16.3 State and Local Income Taxes or General Sales Taxes

If you paid state and local income taxes during 2012, you may deduct them on Schedule A (Form 1040). It may be more advantageous for you to deduct state and local general sales taxes that you paid during the year, but whether that option will be available for 2012 depends on Congress. The law that authorized the option to deduct state and local general sales taxes in lieu of state and local income taxes expired at the end of 2012, and although an extension of the sales tax option to 2012 is expected, Congress had not yet enacted the extension legislation when this book went to press.

If the legislation is enacted, the election to deduct state and local general sales taxes for 2012 will be made by checking a box on Line 5 of Schedule A (Form 1040). Check the e-Supplement at jklasser.com for a legislation update.

State and local income taxes.

You may deduct on your 2012 return state and local income taxes withheld from your pay and estimated state and local taxes paid in 2012. Also deduct the balance of your 2011 state and local taxes you paid during 2012. If in 2013 you pay additional state income tax on your 2012 income, that payment will be deductible on your 2013 tax return.

State income taxes may be claimed only as itemized deductions, even if attributed solely to business income. That is, state income taxes may not be deducted as business expenses from gross income.

To increase your itemized deductions on your 2012 return, consider prepaying state income taxes before the end of 2012. The prepayment is deductible provided the state tax authority accepts prepayments and state law recognizes them as tax payments. The IRS has ruled, however, that prepayments are not deductible if you do not reasonably believe that you owe additional state tax. Do not make prepayments if you expect to be subject to alternative minimum tax, since state and local taxes are not deductible for AMT purposes (23.2).

If you report on the accrual basis and you contest a tax liability, claim the deduction in the year of payment.

Filing Tip

Refund Credited to State Estimated Tax

If you were entitled to a refund on your 2011 state tax return and you credited the overpayment towards your 2012 estimated state tax, do not forget to include the credited amount with other 2012 payments of state and local income tax on your 2012 Schedule A.

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You may deduct on your federal return state and local income taxes allocable to interest income that is exempt from federal tax but not state and local income tax. However, state and local taxes that are allocated to other federal exempt income are not deductible. For example, state income tax allocated to a cost-of-living allowance exempt from federal income tax is not deductible as a state tax.

The IRS has held that mandatory employee contributions to state disability or worker’s compensation funds in California, New Jersey, New York, Rhode Island and Washington, and mandatory contributions to the Alaska, California, New Jersey, and Pennsylvania state unemployment funds, are deductible as state income taxes. In addition, mandatory contributions to state family leave programs, such as in New Jersey and California, are deductible as state income taxes.

However, employee contributions to a private or voluntary disability plan in California, New Jersey, or New York have been held by the IRS to be nondeductible.

Note: If you get a refund of state income taxes that you claimed as an itemized deduction, you may may have to report it as income (11.5).

State and local general sales taxes option-assuming Congress allows it.

If Congress passes legislation to allow state and local generals sales taxes for 2012 in lieu of claiming state and local income taxes, you will generally have two ways to figure the deduction. You can figure deductible state and local general sales taxes using your credit card receipts and other records of non-business purchases during 2012. Alternatively, you can use the IRS’s optional tables and worksheet in the Schedule A instructions or the Sales Tax Deduction Calculator at IRS.gov.

Generally, you can only deduct sales taxes to the extent that the rate is the same as the general sales tax rate. However, sales taxes on food, clothing, medical supplies, and motor vehicles are deductible as general sales taxes even if the rate paid is less than the general sales tax rate.

If you paid sales taxes on the purchase or lease of a motor vehicle used for personal purposes (car, motorcycle, SUV, truck, van, or off-road vehicle) at a rate that is higher than the general sales tax rate, you may only include up to the general sales tax rate.

You may also include sales taxes paid at the general sales tax rate on the purchase of (1) a home, including a mobile or prefabricated home, or on a substantial addition to a home or a major home renovation, (2) a boat, or (3) an aircraft. See the Schedule A instructions for restrictions on taxes paid on the purchase of a home or major home renovation.