Last-Chance Opportunity to Deduct General Sales and Use Taxes

December 10, 2005

The year may provide a last chance opportunity for taxpayers who itemize deductions to deduct state and local sales taxes in lieu of state and local income taxes. That’s because, the option to deduct sales taxes is set to expire at the end of 2005. While it may be extended, there is no way of knowing what Congress may do. Accordingly, individuals who are considering the purchase of a big ticket item may want to push the purchase into this year to achieve a higher itemized deduction for sales taxes, as explained below.

Deduction background. For tax years beginning in 2005, taxpayers may elect to take state and local general sales and use taxes as an itemized deduction, instead of deducting state and local income taxes. (Code Sec. 164(b)(5)) Taxpayers who make this election may either (a) deduct their actual sales and use taxes or (b) use IRS-published tables and then add to the amount from those tables the actual amount of their sales tax for certain “big-ticket” items—motor vehicles, boats, aircraft, homes (including mobile and prefabricated homes), and home building materials. IRS has published tables based on the average consumption by taxpayers, on a state-by-state basis, of items other than motor vehicles, boats, etc, taking into account total available income, number of exemptions claimed, and the rate of state general sales taxation. (Code Sec. 164(b)(5))

Observation: This provision primarily benefits taxpayers who live in states without an income tax, but some taxpayers in other states may benefits if they made major purchases during the year and their state income tax is relatively low.

Planning considerations. Regardless of where a taxpayer resides, unless Congress approves an extension, the sales tax deduction will not be available for tax years beginning after 2005. So taxpayers in a position to benefit from the deduction should consider accelerating big-ticket purchases. For example, if a taxpayer is planning on buying a new automobile in the near future, buying the automobile by Dec. 31, 2005 will lock in a sales tax deduction.

Illustration: Clara lives in a state without an income tax. For 2005, she expects her itemized deductions (including the deduction for state sales tax) to total around $4,800. So, as things stand now she will claim the standard deduction of $5,000. However, she is thinking about buying a new automobile on which she will pay a sales tax of $2,500. If Clara purchases the automobile by Dec. 31, 2005, her 2005 itemized deductions will exceed the standard deduction. She will be able to claim $7,300 of itemized deductions ($2,500 for the sales tax on the auto, plus $4,800 in other itemized deductions) instead of the $5,000 standard deduction. In states with an income tax, taxpayers should first determine whether their sales taxes for a particular year will exceed their income taxes for that year. If the sales tax will exceed the income tax, accelerating big-ticket purchases into 2005 may also be appropriate.

Even a taxpayer who lives in a state with an income tax may benefit by accelerating a big ticket purchase, as shown in the example that follows.

Illustration: Tim lives in a state with an income tax. He expects to pay $6,000 in state income taxes in 2005. Early in 2005, Tim bought a boat on which he paid a sales tax of $4,000. Assume that based on IRS tables, Tim will be able to deduct $1,500 in sales and use taxes in addition to the sales tax paid on the purchase of the boat. Thus, Tim’s total sales and use taxes in 2005 (without any additional major purchases) will be $5,500, or $500 less than his State income taxes. Thus, he would not benefit from electing to deduct state sales and use taxes instead of his state income taxes. However, Tim is also planning to buy an auto in the near future on which he will pay a sales tax of $3,000. If Tim buys the auto in 2005, his total sales and use taxes for the year will be $8,500, or $2,500 more than his 2005 state income taxes. So, even though he lives in a state with an income tax, Tim will also benefit by accelerating his purchase into 2005.

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