Thursday, December 21, 2006


George W signed the TAX RELIEF AND HEALTH CARE ACT OF 2006 into law yesterday, making the extension of expired tax breaks official.

I have posted an analysis of the Act on the FEDERAL TAX UPDATE Page of my website.

Now, back to my discussion of the top three extended tax breaks -


Taxpayers who itemize on Schedule A can elect to deduct state and local sales tax paid instead of deducting state and local income tax paid. If you deduct state and local income tax on your Schedule A you cannot also deduct state and local sales tax, and vice versa. For this purpose state and local income tax includes the deductible unemployment (SUI) and/or disability (SDI) tax withheld in certain states.

You have two options for claiming a sales tax deduction – the actual amount paid for the year, per accumulated receipts, or the amount taken from the IRS-generated Optional State Sales Tax Tables, with an additional amount allowed if you also pay local sales tax, plus the actual tax paid on the purchase of “big-ticket” items such as a car, motorcycle, truck, van, recreational vehicle, sport utility vehicle, off-road vehicle, boat, airplane, motor home, home, and home building materials, and any sales tax paid on the lease of a motor vehicle.

The amount you can deduct if you use the IRS tables is based on your “total available income”, your state of residence, and the number of exemptions you claim. Your “total available income” includes your Adjusted Gross Income plus any nontaxable receipts, such as –

· tax-exempt interest,
· Veteran’s benefits,
· Nontaxable combat pay,
· Workers’ Compensation benefits,
· the non-taxable portion of Social Security and Railroad benefits
· IRA, pension or annuity distributions (does not include any amounts that are “rolled-over”), and
· public assistance payments.

If you also pay local sales tax you determine the additional amount you can deduct by (1) dividing the local sales tax rate by the state sales tax rate and (2) multiplying the result times the amount from the tables for your state. Let’s say your state imposes a 5% sales tax and your city imposes a 1% local sales tax. 1% divided by 5% = .2, or 20%. The deduction you are allowed from the Optional State Sales Tax Table is $500.00. $500.00 multiplied by 20% = $100.00. Your total deduction is $600.00 - $500.00 for state sales tax and $100.00 for local sales tax.

Taxpayers who lived in more than one state during the year must pro-rate the amount from the tables for each state by the number of days in the year lived in each state.

If you are filing separately and your spouse elects to deduct state and local sales tax you are required to also deduct state and local sales tax on your separate Schedule A.

If you live in a state that does not have a state income tax, the sales tax deduction is indeed a welcome break. However, under the right circumstances, even taxpayers in such high income tax states as New York, New Jersey and California can realize a greater tax savings by electing to deduct sales tax.

When deciding whether to deduct sales tax or income tax you must keep in mind the fact that if you deduct the state income tax paid on your 2006 Schedule A you must report as taxable income in 2007 any state income tax refund you receive in 2007 (to the extent that you received a “tax benefit” from the state income tax deduction). If you deduct state and local sales tax you do not have to claim your state income tax refund on your 2007 Form 1040. So when calculating the allowable state and local income tax paid to compare to sales tax paid, do not include the total amount of state withholding and estimated tax payments for the year, but instead use the actual state tax liability for 2006 from a finished, or draft, 2006 state tax return.

The sales tax deduction may be especially beneficial to retired taxpayers who itemize. Many states have a “retirement income exclusion”, as does New Jersey, and seniors often pay minimal, if any, state of local income tax.

While it is too late for 2006, here is something you might want to do for 2007. It is “déjà vu all over again”, as this advice is taken from a tax planning booklet I wrote in 1983, when both sales tax and state income tax were deductible:

“Keep a manilla envelope or shoe box in your kitchen, bedroom or study and save every supermarket, department store, credit card or other receipt that lists the amount of sales tax paid on your purchases. If you are dining out and pay cash, make a note of the date, name of restaurant, cost of meal, and amount of sales tax and put it with your receipts. If you use your credit card when dining out, make sure the sales tax is itemized on the receipt.

At the end of the year, add up the sales tax from these records, exclusive of any applicable to a car, boat, etc, and compare your total to the amount allowed in the Optional Sales Tax Table. You may find that you are allowed a larger deduction by using the tables, but you will never know unless you save your receipts and compare.”

The 2006 Schedule A does not include a box to check if you are claiming sales tax or income tax, and the 2006 instruction booklet will not include the Optional State Sales Tax Tables. Although I have not verified this via an actual IRS notice or publication, it seems that, according to the Update section of the Quickfinder Handbooks website (the 1040 Handbook is an excellent resource which I have been using for at least the past 16 years), if you elect to deduct state and local sales tax you should write “ST” on Line 5 of the 2006 Schedule A. The IRS will apparently be issuing a 2006 Publication 600 with the Optional State and Local Sale Tax Tables, worksheets and instructions, similar to what it did for 2004.

The Quickfinder Handbook update also indicates that the deduction for Educator Expenses should be entered on Line 23 in the “Adjusted Gross Income” section of Page 1 of the 2006 Form 1040. This is the line for deducting contributions to an Archer Medical Savings Account (MSA). You should write “E” on Line 23 if you are claiming this deduction and “B” if you are claiming a deduction for both Educator Expenses and contributions to an MSA. If you write “B” you must attach a statement to the 1040 identifying the amount for each deduction.

Similarly, the deduction for Tuition and Fees is reported on Line 35 of the same section, which is the line for claiming a deduction for the Domestic Production Activities Deduction. Write “T” on this line if you are deducting Tuition and Fees and write “B”, and attach a breakdown, if claiming a deduction for both items.

Any questions?


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