Deducting State and Local Taxes for 2021 and 2022by
With Tax Season 2022 about to kick into full swing, we look to tax expert Mike Pusey, CPA for some need-to-know facts and rules associated with deducting state and local taxes.
For this tax filing season, the limitations on deducting state and local taxes result in many more taxpayers using the standard deduction.
The standard deduction is as follows in 2021 and 2022:
|Filing Status||Standard Deduction 2021||Standard Deduction 2022|
|Single; Married Filed Seperately||$12,550||$12,950|
|Married Filing Jointly & Surviving Spouses||$25,100||$25,900|
|Head of Household||$18,800||$19,400|
For 2018-2025, the general rule says the sum of the following are deductible as itemized deductions but limited to $10,000 ($5,000 if married filing separately):
- state and local income taxes (or state sales tax)
- state and local real estate taxes (but not foreign real property taxes)
- state and local personal property taxes (but not foreign personal property tax) (See Sec. 164(b)(6))
The above are summed on the “Taxes You Paid” portion of Form 1040’s Schedule A, line 5. The emphasis is on amounts paid. The state income tax would be as reduced by state credits.
For example, the taxes paid in the state of residency may be reduced for taxes paid in a work situs state. It is permissible to deduct taxes paid multiple states.
Computing Taxes Paid Isn’t Always Simple
The amounts on Schedule A, line 5 can be affected by such complexities as the taxpayer making a charitable contribution in exchange for a state and local tax credit with the deduction being reduced due to such credit (See the Schedule A instructions for details).
See generally the instructions to Schedule A for potential adjustments in particular jurisdictions for taxes described as disability benefit funds, payments to supplemental workmen’s compensation fund, certain state unemployment funds and mandatory contributions to state leave programs. The state and local real estate tax deduction may need adjusting for specific services, such as a trash collection fee.
Tax deductions are reduced for payments that yield specific improvements that would normally be added to basis, such as sidewalks. Following is another item that may be considered an asset under the tax rules despite coming via a tax bill:
“There are popular loan programs that finance energy saving improvements through government-approved programs. You sign up for 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 special tax on your real estate property tax bill over the period of the loan. The payments on these loans may appear to be deductible real estate taxes; however, they're not deductible real estate taxes. Assessments or taxes associated with a specific improvement benefitting one home aren't deductible. However, the interest portion of your payment may be deductible as home mortgage interest.” (See “Topic 503 Deductible Taxes,” IRS.gov).
The state and local personal property tax may need adjusting when a car’s fee 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 in lieu of state and local income taxes. The itemizing taxpayer can assert state sales tax measured by actual expenditures or sales tax table amounts found in the instructions to Schedule A.
The sales tax tables focus on adjusted gross income but with certain adjustments, such as an add-back for the nontaxable portion of social security benefits and tax-exempt interest. The math can be complicated by such circumstances as living in different states during the year.
State sales tax paid on autos may need adjusting in some circumstances if the rate is higher than the normal sales tax.
Refunds of state sales tax (a) can affect the measure of expense in the year of the refund, (b) may be ignored if refunds of a prior year purchase when such sales tax was not deducted, or (c) may require income inclusion if previously yielding a deduction.
Foreign Income Tax - Even Generation-Skipping Can Be Factors
Schedule A, line 6 “other taxes” can include a generation-skipping tax imposed on an income distribution, as well as foreign income taxes. This is more commonly the place for deducting foreign income taxes. Consider claiming the foreign income tax credit rather than deducting such taxes.
Nondeductibles, or Other Deductibles that Aren’t Itemized
The 2020 Instructions to Schedule A have a “don’t deduct” narrative as follows:
- Federal income and most excise taxes
- Social security, Medicare, federal unemployment (FUTA), and railroad retirement (RRTA) taxes
- Customs duties
- Federal estate and gift taxes. However, see Line 16, later, if you had income in respect of a decedent
- Certain state and local taxes, including tax on gasoline, car inspection fees, assessments for sidewalks or other improvements to your property, tax you paid for someone else, and license fees (for example, marriage, driver's, and pet)
- Foreign personal or real property taxes
The reference to income in respect of a decedent is to additional estate tax incurred when income in respect of a decedent is valued and included in the estate tax return. The references to such topics as gasoline tax or car inspection fees aren’t to preclude deductions for ordinary and necessary business expenses.
The limitations on this particular itemized deduction would not generally affect deductions arising under section 162 for ordinary and necessary business expenses; e.g., taxes on the business headquarters or warehouse. It would also appear that the limitations would not apply, for example, to taxes on land held for investment (Sections 164(a) and (b)(6) provide exceptions to its limitations for investment activities under section 212).
The biggest 2021 discussion items with respect to our topic include the following, which is of particular importance to taxpayers in high-tax states like California: Will the $10,000 limit be increased to $80,000 or some other figure?
The 2021 House version of 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 topic without specific provision should such relief eventually be included in any final bill.
Political discussions at the current juncture include some prospect that such a relief provision might eventually be included in any eventual bill (including any new bill), but the eventuality and degree of any relief are uncertain.
Some entity level workaround to achieve relief for state and local tax has been achieved. The relief approach is state income tax benefit achieved via the flow-through entity, whether a partnership or S corporation (See the legislative history of the limitation at H.R. Rep. No. 115-466 (2017), and Notice 2020-75).
“Notice 2020-75 clarified the IRS's position by announcing that forthcoming proposed Treasury regulations would provide that (1) amounts paid by a Pass-Through Entity to satisfy its direct liability for state and local income taxes would be deductible by the Pass-Through Entity, (2) such amounts would be reflected in an individual owner's distributive or pro-rata share of the Pass-Through Entity's non-separately stated income or loss and (3) state and local income taxes imposed on, and paid by, a Pass-Through Entity would not be subject to the SALT limitation at the level of the individual owner of the Pass-Through Entity.” (“United States: SALT Deduction Workarounds Create M&A Structuring Opportunities,” Bray, Crouch, Kershaw, Lowther, Shulman and Pashin, Shearman & Sterling, 9/13/21).
Yet there can be elections and state-by-state complexities within this topic of achieving relief via deduction or credit in a particular state.
There Are Also Important Planning Issues
If an entity-level tax may get federal relief for state taxes, this can affect the math in planning to sell assets at the flow-through entity level vs. ownership interests in the partnership or S corporation (Ibid. See also AICPA Comment Letter “Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” American Institute of Certified Public Accountants, 10/27/21).
The deductibility of entity level taxes may also affect planning ownership via a partnership versus a co-ownership arrangement, which is permissible in some realty rental situations (See Regs. 1.761-2).
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...