Make a Choice on State Tax Deductions

Thanks to the tax law signed at the beginning of 2013—officially called the American Taxpayer Relief Act of 2012 (ATRA)—taxpayers are able to deduct the state sales tax they paid last year on their 2013 tax returns. But there’s a catch: If you deduct the sales tax, you are not permitted to claim any deduction for state and local income taxes. In other words, you cannot have it both ways: It is one or the other.

For many taxpayers, particularly those residing in states where income taxes are relatively high, state and local income taxes will produce a bigger deduction. However, for other taxpayers, the sales tax deduction may be preferable, especially if you purchased certain “big-ticket items” last year.

Background: ATRA reinstated for two years the rule allowing taxpayers to deduct state sales tax in lieu of claiming a deduction for state and local income taxes. Technically, the option had expired at the end of 2011, but the ATRA reinstatement was retroactive to the 2012 tax year.

Both state and local income taxes and sales taxes are claimed as itemized deductions. Such deductions are subject to a reduction on 2013 returns under the “Pease rule,” also revived by ATRA.

If you elect to deduct sales tax on your return, you can actually choose between one of two methods. With the first method, you deduct the actual amount of sales tax you paid in 2013, based on the receipts you have kept. Although this method will often provide a bigger overall deduction than the second method, it requires diligent recordkeeping.

With the second method, which is simplified and less time-consuming, you are entitled to deduct an amount based on a special table prepared by the IRS. The table provides a specific amount for each state based on the size of your family.

Icing on the cake: In addition to the specific amount listed for your state in the IRS table, you can increase your sales tax deduction by the amount of sales tax paid on—

*the purchase or lease of a vehicle;

*the purchase of a boat or aircraft; and

*the purchase, or substantial addition or renovation of a home.

Thus, even if you are using the simplified method for a sales tax deduction, it is beneficial to keep records for these big-ticket items.

Note that you may have to report a state income tax refund you received from a 2012 return as income on your 2013 return. However, the income tax refund does not have to be reported if you choose to deduct sales tax on your 2012 return rather than state and local income taxes.

Finally, other special rules may come into play if you are filing separately as a married person. If both spouses itemize deductions, both must claim either the state and local income tax deduction or the sales tax deduction on their 2013 returns.

This decision may require an in-depth analysis. Do not assume that you are always better off with one option. Have the numbers crunched to determine the optimal choice for your situation.