Winner of the Well Workplace Small Business Award

 

February 2, 2005 - Sales Tax Deduction

I’ve heard that either sales or income tax can be deducted on 2004 tax returns. What do I need to consider when choosing between these two options?

The American Jobs Creation Act of 2004 (Jobs Act) allows individuals who itemize deductions to elect to deduct state and local sales taxes instead of state and local income taxes for 2004 (and 2005).

Taxpayers in states without income taxes. For taxpayers who live in states without income taxes ( Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming), it's a no-brainer. If they itemize, they will deduct sales taxes. Many more individuals will be able to itemize because of the new choice.

Taxpayers in states with both income and sales taxes. Most taxpayers who live in states like Colorado that have both income and sales taxes will deduct income taxes. But that is not always the case. The new choice may actually provide a deduction for some taxpayers who previously wouldn't have been able to deduct any state taxes. For example, in Colorado a retiree who pays little or no Colorado state income tax as a result of Colorado’s exclusion for pension income should benefit from the new deduction.

Other factors affecting the deduction. The choice of which way to go also may be affected by some special considerations, some of which can be “tricky." Taxpayers everywhere also have to consider whether to use IRS's optional sales tax tables and how to take maximum advantage of them or to keep records of all sales taxes paid throughout the tax year.

  • Actual deduction. Most taxpayers will not have saved all of their receipts for 2004 because the deduction didn't come into existence until October 22, 2004, when the Jobs Act was signed into law. Thus, most taxpayers will have to use the tables because they won't have the records needed to compute an actual deduction. However, in some cases, an actual deduction could be higher where the taxpayer has not saved all receipts but has saved receipts for expensive items. For example, a taxpayer who in 2004 purchased all new furniture and appliances for his home or expensive electronic equipment like an HD plasma TV probably saved receipts and might get a higher actual deduction than that provided under the table.
  • Optional tables. The tables give taxpayers a sales tax deduction amount as an alternative to saving their receipts throughout the year and tabulating the amount actually paid. Taxpayers use their level of total available income (which includes nontaxable items, such as tax-exempt interest, workers' compensation, and the nontaxable portion of Social Security benefits) and number of exemptions to find the sales tax amount for their state. The table instructions explain how to add an amount for local sales taxes where applicable.

Taxpayers also may add to the table amount any sales taxes paid on:

  • A purchased or leased motor vehicle (the term includes cars, motorcycles, motor homes, recreational vehicles, SUVs, trucks, vans, and off-road vehicles) but only up to the amount of tax paid at the general sales tax rate; and
  • An aircraft, boat, home (including mobile or prefabricated), or home building materials, if the tax rate is the same as the general sales tax rate.

State tax treatment may affect the choice. In choosing to claim income taxes or sales taxes on the federal return, taxpayers should consider the impact of the state tax treatment of these items. Some states, including Colorado, Kansas, Maryland, Missouri, Nebraska, New York, and Utah disallow deductions for state income taxes but at least for the 2004 tax year, will allow deductions for state sales taxes. Therefore, a higher federal deduction for state income taxes won't necessarily mean higher combined federal and state tax savings. Taxpayers should determine whether the added tax savings from a potentially larger federal deduction for state income taxes would be outweighed by an allowable state deduction for state sales taxes. If so, the taxpayer should deduct sales taxes on the federal return to achieve higher combined federal and state tax savings from the deduction.

Return to Tax Talk.