- Bargaineering - http://www.bargaineering.com/articles -

Tax Relief 101 – Deducting State Sales Tax (vs. State Income Tax)

This article has been made somewhat obsolete for 2006 (2005 tax year). The rules are the same but the documents you reference have changed. See the note at the end of the article.

Welcome to the second article in a series I call Tax Relief 101 designed to help you save some cash from the tax man. You can see the whole collection under the category of Tax Relief 101 [3].

When you are doing your federal taxes, you typically will deduct what you pay to the state in taxes from your income. That prevents double taxation because otherwise you would be taxed on money you paid to your state government. Well, the American Jobs Creation Bill of 2004 has a provision that now allows you to deduct what you’ve paid in state sales tax instead. It’s an ‘either or’ situation, you can deduct one or the other and you must pick. This is an option you can use on your 2004 and 2005 taxes.

First things first, this is for people who itemize deductions on a Schedule A. So if you claim the standard deduction, this option isn’t going to be possible for you. What this does mean is that if you always just claimed standard, perhaps a little investigation would reveal itemizing with state sales tax would produce a greater refund (lower tax liability).

Nine No-Brainer States:
Nine states don’t collect state income tax but to have some sort of state sales tax and so in those states it’s a no-brainer. If you’re a resident of Florida, Nevada, South Dakota, Tennessee, Texas, Washington or Wyoming and you itemize, deducting sales tax is the way to go. Alaska doesn’t have income taxes but some areas do charge sales tax and New Hampshire is the same situation except they only charge taxes on touristy-type activities like meals, hotel rooms, and vehicle rentals. Live elsewhere? Then you need to do the math and decide for yourself.

Calculating the Break:
You have two options: save your receipts or use IRS tables [4].
1. Save Your Receipts – Stick your receipts in a box, keep a running total, claim the deduction and when the IRS asks (which it probably won’t) then just show them the box.
2. Use IRS Tables – The tables are available here. The IRS document does a good job with its worksheets to help you find out how much you can deduct based on your adjusted gross income. [Pub 600 has been rolled into the Instructions for Schedule A & B [5]]

Alternative: If you made a large purchase such as a car or boat, you can claim the average sales tax deduction from the tables using Method 2 and then add the tax on your large purchase. They might also add other large items like appliances or something similar.

WARNING: Check if you’ve been pushed into the Alternative Minimum Tax, because this might hurt you also. Remember to consider this as an input in your calculations.

I hope this has helped clear up any confusion you may have had regarding the whole “deduct sales tax” thing you might have heard around the water cooler.

2006 UPDATE: The sales tax rules for 2006 (applicable to 2005 tax returns) are roughly the same but Publication 600 no longer exists, it’s been rolled into the instructions of the Schedule A. I’ve written an update to these rules [6].