This tax filing season, state and local tax deduction limits mean many more taxpayers are using the standard deduction.
The standard deduction is as follows in 2021 and 2022:
|Filing status||Flat rate deduction 2021||Flat rate deduction 2022|
|Only; Married filed separately||$12,550||$12,950|
|Joint Declaration of Married Spouses and Surviving Spouses||$25,100||$25,900|
|head of household||$18,800||$19,400|
For 2018-2025, the general rule states that the sum of the following items is deductible as itemized deductions, but limited to $10,000 ($5,000 if you are married and filing separately):
- State and local income taxes (or state sales tax)
- national and local property taxes (but not foreign property taxes)
- state and local property taxes (but not foreign property taxes) (See Sec. 164(b)(6))
The above items are added together in the “Taxes you paid” portion of Schedule A of Form 1040, line 5. The focus is on the amounts paid. State income tax would be reduced by state credits.
For example, taxes paid in the state of residence may be reduced for taxes paid in a state of work status. Taxes paid in multiple states are allowed to be deducted.
Calculating taxes paid is not always easy
The amounts in Schedule A, Line 5 may be affected by complexities such as the taxpayer making a charitable contribution in exchange for a state and local tax credit, the deduction being reduced due to this credit (see instructions of Appendix A for more details).
See Appendix A instructions generally for potential adjustments in particular jurisdictions for taxes described as disability benefit funds, payments to supplementary workers’ compensation funds, certain unemployment funds State and mandatory contributions to state leave programs. The state and local property tax deduction may need to be adjusted for specific services, such as garbage collection fees.
Tax deductions are reduced for payments that earn specific improvements that would normally be added to the base, such as sidewalks. Here is another item that can be considered an asset under tax rules, even if it comes from a tax invoice:
“There are popular loan programs that fund energy efficiency upgrades through government-approved programs. You take out a home energy system loan and use the proceeds to make energy improvements to your home. In some programs, the loan is secured by a lien on your home and appears as a special assessment or levy on your property tax bill over the term of the loan. Payments on these loans may appear to be deductible property taxes; however, these are not deductible property taxes. Appraisals or taxes associated with a specific improvement benefiting a home are not deductible. However, the interest portion of your payment may be deductible as mortgage interest. (See “Topic 503 Deductible Taxes”, IRS.gov).
State and local property tax may need to be adjusted when the cost of a car is measured by weight, not just value.
Sales tax in lieu of state and local income taxes
There is an exception that allows the individual to deduct state sales tax as an itemized deduction instead of state and local income taxes. The itemizing taxpayer may claim state sales tax measured by actual expenses or the sales tax table amounts listed in the instructions on Schedule A.
The sales tax tables focus on adjusted gross income, but with certain adjustments, such as a write-back for the non-taxable portion of Social Security benefits and tax-exempt interest. Calculations can be complicated by circumstances such as living in different states during the year.
State sales tax paid on automobiles may need to be adjusted in certain circumstances if the rate is higher than normal sales tax.
Refunds of state sales tax (a) may affect the measurement of expenses in the year of the refund, (b) may be ignored if refunds of a purchase from the prior year when that sales tax n has not been deducted, or (c) may require the inclusion of income if it has already given rise to a deduction.
Foreign Income Tax – Even Generation Skipping Can Be a Factor
Schedule A, line 6 “other taxes” may include a generation skip tax imposed on an income distribution, as well as foreign income taxes. This is most often the place where foreign income taxes are deducted. Consider claiming the foreign income tax credit instead of deducting these taxes.
Non-deductible deductibles or other non-detailed deductibles
The 2020 instructions to Schedule A contain “do not deduct” text as follows:
- Federal income and most excise taxes
- Social Security, Medicare, Federal Unemployment (FUTA), and Railroad Retirement (RRTA) taxes
- Federal estate and gift taxes. However, read line 16, below, if you had income in respect of a deceased person
- Certain state and local taxes, including gas tax, car inspection fees, sidewalk assessments or other improvements to your property, taxes you paid for someone else, and license fees (e.g. wedding, driver and pet)
- Personal or real estate foreign taxes
The reference to income in respect of a deceased is to the additional estate tax incurred when income in respect of a deceased is assessed and included in the estate tax return. References to matters such as gasoline tax or vehicle inspection fees shall not preclude deductions for ordinary and necessary business expenses.
The limitations on this particular itemized deduction would generally not affect deductions arising under section 162 for ordinary and necessary business expenses; for example, head office or warehouse taxes. It would also appear that the limitations would not apply, for example, to taxes on land held for investment purposes (Sections 164(a) and (b)(6) provide exceptions to its limitations for activities investment under section 212).
The main topics of discussion for 2021 regarding our subject are the following, which are particularly important for taxpayers in high-tax states such as California: will the $10,000 limit be increased to $80,000 or another figure ?
The 2021 House version of the Build Back Better Act would have increased the deduction to $80,000 for tax years beginning after 2020. The Senate version has a “placeholder” on the subject with no specific provision if such relief were to eventually be included in a final bill.
Political discussions at this time anticipate that such a relief provision could eventually be included in any eventual draft legislation (including any new legislation), but the eventuality and degree of any relief is uncertain.
An entity-level workaround to obtain state and local tax relief has been completed. The relieving approach is the state tax benefit obtained through the flow-through entity, whether it is a partnership or an S corporation (see the legislative history of the limitation in HR Rep. No. 115-466 (2017) and Opinion 2020-75).
“Notice 2020-75 clarified the position of the IRS by announcing that future regulations proposed by the Treasury would provide that (1) amounts paid by a transit entity to satisfy its direct liability for income taxes state and local income would be deductible by the transit entity, (2) such amounts would be reflected in an individual owner’s distributive or prorated share of the transit entity’s not separately reported income or loss, and ( 3) state and local income taxes imposed and paid by a pass – The transit entity would not be subject to the SALT limitation at the level of the individual owner of the transit entity.” (“United States : SALT Deduction Workarounds Create M&A Structuring Opportunities”, Bray, Crouch, Kershaw, Lowther, Shulman and Pashin, Shearman and Sterling, 9/13/21).
Still, there can be state-to-state elections and complexities in this area of obtaining deduction or credit relief in a particular state.
There are also significant planning issues
If an entity-level tax can obtain federal relief for state taxes, this may affect calculations in planning the sale of assets at the flow-through entity versus interests in the partnership. or S corporation (Ibid. See also AICPA comment letter “Notice 2020-75, Upcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State Income Taxes and premises”, American Institute of Certified Public Accountants, 10/27/21).
Entity-level tax deductibility may also affect the planning of ownership through a partnership versus a joint ownership arrangement, which is permitted in certain real estate rental situations (see Regs. 1.761-2).