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Chapter 23. Taxes Limit on itemized deductions. If your adjusted gross income is more than $105,250 ($52,625 if you are married filing separately), the overall amount of your itemized deductions may be limited. See Chapter 21 if you need more information about this limit. Introduction This chapter discusses which taxes you can deduct if you itemize deductions on Schedule A (Form 1040). It also explains which taxes you can deduct on other schedules or forms, and which taxes and other items you cannot deduct. The chapter will cover the following types of taxes in this order: ∙ Income Taxes (state, local, or foreign) ∙ Real Estate Taxes (state, local, or foreign) ∙ Personal Property Taxes (state or local) ∙ Taxes That Are Expenses of Business or Producing Income ∙ Taxes You Cannot Deduct A final section explains Where to Deduct each type of tax. State or local taxes. These are taxes imposed by the 50 states, U.S. possessions, or any of their political subdivisions (such as a county or city), or by the District of Columbia. Indian tribal government. An Indian tribal government and any of its subdivisions that are recognized by the Secretary of the Treasury as performing substantial government functions will be treated as a state for this purpose. Therefore, income taxes, real estate taxes, and personal property taxes imposed by an Indian tribal government or by any of its subdivisions that have been so recognized by the Secretary are deductible. Foreign taxes. These are taxes imposed by a foreign country or any of its political subdivisions. Related publications and forms. This chapter refers to several publications and forms that you may need. The list of forms does not include Forms 1040, 1040A, and 1040EZ. For more information, you may want to order the following: Publication 514, Foreign Tax Credit for Individuals Publication 530, Tax Information for Homeowners Schedule A (Form 1040), Itemized Deductions Schedule E (Form 1040), Supplemental Income and Loss Form 1116, Foreign Tax Credit Form 2106, Employee Business Expenses Form 2119, Sale of Your Home Tests to Deduct Any Tax All the following tests must be met for any tax to be deductible by you. 1) The tax must be imposed on you. 2) The tax must be paid by you. 3) The tax must be paid during your tax year. The tax must be imposed on you. Generally, you can deduct only taxes that are imposed on you. Generally, you can deduct property taxes only if you are the property owner. If real estate taxes are paid by your spouse who owns a home, they are deductible on your spouse's separate return or on your joint return. The tax must be paid by you. You cannot deduct a tax that another person paid for you. The tax must be paid during your tax year. If you are a cash basis taxpayer, you can deduct only those taxes paid during the calendar year for which you file a return. If you pay your taxes by check, the day you mail or deliver the check is generally the date of payment. If you use a pay-by-phone account, the date reported on the statement of the financial institution showing when payment was made is the date of payment. If you question a tax liability and use the cash method of accounting, you can deduct the tax only in the year you actually pay it. If you use the accrual method of accounting, you must use special rules for determining when you can deduct the tax liability you are questioning. See Contested Liabilities in Publication 538, Accounting Periods and Methods, for more information. Income Taxes You can deduct state and local income taxes, including taxes on interest income that is exempt from federal income tax. However, you cannot deduct state and local taxes on other exempt income. For example, the part of state income tax on a cost-of-living allowance that is exempt from federal income tax is not deductible. State and local income taxes. Deduct state and local income taxes withheld from your salary. Deduct payments made on taxes for an earlier year in the year they were withheld or paid. Deduct estimated tax payments you make under a pay-as-you-go plan of a state or local government. However, you must have a reasonable basis for making the estimated tax payments. Any estimated state or local tax payments you make that are not reasonably determined in good faith at the time of payment are not deductible. For example, if you made an estimated state income tax payment, but the estimate of your state tax liability for the year shows that you will get a refund of the full amount of your estimated payment, then you had no reasonable basis to believe you had any additional liability to make the payment, and you cannot deduct it. Also deduct any part of a refund of prior-year state or local income taxes that you chose to have credited to your 1992 estimated state or local income taxes. Do not reduce your deduction by either of the following: ∙ Any state and local income tax refund (or credit) you expect to receive for 1992, or ∙ Any refund of (or credit for) prior year state and local income taxes you actually received in 1992. Refund. If you receive a refund of state or local (or foreign) income taxes in a year after the year in which you paid them, you may have to include all or part of the refund in income on line 10 of Form 1040, in the year you receive it. This includes refunds resulting from taxes that were overwithheld, not figured correctly, or figured again as a result of an amended return. However, if you did not itemize your deductions in the previous year, you do not have to include the refund in income. For a discussion of how much to include, see Recoveries in Chapter 13. Separate returns. If you and your spouse file separate state and separate federal income tax returns, you each can deduct on your federal return only the amount of your own state income tax. If you file separate state returns and a joint federal return, you can deduct on your joint federal return the sum of the state income taxes both of you pay. If you and your spouse file a joint state return and separate federal returns, each of you can deduct on your separate federal return part of the state income taxes. You can deduct only the amount of the total taxes that is proportionate to your gross income compared to the combined gross income of you and your spouse. But you cannot deduct more than the amount you actually paid during the year. If you and your spouse are jointly and individually liable for the full amount of the state income tax, you and your spouse can deduct on your separate federal returns the amount you each actually paid. Employee contributions to a state disability fund. You can deduct mandatory contributions to state disability benefit funds that provide protection against loss of wages. Payments made to the following disability funds are deductible as state income taxes on Schedule A (Form 1040): California Nonoccupational Disability Benefit Fund New Jersey Nonoccupational Disability Benefit Fund New York Nonoccupational Disability Benefit Fund Rhode Island Temporary Disability Benefit Fund Employee contributions to private or voluntary disability plans are not deductible. Employee contributions to a state unemployment fund that covers you for the loss of wages from unemployment caused by business conditions are deductible as taxes on Schedule A (Form 1040). Foreign income taxes. Generally, you can take either a deduction or a credit for income taxes imposed on you by a foreign country or a U.S. possession. However, you cannot take a deduction or credit for foreign income taxes paid on income that is exempt from tax under the foreign earned income exclusion or the foreign housing exclusion. For more information about the exclusions, get Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. Eligible foreign income taxes are either deducted on Schedule A (Form 1040) under "Other taxes," or taken as a credit on Form 1116, Foreign Tax Credit. Real Estate Taxes Deductible real estate taxes are any state, local, or foreign taxes on real property levied for the general public welfare. They must be charged at the same rate against all property under the jurisdiction of the taxing authority. They generally do not include taxes charged for local benefits and improvements that increase the value of the property. See Taxes You Cannot Deduct, later. Tenant-shareholders in a cooperative housing corporation. Generally, you can deduct your share of the real estate taxes the corporation paid or incurred on the property. For more information, see Publication 530, Tax Information for Homeowners. If the corporation leases the land and buildings and pays the real estate taxes under the terms of the lease agreement, your part of the taxes is not deductible. Purchase or sale of real estate. If you bought or sold real estate during the year, the real estate taxes must be divided between the buyer and the seller. The buyer and the seller must divide the real estate taxes according to the number of days in the real property tax year (the period to which the tax imposed relates) that each owned the property. The seller is treated as paying the taxes up to the date of the sale, and the buyer is treated as paying the taxes beginning with the date of the sale, regardless of the lien dates under local law. If you use the cash method of accounting and cannot deduct taxes until they are paid, and the buyer of your property is personally liable for the tax, you are considered to have paid your part of the tax imposed at the time of the sale. This lets you deduct the part of the tax to the date of sale even though you did not actually pay it. You figure your deduction for taxes on each property bought or sold during the real property tax year as follows. 1. Enter the total real estate taxes for the real property tax year ..................... __________ 2. Enter the number of days in the real property tax year that you owned the property ................................... __________ 3. Divide line 2 by 365 ....................... __________ 4. Multiply line 1 by line 3. This is your deduction. Claim it on line 6 of Schedule A (Form 1040) .............................. __________ Note. Repeat steps 1 through 4 for each property you bought or sold during the real property tax year. Example 1. Dennis and Beth White's real property tax year for both their old home and their new home is the calendar year, with payment due August 1. The tax on their old home, sold on May 5, was $620. The tax on their new home, bought on May 4, was $732. Dennis and Beth are considered to have paid a proportionate share of the real estate taxes on the old home even though they did not actually pay them to the taxing authority. On the other hand, they can claim only the proportionate share of the taxes they paid on their new property even though they paid the entire amount. Dennis and Beth owned their old home during the real property tax year for 124 days (January 1 to May 4, the day before the sale). They figure their deduction for taxes on their old home as follows. 1. Enter the total real estate taxes for the real property tax year ..................... $620 __________ 2. Enter the number of days in the real property tax year that you owned the property ................................... 124 __________ 3. Divide line 2 by 365 ....................... .34 __________ 4. Multiply line 1 by line 3. This is your deduction. Claim it on line 6 of Schedule A (Form 1040) .............................. $211 __________ They owned their new home during the real property tax year for 242 days (May 4 to December 31, including their date of purchase). They figure their deduction for taxes on their new home as follows. 1. Enter the total real estate taxes for the real property tax year ..................... $732 __________ 2. Enter the number of days in the real property tax year that you owned the property ................................... 224 __________ 3. Divide line 2 by 365 ....................... .66 __________ 4. Multiply line 1 by line 3. This is your deduction. Claim it on line 6 of Schedule A (Form 1040) .............................. $483 __________ Dennis and Beth's real estate tax deduction for their old and new homes is the sum of $211 and $483, or $694. They will enter this amount on line 6 of Schedule A (Form 1040). Example 2. George and Helen Brown bought a home on May 2, 1992. Their real property tax year is the calendar year. Real estate taxes for 1991 were assessed in their state on January 2, 1992. They became due on May 31, 1992 and October 31, 1992. Under state law, the tax became a lien on May 31, 1992. George and Helen agreed to pay all taxes due after the date of purchase. Real estate taxes for 1991 were $680. George and Helen paid $340 tax on May 31, 1992, and $340 tax on October 31, 1992. Since the taxes paid in 1992 relate to 1991, the Browns cannot deduct them. Instead, they must add $680 to the cost of their home. In January 1993, George and Helen receive their property tax statement for 1992 taxes of $752, which they will pay in 1993. George and Helen owned their new home during the 1992 real property tax year for 244 days (May 2 to December 31). They will figure their 1993 deduction for taxes as follows. 1. Enter the total real estate taxes for the real property tax year ..................... $752 __________ 2. Enter the number of days in the real property tax year that you owned the property ................................... 244 __________ 3. Divide line 2 by 365 ....................... .67 __________ 4. Multiply line 1 by line 3. This is your deduction. Claim it on line 6 of Schedule A (Form 1040) .............................. $504 __________ The remaining $248 of taxes paid in 1993, along with the $680 paid in 1992, is added to the cost of their home. Because the taxes up to the date of sale are considered paid by the seller on the date of sale, the person who sold the Browns their home is entitled to a 1992 tax deduction of $928. This is the sum of the $680 for 1991 and the $248 for the 121 days the seller owned the home in 1992. The $928 also must be added to the amount realized on the sale when the seller completes Form 2119, Sale of Your Home (which must be attached to the seller's 1992 tax return). The seller should contact the Browns in January 1993 to find out how much real estate tax is due for 1992. Delinquent taxes. Delinquent (late) taxes charged to the seller, but paid by the buyer as part of the contract price, are not deductible. The buyer adds these taxes to the cost of the property. Taxes placed in escrow. If your monthly mortgage payment includes an amount placed in escrow (put in the care of a third party) for real estate taxes, you cannot deduct the total of these amounts included in your payments for the year. You can deduct only the amount of the tax that the lender actually paid to the taxing authority. If the lender does not notify you of the amount of real estate tax that was paid for you, contact the lender or the taxing authority to find the proper amount to show on your return. Married filing separate return. If you and your spouse held property as tenants by the entirety and you file separate returns, each of you can deduct only the taxes each of you paid on the property. Minister's and military housing allowances. If you are a minister or a member of the uniformed services and receive a housing allowance that you can exclude from income, you still can deduct all of the real estate taxes you pay on your home. Items you cannot deduct. The following are not deductible as real estate taxes: ∙ Taxes for local benefits, ∙ Trash and garbage pickup fees, ∙ Rent increases due to higher real estate taxes, and ∙ Homeowners association charges. Taxes for local benefits. Deductible real estate taxes generally do not include taxes charged for local benefits and improvements that increase the value of the property. See Taxes You Cannot Deduct, later. Trash and garbage pickup fees. Fees charged for trash and garbage pickup services are not taxes. However, real estate taxes are deductible even if used to provide services such as trash collection or fire protection. Rent increase due to higher real estate taxes. If your landlord increases your rent in the form of a tax surcharge because of increased real estate taxes, you cannot deduct the increase as taxes. Homeowners association charges. These charges are not deductible because they are imposed by the homeowners association, rather than the state or local government. Personal Property Taxes To qualify as a deductible personal property tax, a state or local tax must be: 1) Charged on personal property, 2) Based only on the value of the personal property, and 3) Charged on a yearly basis, even if it is collected more than once a year, or less than once a year. A tax can be considered charged on personal property even if it is for the exercise of a privilege. For example, a yearly tax based on value qualifies as a personal property tax even if it is called a registration fee and is for the privilege of registering motor vehicles or using them on the highways. Example. Your state charges a yearly motor vehicle registration tax of 1% of value plus 50 cents per hundredweight. You paid $32 based on the value ($1,500) and weight (3,400 lbs.) of your car. You can deduct $15 (1% * $1,500) as a personal property tax, since it is based on the value. The remaining $17 ($.50 * 34), based on the weight, is not deductible. Taxes That Are Expenses of Business or Producing Income You can deduct certain taxes not previously listed in this chapter only if they are ordinary and necessary expenses of your trade or business or of producing income. For a discussion of business taxes, see Chapter 7 of Publication 535, Business Expenses. In some cases, these taxes are not deducted on Schedule A, but are deducted on other schedules or forms. See Where to Deduct, later. Tax connected with purchase or sale. Generally, any tax paid in connection with the purchase or sale of property must be treated as part of the cost basis of the property or, in the case of a sale, as a reduction in the amount realized. But if the cost of the property is a business expense, such as the cost of supplies, any tax paid is deductible as part of the business expense. Self-employment tax. If you work for yourself, you can deduct half of the self-employment tax you figured on your 1992 Schedule SE, Self-Employment Tax. Occupational taxes. You can deduct as a business expense an occupational tax charged at a flat rate by a locality for the privilege of working or conducting a business in the locality. Taxes You Cannot Deduct Many federal, state, and local government taxes are not deductible. Nondeductible Federal Taxes Nondeductible federal taxes include: Federal income taxes, including those withheld from your pay. Social security or railroad retirement taxes withheld from your pay. Federal estate and gift taxes. These taxes are generally not deductible. However, you generally can deduct the estate tax if you must include in gross income an amount of income in respect of a decedent. In that case, the estate tax can be deducted as a miscellaneous deduction that is not subject to the 2% of adjusted gross income limit. For more information, see Estate Tax Deduction in Publication 559, Tax Information for Survivors, Executors, and Administrators. Social security and other employment taxes for household workers. You generally cannot deduct the social security or other employment taxes you pay on the wages of a household worker. However, you may be able to include them in medical or child care expenses. For more information, see Chapter 22 and Chapter 33. Nondeductible State and Local Taxes Nondeductible state and local taxes include: Inheritance, legacy, succession, or estate taxes. Gift taxes. Per capita or poll taxes. Cigarette, tobacco, liquor, beer, wine, etc., taxes. Taxes for local benefits. Local benefit taxes that are for improvements to property are not deductible. These include assessments for streets, sidewalks, water mains, sewer lines, public parking facilities, and similar improvements. You should increase the basis of your property by the amount of the assessment. Local benefit taxes are deductible if they are for maintenance, repair, or interest charges related to those benefits. If only a part of the taxes is for maintenance, repair, or interest, you must be able to show the amount of that part to claim the deduction. If you cannot determine what part of the tax is for maintenance, repair, or interest, none of it is deductible. Transfer taxes (or stamp taxes). Transfer taxes and other taxes and charges on the sale of a personal home are not deductible. If they are paid by the seller, they are expenses of the sale and reduce the amount realized on the sale. If paid by the buyer, they are included in the cost basis of the property. If you deduct these taxes and charges as moving expenses as explained in Chapter 27, you cannot use them either to reduce the amount realized on the sale of your home or to increase the cost basis of your new home. Nondeductible fees and charges include: Marriage licenses. Fines (such as for parking or speeding) and collateral deposits. Driver's licenses. Taxes You Can Deduct Only If Business-Connected Certain taxes are deductible only if connected with your trade or business or income-producing activity. Federal taxes and charges that are deductible only if connected with your trade or business or income-producing activity include: Postage. Federal excise taxes or customs duties. These include the federal taxes on telephone service, air transportation and gasoline. State and local taxes and charges that are deductible only if connected with your trade or business or income-producing activity include: Motor vehicle taxes. However, see Personal Property Taxes, earlier. Utility taxes. Car registration fees, inspection fees, and license plates. However, see Personal Property Taxes, earlier. Dog tags, hunting licenses. Tolls for bridges and roads, and parking meter deposits. Water bills, sewer, and other service charges. Fuel adjustment charges by a municipally-owned electric utility company. Taxes on gasoline, diesel, and other motor fuels. Sales taxes. If you buy supplies or other items for your trade or business and can deduct their cost as a business expense, you can deduct the sales tax on the purchase as part of the business expense. Sales tax on the purchase of property whose cost you cannot deduct as a business expense is added to the property's cost. See Cost Basis in Chapter 14. Example 1. You pay sales tax on a purchase of supplies for your business. You can deduct the cost of the supplies, including the sales tax, as a business expense. Example 2. You pay sales tax on a purchase of a new car that will be used for business. You must add the sales tax to your basis for figuring depreciation on the car. You cannot deduct the sales tax. Where to Deduct You deduct taxes on the following schedules: State and local income taxes. These taxes are deducted only on Schedule A (Form 1040), even if your only source of income is from business, rents, or royalties. Foreign income taxes. Generally, income taxes you pay to a foreign country or U.S. possession can be claimed as an itemized deduction on Schedule A (Form 1040), or as a credit against your U.S. income tax on Form 1116, Foreign Tax Credit. For more information, get Publication 514, Foreign Tax Credit for Individuals. Real estate taxes and personal property taxes. These taxes are deducted on Schedule A (Form 1040), unless they are paid on property used in your business or producing rent or royalty income. See Business taxes, next, and Taxes on property producing rent or royalty income, later. Business taxes. Taxes that you must pay in operating your business, or on your property used in your business, are generally deducted on Schedule C (Form 1040) or Schedule F (Form 1040). Taxes that are employee business expenses. Taxes you paid that are deductible as employee business expenses are generally claimed on Schedule A (Form 1040) as a miscellaneous itemized deduction subject to the 2% of adjusted gross income limit. If you also deduct certain other employee business expenses or if you are reimbursed by your employer, you may also have to file Form 2106, Employee Business Expenses. The Form 2106 instructions explain who must file that form. Self-employment tax. Deduct one-half of your self-employment tax on line 25, Form 1040. Taxes on property producing rent or royalty income. These taxes generally are deducted on Schedule E (Form 1040). Other taxes. All other deductible taxes are deducted on Schedule A (Form 1040).