For tax years beginning in 2004 and 2005, the American Jobs Creation Act of 2004, recently passed by Congress, allows taxpayers to elect to take state and local general sales and use taxes as an itemized deduction on their federal income tax returns for those years. However, a taxpayer who makes this election will not be able to take an itemized deduction for state and local income taxes for the same year.
Taxpayers who make this election may either deduct their actual sales and use taxes, or use tables published by the Internal Revenue Service to determine the base amount that they can deduct. They would then add to the amount from those tables the actual amount of their sales tax for motor vehicles, boats and other items specified by the IRS.
The tables are to be based on the average consumption by taxpayers, on a state-by-state basis, of items other than motor vehicles, boats, etc., taking into account filing status, number of dependents, adjusted gross income, and the rate of state and local general sales taxation.
Observation: Because the IRS is in the process of finalizing tax forms for 2004, and developing the tables will require a significant amount of time and effort, there may be some difficulty in getting the tables prepared in time to prepare 2004 tax returns.
However, Congress expects that the IRS will do the best it can to reasonably and accurately implement the sales and use tax rules in time for the next tax-filing season. Presumably, the tables issued will be similar to the tables issued before the deduction formerly allowed for sales and use taxes was repealed by the Tax Reform Act of 1986.
A tax is a general sales tax if it is imposed at one rate with respect to the sale at retail of a broad range of classes of items. However, in the case of items of food, clothing, medical supplies and motor vehicles, the fact that a tax does not apply with respect to some or all of such items is not taken into account in determining whether the tax applies with respect to a broad range of classes of items, and the fact that the rate of tax applicable with respect to some or all of those items is lower than the general rate of tax is not taken into account in determining whether the tax is imposed at one rate.
States without a state or local income tax
This election primarily benefits taxpayers who live in states without state or local income taxes. In those states, a taxpayer planning to make a major purchase, such as a new auto, toward the end of 2004 should consider whether she would benefit more from delaying the purchase until 2005.
This will generally depend on whether the taxpayer will be in a higher tax bracket next year than this year. It will also depend on whether the taxpayer will otherwise benefit from itemizing her deductions in each year. A taxpayer who would benefit from taking the standard deduction in one year and from itemizing in another year should make the purchase in the year that she would otherwise itemize to get the full benefit of the deduction for sales and use taxes.
Example 1: Your client lives in a state without an income tax. She is planning to buy a new automobile on which she will pay a sales tax of $5,000. In 2004, she will be in a 28 percent marginal tax bracket, but expects to receive a large bonus early in 2005 for work done in 2004 that will put her in the 33 percent tax bracket for that year. She expects to benefit from itemizing her deductions in each year even before taking the deduction for sales taxes into account.
If she buys the auto in 2004, she will save income taxes of $1,400 (28 percent of $5,000) by including the sales taxes in her itemized deductions. If she delays the purchase until 2005, she will save $1,650 (33 percent of $5,000), or $250 more than she would save if she made the purchase in 2004.
Example 2: The same facts apply as in Example 1, except that your client will be in the 28 percent tax bracket each year, and in 2004 she expects her itemized deductions (before including the sales tax on the auto) to be $2,000 less than the standard deduction she could claim. In 2005, she expects her itemized deductions (without the sales tax on the auto) to be at least equal to her standard deduction.
If she buys the auto in 2004, she will reduce her taxes by only $840 (28 percent of $3,000 [the excess of $5,000 over $2,000]) by claiming the sales tax on the auto as an itemized deduction. This is because her itemized deductions (after including the sales tax on the auto) will be only $3,000 more than her standard deduction.
On the other hand, if your client delays buying the auto until 2005, she will save $1,400 (28 percent of $5,000) in taxes by deducting the sales tax on the auto as an itemized deduction. This is because her taxable income will be reduced by the full amount of the sales tax, since her itemized deductions without the sales tax are already at least equal to her standard deduction.
States with a state or local income tax
In states that do have state or local income taxes, taxpayers should determine whether their sales and use taxes for a particular year would exceed their state and local income taxes for that year. In some cases, taxpayers may want to bunch major purchases into the same year so that sales and use taxes for that year will exceed that year's state income taxes. By doing this, they can deduct their sales and use taxes in one year, and their income taxes in another year.
Example 3: Your client lives in a state with an income tax. He expects to pay $8,000 in state income taxes in both 2004 and 2005, and to be in a marginal 33 percent federal income tax bracket in both those years. Early in 2004, he bought a boat on which he paid a sales tax of $6,000.
Assume, based on tables put out by the IRS, that your client will be able to deduct $1,500 in sales and use taxes in addition to the sales tax paid on the purchase of major items such as boats and autos. Thus, his total sales and use taxes in 2004 (without any additional major purchases) will be $7,500, or $500 less than his state income taxes for that year. Thus, he would not benefit from electing to deduct state sales and use taxes instead of his state income taxes.
However, your client is also planning to buy an auto on which he will pay a sales tax of $5,000. He does not plan to make any other major purchases before the end of 2005. If he buys the auto in 2005, his total sales and use taxes for that year will be only $6,500 (table amount of $1,500 plus $5,000 tax on the auto), or $1,500 less than the $8,000 in state income taxes that he expects to pay that year.
On the other hand, if he buys the auto in 2004, his total sales and use taxes for that year will be $12,500 ($6,000 on the boat, $5,000 on the auto and $1,500 from the tables), or $4,500 more than his state income taxes for that year. He will save $1,485 (33 percent of $4,500) in federal income taxes in 2004 by buying the auto in that year and electing to deduct his sales and use taxes instead of his income taxes. He will still be able to deduct his state income taxes in 2005.
Recommendation: Taxpayers who pay all or part of their state and local income taxes by means of estimated tax payments often pay their final installment for a year in December of that year, even though that installment is not due until January of the following year. This is so that the full amount of the state and local income taxes owed for a year can be deducted on the federal income tax return for that year.
However, a taxpayer who knows that he will be electing to deduct sales and use taxes on his federal income tax return for that year should delay paying the last installment of the state or local income taxes until the following year, so as to increase the deduction for those taxes in that following year.
Example 4: The same facts apply as in Example 3, plus your client has to make four estimated tax payments of $2,000 each with respect to his state income taxes for 2004. The final installment is due in January 2005, but normally he would make that payment in December 2004, so that he could deduct it on his 2004 federal income tax return.
If he buys the auto in 2004 and elects to deduct his sales and use taxes instead of his state income taxes on his federal income tax return for that year, he should delay making his final estimated tax payment of his 2004 state income taxes until 2005, thus increasing the total amount that he can deduct on his 2005 federal income tax return to $10,000.
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