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The U.S. Federal Government was granted the authority to impose taxes by the Constitution. The states, however, also retained the right to impose any type of tax except those taxes that are clearly forbidden by the US Constitution and their own state constitution. Among the common types of taxes that many states impose are personal income tax, corporate income tax, sales tax, and real property tax.
In addition to the federal government, 43 states and many local municipalities require their residents to pay income taxes.
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State and local taxes have been deductible since the very beginning of the federal income tax in 1913. In 1964, deductible taxes were limited to state and local property (real and personal property), income, general sales, and motor fuels taxes. Congress eliminated the deduction for taxes on motor fuels in 1978, and eliminated the deduction for general sales tax in 1986.
In more recent years, taxpayers who itemize deductions can deduct what they paid in certain state and local taxes, which includes property, income and sales taxes. More specifically, anyone who itemizes can deduct property taxes, but must choose between deducting their income taxes and sales taxes. Most choose to deduct their income taxes because those payments generally exceed sales tax payments.
This newsletter is intended to give you a better understanding of SALT, the State And Local Tax, as impacted by the new limit on its deduction. It will also offer you a little “taste” of the tax treatment of state and local tax refunds.
Up until 2018, there was virtually no limit to the SALT deduction.
Internal Revenue Code Section 164(b)(6), as added by the new tax law known as the Tax Cuts and Jobs Act (TCJA), limits an individual's deduction for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return).
The limit applies to tax years 2018 to 2025.
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The limit is important for another reason as well: the 2018 standard deduction is $12,000 for single filers who now need to have another $2,000 of itemized deductions, beyond the SALT deduction limit, in order to itemize.
The SALT deduction is only one of many deductions available to taxpayers at present. The mortgage interest deduction is still intact, albeit at a lower threshold. Whereas you could previously write off the interest paid on loans of up to $1 million, this limit now sits at $750,000.
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Nevertheless, most homeowners are not impacted by this change, since the average U.S. mortgage is well below $750,000. Furthermore, no changes have been made to the charitable contributions deduction, which means that if you're extra generous, you can use that to your advantage when you sit down to decide on itemized deductions vs, the standard deduction.
Here are a few more numbers that may be of interest to you. Less than one-third of tax filers opted to itemize deductions on their federal income tax returns in 2016, but virtually all who itemized claimed a deduction for state and local taxes paid.
High-income households are more likely than low- or moderate-income households to benefit from the SALT deduction. The amount of state and local taxes paid, the probability that taxpayers itemize deductions, and the reduction in federal income taxes for each dollar of state and local taxes deducted, all increase with income.
The impact is keenly felt by middle-class homeowners who live in towns with high property taxes. New York, Connecticut, New Jersey, California, Massachusetts, Illinois, Maryland, Rhode Island and Vermont, plus the District of Columbia, are the states with the highest average deduction for state and local taxes. In 2015, the average New Yorker’s SALT deduction was more than $22,000. In New Jersey and California, the average deductions were around $18,000
Regarding the tax treatment of state and local tax refunds, state and local tax refunds are not subject to tax if you chose the standard deduction for the year in which the tax was paid.
But if you itemized deductions for that year on Schedule A, Itemized Deductions, part or all of the refund may be subject to tax, to the extent you received a tax benefit from the deduction. |
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If you are impacted by the SALT limit—those of you who itemize deductions and paid state and local taxes in excess of the SALT limit — you may not be required to include the entire state or local tax refund in income in the following year.
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A key part of that calculation is determining the amount you would have deducted had you only paid the actual state and local tax liability—that is, no refund and no balance due.
The IRS recently clarified the tax treatment of state and local tax refunds arising from any year in which the new limit on the state and local tax (SALT) deduction is in effect.
The IRS ruled that if a taxpayer received a tax benefit from deducting state or local taxes in a prior tax year and the taxpayer recovers all or a portion of those taxes in the current tax year, the taxpayer must include in gross income the lesser of: |
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The difference between the taxpayer's total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax; or
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The difference between the taxpayer's itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year.
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This holding applies to the recovery of any state or local tax, including state or local income tax and state or local real or personal property tax.
In Revenue Ruling 2019-11, posted on IRS.gov, the IRS provided four examples illustrating how the long-standing tax benefit rule interacts with the new SALT limit to determine the portion of any state or local tax refund that must be included on the taxpayer’s federal income tax return. |
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| Here is one of these examples: |
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“A single taxpayer itemizes and claims deductions totaling $15,000 on the taxpayer’s 2018 federal income tax return. A total of $12,000 in state and local taxes is listed on the return, including state and local income taxes of $7,000. Because of the limit, however, the taxpayer’s SALT deduction is only $10,000.
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In 2019, the taxpayer receives a $750 refund of state income taxes paid in 2018, meaning the taxpayer’s actual 2018 state income tax liability was $6,250 ($7,000 paid minus $750 refund). Accordingly, the taxpayer’s 2018 SALT deduction would still have been $10,000, even if it had been figured based on the actual $6,250 state and local income tax liability for 2018.
The taxpayer did not receive a tax benefit on the taxpayer’s 2018 federal income tax return from the taxpayer’s overpayment of state income tax in 2018. Thus, the taxpayer is not required to include the taxpayer’s 2019 state income tax refund on the taxpayer’s 2019 return.”
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The taxable part of your state and local tax refund must be reported on your tax return on line 10 of Schedule 1, Additional Income and Adjustments to Income, of the new 2018 Form 1040.
You can calculate the taxable portion of your state tax refund by using the State and Local Tax Refund Worksheet included in the Instructions for Form 1040 provided by the IRS. You must file this worksheet along with your tax return.
This ruling has no impact on state or local tax refunds received in 2018 and reportable on 2018 returns taxpayers are filing this season.
Also, if you were able to deduct your sales tax and not your state income taxes on last year’s return, then your state refund is not taxable when you file this year.
Some of you may not be sure whether they itemized deductions for tax year 2017 or not. It may be useful to remind you that if you used Forms 1040A or 1040EZ to file your return for 2017 tax year, then you claimed the standard deduction because these returns don’t give you the option of itemizing. |
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If you filed a 2017 Form 1040, check the return to see if it includes a Schedule A. You should also be able to tell if you itemized by checking line 40 of your 2017 Form 1040. You almost certainly claimed the standard deduction if you entered $6,350, $9,350, or $12,700 in this space, as these were the standard deduction amounts for single, head of household and married filing jointly taxpayers respectively for that tax year. This information appears on Line 8 of the new 2018 tax return.
With all the changes in the tax law, it is always better to consult with a tax professional for the most informed and up-to-date advice in all your dealings with the IRS. |
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