The Second of the "Big Three" of Itemized Deductions – State and Local Taxes You Pay

This category primarily deals with state and local income taxes and real estate property taxes.  Most other state and local taxes, like sales and excise taxes, are not deductible.

Even if you are lucky enough to live in a state like Alaska or Nevada where there is no state income tax, the municipality in which you live and/or work may well be income taxing you under a local income tax.  Thus, very few of us are exempt from paying either state or local income tax.  A much more common situation is like mine in the state of Ohio.  Not only do I pay a federal income tax, I also pay an income tax to the state of Ohio.  Moreover, I also pay a local income tax to the city where I live and an additional local income tax in the city where I work.

For many middle-class Americans, depending on the state and municipality in which we live, this combined state and local income tax liability may be many thousands of dollars.  Indeed, probably a majority of Americans find themselves paying more in combined state and local income taxes than they pay in federal income taxes.  Lessening the blow of this triple income tax hit a bit is the fact that the state and local income taxes (but not federal income taxes) are deductible as Itemized Deductions on our federal income tax return. Therefore, we almost universally find that the state and local income tax number is a big hit and a big addition in computing our total Itemized Deductions.

But it is not just state and local income taxes that are deductible as an Itemized Deduction in this category.  Additionally, we can pad this state and local tax number with any real estate property taxes we pay.  If you are a homeowner of even a modestly priced home, you are probably paying a local county government a few thousand dollars a year in real estate property taxes (go back to page 13 and re-read my Example of the effect of home ownership on state and local tax payments).

Let's start our detailed analysis with real estate property taxes and then we will look at state and local income tax Examples.

Real Estate Property Taxes

How do you assure that you are optimizing your ability to pump up your Itemized Deductions in this category? Again, if you own the home in which you are living, you are paying a significant amount of real estate property taxes.  As I mentioned earlier, even in the case of a $100,000 valued home, the property tax liability may be $2,000 to $3,000 per year.

Most people budget their property tax liability through the Bank from which they have their mortgage.  In this case, each month when you make your mortgage payment to the Bank, you are really making three different payments:  1) a repayment of some of the principal of the loan, 2) an interest payment on the unpaid principal of the mortgage loan, and 3) a prepayment of your property tax liability.  With regard to the third type of payment (the property tax liability), the Bank will set up a property tax account for you and will pay your property tax on your behalf as it comes due.  This technique, by the way, is a very good way to budget for your property tax liability in that it is a "forced savings" arrangement that will assure that there are sufficient funds to pay your property taxes as they come due.

Example:  Mark and Debbie have a mortgage loan with their Bank.  Each month they pay the Bank a total of $1,000.  $750 of the $1,000 goes to pay the principal and interest expense on the mortgage itself.  $250 of the $1,000 is credited to their property tax account.  Every six months, Mark and Debbie's property tax bill is sent directly to the Bank and the Bank pays $1,500 twice a year to the taxing authority on their behalf.  Thus, by paying the $1,000 each month to the Bank, Mark and Debbie have attended to both their debt service on the mortgage and their property tax liability.

If you are in this situation, since the Bank is paying these property taxes on your behalf, you may claim them as real estate property taxes you paid in the computation of your Itemized Deductions.  Remember that every year the Bank sends you the Form 1098 on which is noted the interest expense paid that year on your mortgage.  The Form 1098 will also note any property taxes the Bank has paid on your behalf.

You get your property tax deduction in the year in which you (or the Bank on your behalf) actually pays the property taxes.  As I just mentioned, the advantage of having the Bank pay your property taxes for you is that you are forced to budget for and prepay this liability.  The disadvantage is that you may lose some timing flexibility and you usually will not earn any interest on that account.  If the Bank is making the payments, they will work on their timetable but not necessarily yours.  For example, the Bank may not pay your real property taxes for the second half of this year until January of next year thus deferring the deductibility of that payment until next tax year.

If you are billed directly for your property taxes and make the payments yourself, we need to talk about possibly manipulating this timing point.  Property taxes generally are billed every six months.  If you are making these payments yourself, in November or December of each year, you will receive a bill for your property taxes.  The bill will typically give you until the end of the following January to make the required semi-annual payment.  Additionally, the bill will give the property owner an optional ability to prepay a second six month's worth of property tax liability in addition to the required payment.

What should the property owner do in this situation?  He or she should at least assure that the required semi-annual payment is made by the end of December so that it can be added to the Itemized Deductions for the current year (again, as noted a moment ago, you might lose the ability to do this if the Bank is paying property taxes on your behalf).  Additionally, if the property owner has the money and could better use the deduction this year than next, pre-paying the second six-month optional payment might be a wise thing to do.

Example:  Mark and Debbie anticipate being in a 25% marginal tax bracket (see page 11 to determine your marginal tax bracket) this year due to unexpectantly high income.  In the next tax year, they anticipate being in a 15% marginal tax bracket.  Therefore, any deductions they can accelerate from next year into the current year would be better utilized against higher taxed income.  In December of the current year, Mark and Debbie received their property tax bill requiring them to pay $1,500 by next January and optionally allowing them to pre-pay a second six month's worth of property taxes of an additional $1,500.  Mark and Debbie will assure that they at least pay the required $1,500 by the end of December.  Additionally, since they have the available cash and desire to optimize the current year's Itemized Deductions, they pre-pay the second $1,500.

Focusing just on the second $1,500 of property tax liability, Mark and Debbie reduce their current year's tax liability by $375 ($1,500 times their 25% marginal tax bracket).  If they had waited until next year to pay the second $1,500 of property tax liability, they would have reduced their taxes by $225 ($1,500 times next year's 15% marginal tax bracket).  Thus, accelerating the deductibility of the second $1,500 saves them $150 of tax liability ($375 minus $225) over the two years and they get it more quickly, thus yielding a time value of money benefit.

Property Tax in the Year Your Home is Sold

NOTE that this particular analysis is applicable only if you have sold your home this tax year. When you receive your property tax bill, you will be billed six months in arrears.  That is, you will be paying a liability that has already accrued over the last six months and that you have already incurred.  So if you sell your home, one of the things that you are going to have to attend to prior to transferring title to the new owner is to pay your property taxes that have accrued through the date of sale but which you have not yet paid.

As we will discuss in the Home Ownership section of the book, a person called an escrow agent is usually used as an intermediary between the buyer and seller of a home.  One of the functions of the escrow agent will be to assure that the seller's property taxes are paid up through the date of transfer of title.  The escrow agent will retain enough of the sale proceeds from the home to pay the seller's final property tax liability.

 When the dust settles after the sale of a home, the escrow agent will give the seller a reconciliation sheet that will note a number of items including the final payment of property taxes on the sold home made by the escrow agent on behalf of the seller.  This last item can be a large number, maybe a few thousand dollars.  It is treated as property taxes paid by the seller in the year of sale of the home and can be added to the other property taxes paid by the seller that year in computing his or her Itemized Deductions.  Remember this if you are selling your home.

State and Local Income Taxes

Now let's look at optimizing the deductibility of our state and local income tax liability.  If you are an employee, you have no doubt noted that there is a great difference between your gross wages and your net take home pay.  Not only is your employer legally required to withhold your federal income tax and social security tax liability from your paycheck, your employer is also obligated to withhold your estimated state and local tax liability and pay them over to the state and municipal government where you work.  The amounts withheld from your paycheck and paid over by your employer are considered paid by you in the year in which they are withheld from your pay.  The Form W-2 that your employer gives you each January will note how much state and local income tax was withheld on your behalf and considered paid by you in the prior year.

 Additionally, you may directly make certain state and local income tax payments during the relevant tax year.  For example, many of us pay two local income taxes, one in the municipality in which we work and a second in the different municipality where we live.  As just discussed, employer withholding will attend to the local income tax liability for the municipality in which you work.  However, you will have to pay directly the local income tax liability for the municipality in which you live.  Typically, you will do this by making quarterly estimated payments.

Also, if you have not prepaid directly or through withholding enough state and local income tax, when you actually file your return you will have to pay any shortfall.  This amount that you pay to the state and/or local government when filing the return is also a payment of state and local income tax in the year in which it is paid.  Let's look at an Example of this, focusing on state income taxes, to make sure that you have a handle on it.

Example:  For the 2003 tax year, Mark and Debbie paid $6,000 of total state income tax. The couple made these payments in three different ways.  On April 15, 2003, they filed their 2002 state income tax return.  Because they did not prepay enough of their 2002 state income tax liability, they paid $500 when they filed the tax return on April 15, 2003.  Additionally, through employer withholding on each of his paychecks for the 2003 tax year, Mark's employer withheld and paid over to the state income tax department a total of $4,500 of tax on Mark's behalf.  Lastly, in order to assure that they prepaid enough state income tax for the 2003 tax year, Mark and Debbie made a direct tax payment of $1,000 on December 15, 2003.  Thus, for purposes of computing how much state income tax they paid in 2003, they are considered to have paid $6,000: the $500 paid on April 15, 2003, the $4,500 of total employer state income tax withholding for 2003, and the $1,000 they directly paid on December 15, 2003.  Mark and Debbie may add $6,000 of Itemized Deductions to their 2003 federal income tax return due to these payments.

Now that you understand how to compute what state and local income taxes you are considered to have paid in a given tax year, let's explore a tax planning angle.  As just noted, we get to add to our Itemized Deductions state and local income tax payments in the year in which they are paid by us or by our employer.  If we had the money and wanted to pump up our Itemized Deductions in a given year, let's explore the effect of overpaying (not underpaying) our state or local income taxes.  Within reason, we can intentionally overpay our state or local income tax liability to take advantage of this technique.

Let's say that you anticipate your state income tax liability to be $2,000 this tax year.  Through employer withholding and direct payments, you figure you will accommodate $1,500 of that liability.  The first thing you should do is increase your employer withholding or make direct payments to your state by the end of the year to assure that you prepay at least the remaining $500 that you anticipate owing for the year.

Now let's say that you do that but because you anticipate being in an unusually high marginal tax bracket this year, you prepay a total of not just $2,000 but $3,000.  What happens?  You will deduct the full $3,000 this tax year when the payments are made.  However, you have overpaid your state income tax by $1,000.  Next year, the state will send you a refund of $1,000 for the overpaid amount.

Since the refund in the second year relates to a payment that reduced your tax liability in the prior year, the $1,000 refund will be included in your federal Gross Income (see page 9) in the second year when the refund is received.  This is known as the "Tax Benefit Rule" – a descriptive title.  Again, the refund is income because it relates to a payment that yielded you a tax benefit (deduction) in an earlier year and that tax benefit is now being reversed out by including it in income in the current year.  Incidentally, the same result would pertain whether you had the $1,000 refund mailed to you or credited against your next year's state income tax liability.

Why would you want to increase your Itemized Deduction in this manner by $1,000 in the earlier year if you would suffer a reversing $1,000 income inclusion in the next year?  I alluded to the answer above.  If you anticipate being in a significantly higher marginal tax bracket this year than next, this technique will be valuable (study again the discussion on determining your marginal income tax bracket on page 11, then the following Example).

Example:  The facts are the same as in the prior Example except that Mark and Debbie are in the 25% marginal tax bracket in 2003 and anticipate being in the 15% marginal tax bracket in 2004.  Let's say their actual state income tax liability for 2003 is only $4,500.  As they have prepaid $5,500 of their 2003 liability (the $4,500 employer withholding and the $1,000 direct payment noted in the prior Example) the couple has overpaid their 2003 state income tax liability by $1,000.   Early in 2004, Mark and Debbie receive a $1,000 refund check from the State.  They will include this $1,000 refund in their 2004 income because it is a recovery of the excess $1,000 payment that they deducted from their Federal income taxes in 2003.  The net result of this is to the couple's benefit.  They deducted $1,000 too much in 2003 and realized savings of $250 of taxes that year ($1,000 times then 25% marginal tax bracket).  In 2004, they will include the refund in their Federal income tax increasing their tax liability by $150 ($1,000 times 15% margin tax bracket for 2004).  The net tax savings between both years relative to the $1,000 extra state income tax payment will be $100 ($250 minus $150).

For more information and examples on the deductibility of state and local taxes you pay, go to my Web site, click on Tax Planning, then IRS Publications, then IRS Publication 17, Your Federal Income Tax (you can picture the IRS official who thought up that one).  Chapter 24 of that Publication provides you with more detail and examples relative to deductibility of taxes that you pay.