The Vanishing State and Local Tax Deduction

2017 Might be Your Last Chance

By Matthew E. Miller, CPA, MBA

Rumors started spreading in the early Fall that the House version of tax reform would significantly reduce the amount taxpayers could deduct on their income tax return for taxes paid to their state and local governments. When the bill was released, rumors proved true. The Senate version took the measure further by completely eliminating the deduction. Now that the legislation is with the Joint Committee, reports are that the final bill will cap the deduction at $10,000. Before the bill is signed, negotiations could take the deduction a different direction. What should be clear to us is that we should expect the deduction for state and local taxes to be significantly reduced for tax years beginning 2018.

Which Taxes are Effected?

Which taxes are being effected and what might you expect to be the impact to your tax return? The most common taxes deducted on your return are state income or state sales tax, real estate and personal property. The aggregate total of these taxes would be subject to the proposed limitation.

This limitation does not apply to rental properties that you own. Real estate taxes on those properties will remain fully deductible against rental income collected from tenants. Additionally, this limitation does not apply to any property taxes or sales tax you pay on business assets.

What is the Impact?

The calculation to determine the tax impact the legislation has on you is a two-part test, A & B.

A. Using your 2016 return, look at line 45 on page 2 of Form 1040. This is the Alternative Minimum Tax (AMT) line. If line 45 is blank or zero, move to step B. If line 45 has any amount in it you were subject to AMT and the tax value of all of your state and local tax deductions is zero. The calculation of AMT does not allow taxpayers a deduction for all the state and local taxes they pay each tax year. So, the impact of the limitation of the deduction for you is none. Since you were subject to AMT in the last year, you did not get a benefit for state and local taxes you paid in 2016. Since you get no benefit for the deduction, limitation of the state and local tax deduction will not negatively impact your taxes. For more information on how Alternative Minimum Tax works, please visit our website by clicking on this link.
B. Using your 2016 return, look at line 9 on Schedule A. This is the total amount of state and local taxes you claimed last year. Multiply this figure, less $10,000, by your effective tax rate. Your effective tax rate is calculated by dividing your tax income liability on line 56 on your form 1040 by your total tax line 43. The product of this calculation is the tax savings lost by the limitation of this deduction.

What Should I Do Before Year-End?

If you believe you will have a 2017 income tax liability to your state and if you are not historically subject to AMT, our recommendation is to make a calculation of the projected liability and pay the amount due to the state by December 31, 2017. If you pay your liability by the end of the year, you get to claim the deduction on this year’s federal income tax return.