taxes are always deductible. Deductible property taxes include not only real estate, but also property taxes on personal property, such as motor vehicles, boats, and airplanes.
Real Estate Taxes
State, local, and foreign real estate taxes on nonbusiness property are deductible if the taxes are ad valorem taxes — based on the assessed value of the property at a uniform rate. If taxes are paid by the bank from the mortgage payments paid by the borrower or from an escrow account, then the borrower can only deduct that amount that was paid by yearend. The bank will issue a Form 1098, Mortgage Interest Statement that will specify the amount that was paid.
Generally, only the taxpayer legally obligated to pay the tax can deduct the paid amount. An owner of a condominium or a cooperative apartment can deduct their share of taxes assessed on any common areas and the taxes that they pay for their individual unit. However, if a cooperative corporation does not own the realty but pays taxes through a lease arrangement, then the taxes are not deductible. Taxes paid on the property owned under a joint tenancy are pro rata deductible to the joint tenants. Spouses who file jointly may deduct the real estate taxes regardless of which spouse owns the property or if the property is owned as a tenancy by the entirety.
Taxes or assessments for local benefits that improve the neighborhood are deductible as an adjustment to the value of the property; the deduction will be recognized when the property is sold. However, assessments charged for the maintenance or repair of the neighborhood, such as for streets and sidewalks, or for water and sewage systems are deductible in the year of the assessment.
Many taxes are deductible under the federal income tax; however, fees are not generally deductible unless they are incurred for a business or income-producing purpose. The IRS defines tax as an enforced contribution that originates from legislative authority in the exercise of its taxing power, which is collected for the purpose of raising revenue for the government. It is not payment for a specific service. Fees, on the other hand, are for specific services, such as registration fees for real estate or automobiles, hunting and fishing licenses, bridge and highway tolls, parking meter charges, and the fees charged for drivers' licenses. Often, fees are higher than what is required to pay for the services, so they are a form of stealth tax, but are nondeductible nonetheless. Other fees that are sometimes charged in relation to home ownership, such as community development district (CDD) fees and homeowners association (HOA) fees, are not deductible.
When real property is sold, there are rules that apportion the real estate taxes between the seller and buyer. The apportionment depends on the date in relation to what is called the real property tax year, which may be different than the calendar year and may differ according to the county. For instance, if the real property tax year is from April 1 to March 31 in a given county, then on the date that the real estate is sold, which is the first day that the buyer assumes ownership of the property according to tax law, then the tax assessed on the seller is the number of days that the seller owned the property during the real property tax year divided by the number of days in the year (366 for leap years, 365 for other years) and the buyer owes the remaining amount of the assessment for that year. If the seller has already deducted the real estate tax for the entire tax year on the sale date, then the seller must include the portion of the deduction allocated to the buyer as income.
|Start of Real Estate Tax Year||4/1/2017|
|End of Real Estate Tax Year||3/31/2018|
|Date of Sale||8/28/2017|
|Number of Days from Start of Tax Year to 1 Day Before Sale||150||Buyer assumes ownership on day of sale.|
|Number of Days in Tax Year||366|
|Annual Real Estate Taxes Assessed on Property||$4,000|
|Seller's Portion of Tax||$1,639.34||= Annual Real Estate Tax × Number of Days Since Start of Tax Year to 1 Day Before Sale / Number of Days in Tax Year = $4,000 × 150 / 366|
|Buyer's Portion of Tax||$2,360.66||= Annual Real Estate Tax – Seller's Portion = $4,000 – $1,639.34|
If the real estate agreement specifies a different proration of the real estate taxes, then the adjustment will affect the amount of money realized by the seller and the basis of the property for the buyer will be adjusted accordingly. For instance, if the buyer agrees to assume the entire real estate tax for the year, then the seller's reportable gain on the property must be increased by the amount of tax that the buyer is paying on his behalf, and the buyer's tax basis in the property is increased by the same amount. So for instance, if you sell a property for $100,000 and the total real estate tax is $4000 for the real estate tax year, and your liability for the tax is $3000, but the buyer assumes the liability for the tax, then you must report the sale of the property as $103,000, which is also the basis of the property for the buyer. Note that since the buyer's basis is increased by the $3,000 of paid real estate taxes, those taxes cannot be deducted until the property is sold. Likewise, if you prepay the entire $4000 of real estate taxes on the property instead of it being assumed by the buyer, then the amount realized by you is $97,000, which is also the basis for the buyer.