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Year-end planning: Last chance opportunity to deduct general sales and use taxes?

The next few months 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 2013. 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 accelerate the purchase into this year to achieve a higher itemized deduction for sales taxes, as explained below.

Deduction background. For tax years beginning before 2014, 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. (Code Sec. 164(b)(5)) 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.

RIA observation: This provision primarily benefits taxpayers who live in states without an income tax, but some taxpayers in other states may benefit under certain circumstances, as explained below.

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 2013. So taxpayers in a position to benefit from the deduction should consider accelerating big-ticket purchases. For example, if a taxpayer is planning to buy a new automobile in the near future, buying the automobile by Dec. 31, 2013 will lock in a sales tax deduction.

RIA illustration Clara, a single person, lives in a state without an income tax. For 2013, she expects her itemized deductions (including the deduction for state sales and use taxes) to total around $5,800. So, as things stand now she will claim the standard deduction of $6,100. However, she is thinking about buying a new car on which she will pay a sales tax of $3,000. If Clara purchases the car by Dec. 31, 2013, her 2013 itemized deductions will exceed the standard deduction. She will be able to claim $8,800 of itemized deductions ($3,000 for the sales tax on the car, plus $5,800 in other itemized deductions) instead of the $6,100 standard deduction.

Most itemizing taxpayers who live in states that have both income and sales taxes will deduct income taxes. But that is not always the case. For example, a retiree may owe no state income tax because his pension and social security benefits are exempt from state tax and he has little other income. At the same time, he may itemize federal deductions because he pays real estate taxes, has deductible medical expenses, pays mortgage interest, and makes charitable contributions. Such a taxpayer will choose to deduct sales tax and could benefit from accelerating a big-ticket purchase into 2013.

Other taxpayers in states with an income tax could also benefit by this strategy. For example, taxpayers who made major purchases during the year and whose state income tax is relatively low because of credits or for other reasons could benefit. These taxpayers should project their sales tax to date and their likely income taxes for the year. If their sales tax already exceeds their income tax or is only slightly less than their income tax, accelerating big-ticket purchases into 2013 may be appropriate.

RIA illustration Tim lives in a state with an income tax. He expects to pay $6,000 in state income taxes in 2013. Early in 2013, 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 2013 (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 2013, his total sales and use taxes for the year will be $8,500, or $2,500 more than his 2013 state income taxes. So, even though he lives in a state with an income tax, Tim will also benefit by accelerating his purchase into 2013.