If you itemize deductions on Schedule A, you may deduct your payments of state, local, and foreign income taxes and real property taxes, as well as state and local personal property taxes. You have the option of deducting state and local general sales taxes in lieu of state and local income taxes; see 16.3.

To increase your deduction for state and local taxes, consider making a year-end prepayment of estimated tax liability. You also may be able to increase withholdings from your pay to increase your deduction.

If you pay transfer taxes on the sale of securities or investment real estate, the taxes are not deductible. However, they reduce the sales price when figuring your profit or loss.

Taxes paid in operating a business are generally deductible, except for sales taxes, which are added to the cost of the property.

If your adjusted gross income for 2017 exceeds the threshold for your filing status, your deduction for taxes is subject to the reduction of itemized deductions (13.7).

16.1 Deductible Taxes

If you itemize deductions for 2017 on Schedule A (Form 1040), you may deduct your payments in 2017 of:

• State, local, and foreign income taxes. You have the option to deduct state and local general sales taxes in lieu of state and local income taxes (16.3).
• State, local, and foreign real property taxes
• State and local personal property taxes

In figuring deductible state or local income taxes, include the amount of state or local income tax withheld from your 2017 pay, any state or local estimated tax for 2017 that you paid in 2017, and any part of a prior year refund that you credited to your 2017 state or local tax. Also, do not forget to include state and local tax that you paid in 2017 when you filed your 2016 state and local tax returns.

Taxes incurred in your business are generally deductible on Schedule C (16.9).

Claim the deduction for deductible taxes on the tax return for the year in which you paid the taxes, unless you report on the accrual basis (16.7).

16.2 Nondeductible Taxes

Transfer taxes. Transfer taxes paid on the sale of securities or investment real estate are not separately deductible; but when you report the sale on Form 8949, transfer taxes along with other selling expenses will decrease your gain or increases your loss; see 5.8.

A transfer tax (which may be called an excise tax in some states) on the sale of a personal residence is not deductible as a real estate tax; it is imposed on the transaction and not on the value of the property. Transfer taxes are added to cost basis by the buyer or treated as an expense of sale by the seller.

Gasoline taxes. State and local taxes on gasoline used for personal purposes are not deductible. If you travel for business, the taxes are deductible as part of your gasoline expenses.

16.3 State and Local Income Taxes or General Sales Taxes

On Schedule A (Form 1040), you may deduct either your payments of state and local income taxes or your payments of state and local general sales taxes. You cannot deduct both. On Line 5 of Schedule A, you check a box to indicate whether you are deducting state and local income taxes or general sales taxes; check Box a to elect to deduct state and local income taxes, or Box b to elect to deduct state and local general sales taxes.

State and local income taxes. You may deduct on your 2017 return state and local income taxes withheld from your pay and estimated state and local taxes paid in 2017. Also deduct any balance of your 2016 state and local taxes that you may have paid in 2017 when you filed your 2016 state/local tax return. If in 2018 you pay additional state income tax on your 2017 income (when you file your 2017 state/local return in 2018 and have a balance due), that payment will be deductible on your 2018 tax return.

State income taxes may be claimed only as itemized deductions, even if attributed solely to business income. That is, state income taxes may not be deducted as business expenses from gross income.

To increase your itemized deductions on your 2017 return, consider prepaying state income taxes before the end of 2017. The prepayment is deductible provided the state tax authority accepts prepayments and state law recognizes them as tax payments. The IRS has ruled, however, that prepayments are not deductible if you do not reasonably believe that you owe additional state tax. Do not make prepayments if you expect to be subject to alternative minimum tax, since state and local taxes are not deductible for AMT purposes (23.2).

If you report on the accrual basis and you contest a tax liability, claim the deduction in the year of payment.

You may deduct on your federal return state and local income taxes allocable to interest income that is exempt from federal tax but not from state and local income tax. However, state and local taxes that are allocated to other federal exempt income are not deductible. For example, state income tax allocated to a cost-of-living allowance exempt from federal income tax is not deductible as a state tax.

The IRS has held that mandatory employee contributions to state disability or worker’s compensation funds in California, New Jersey, New York, Rhode Island and Washington, and mandatory contributions to the Alaska, California, New Jersey, and Pennsylvania state unemployment funds, are deductible as state income taxes. In addition, mandatory contributions to state family leave programs, such as in New Jersey and California, are deductible as state income taxes.

However, employee contributions to a private or voluntary disability plan in California, New Jersey, or New York have been held by the IRS to be nondeductible.

Note: If you get a refund of state income taxes that you claimed as an itemized deduction, you may have to report it as income (11.5).

State and local general sales taxes option. If you elect to deduct state and local general sales taxes in lieu of state and local income taxes, you have two ways to figure the sales tax deduction. You can figure deductible state and local general sales taxes using your credit card receipts and other records of non-business purchases for the year. Alternatively, you can use the IRS’ optional tables and worksheet in the Schedule A instructions or the Sales Tax Deduction Calculator at IRS.gov.

Generally, you can only deduct sales taxes to the extent that the rate is the same as the general sales tax rate. However, sales taxes on food, clothing, medical supplies, and motor vehicles are deductible as general sales taxes even if the rate paid is less than the general sales tax rate.

If you paid sales taxes on the purchase or lease of a motor vehicle used for personal purposes (car, motorcycle, SUV, truck, van, or off-road vehicle) at a rate that is higher than the general sales tax rate, you may only include up to the general sales tax rate.

You may also include sales taxes paid at the general sales tax rate on the purchase of (1) a home, including a mobile or prefabricated home, or on a substantial addition to a home or a major home renovation, (2) a boat, or (3) an aircraft. See the Schedule A instructions for restrictions on taxes paid on the purchase of a home or major home renovation.

16.4 Deducting Real Estate Taxes

Your payments of state, local, or foreign real estate taxes on your non-business property are deductible on Schedule A (Form 1040). The tax must be based on the assessed value of the property and the assessment must be based on a uniform rate imposed for public purposes. See 16.5 for deductible and nondeductible assessments for local benefits.

The monthly mortgage payment to a bank or other mortgage holder generally includes amounts allocated to real estate taxes, which are paid to the taxing authority on their due date. Mortgage payments allocated to real estate taxes are deductible in the year you make the payments only if the mortgage holder actually pays the taxes to the tax authority by the end of that year. Typically, banks will furnish you with a year-end statement of disbursements to taxing authorities, indicating dates of payment.

See 16.5–16.7 for further details on real estate taxes.

Who may deduct real property taxes. A person who pays a property tax must have an ownership interest in the property to deduct the payment. Table 16-2 below summarizes who may deduct payments of real property taxes.

Real estate tax paid on your principal residence with assistance from Hardest Hit Fund. An IRS safe harbor (Notice 2017-40) allows you to claim a 2017 deduction for real estate taxes paid on your principal residence although you received tax-free assistance from a State Housing Finance Agency (State HFA) using funds from the Treasury Department’s HFA Hardest Hit Fund. The safe harbor allows you to deduct the real estate taxes paid to the mortgage servicer or the State HFA, assuming you otherwise qualify for a deduction of the taxes. The lender may report the real estate taxes paid (this is optional) in Box 11 (“Other”) of Form 1098. The same safe harbor allows a deduction for mortgage interest paid and, if extended to 2017, mortgage insurance premiums (15.1, 15.6). The safe harbor is scheduled to apply through 2021.

16.5 Assessments

Assessments by homeowner’s association not deductible as taxes. Assessments paid to a local homeowner’s association for the purpose of maintaining the common areas of the residential project and for promoting the recreation, health, and safety of the residents are not deductible as real property taxes because they are not imposed by a state or local government.

Assessments for government services. If property is used solely as your residence, you may not deduct charges for municipal water bills (even if described as a “tax”), sewer assessments, assessments for sanitation service, or title registration fees. A permit fee to build or improve a personal residence is added to the cost basis of the house.

Assessments for local benefits are deductible if they cover maintenance or repairs of streets, sidewalks, or water or sewer systems, or interest costs on such maintenance. However, assessments for construction of streets, sidewalks, or other local improvements that tend to increase the value of your property are not deductible as real estate taxes. You add such assessments to your cost basis for the property.

If you are billed a single amount, you may deduct the portion allocable to assessments for maintenance or repairs. The burden is on you to support the allocation.

16.6 Tenants’ Payment of Taxes

You generally may not deduct a portion of your rent as property taxes. This is so even where state or local law identifies a portion of the rent as being tied to tax increases.

Tenants have been allowed a deduction for property taxes in the following cases: In Hawaii tenants with leases of 15 years or more were allowed to deduct the portion of the rent representing taxes. In California, homeowners on leased land who placed their names on the county tax rolls and who paid the taxes directly to the county were allowed to claim a deduction.

In New York, liability for tax is placed directly on the tenant and the landlord is a collecting agent for paying over the tax to the taxing authorities. However, since the landlord also remains liable for the tax, the IRS ruled that the tenant’s payment is in reality rent that cannot be deducted as a payment of real estate tax.

16.7 Allocating Taxes When You Sell or Buy Realty

When property is sold, the buyer and seller apportion the real estate taxes imposed on the property during the “real property year.” A “real property year” is the period that a real estate tax covers. This allocation is provided for you in a settlement statement at the time of closing. If you want to figure your own allocations, your local tax authority can give you the “real property year” of the taxes you plan to apportion. If you are the seller, you deduct that portion of the tax covering the beginning of the real property year through the day before the sale. If you are the buyer, you deduct the part of the tax covering the date of the sale through the end of the real property year, even if the seller paid the entire tax prior to your purchase.

The allocation of taxes between the buyer and seller is mandatory for a property year during which both the seller and buyer own the property, whether or not your contract provides for an allocation. However, you do not allocate taxes for a real property year that begins after the date of sale. The buyer gets the deduction for all of the tax for that year because he or she owns the property for the entire real property year. There also is no allocation for a real property year that ends before the date of sale. The seller gets the deduction for that year’s tax because the seller owned the property for that entire real property year.

Form 1099-S. If Form 1099-S is filed by the mortgage lender or real estate broker responsible for the closing, Box 6 will show the buyer’s share of the real estate tax paid in advance by the seller. For example, Smith sells her house in Green County, where the real estate tax is paid annually in advance. In the year of sale she paid $1,200 in real estate taxes. Assuming that the home is sold at the end of the ninth month of the real property tax year, the amount of the real estate tax allocable to the buyer is $300 ($100 per month × 3 months). This amount, which is shown as paid by the seller in advance on an HUD-1 (“Settlement Statement”) form provided at the closing, is reported as the buyer’s share of the real estate tax in Box 6 of Form 1099-S.

Seller’s deduction in excess of the allocated amount is taxed. If, in the year before the sale, the seller deducts an amount for taxes in excess of the allocated amount, the seller must report the excess as income in the year of the sale. This may happen when the seller is on the cash basis and pays the tax in the year before the sale.

Buyer may not deduct payment of seller’s back taxes. If you agree to pay the seller’s delinquent taxes as part of your purchase, the back taxes paid are added to your cost of the property. The amount realized on the sale by the seller is increased by your payment of the back taxes.

Seller’s payment upon buyer’s failure to pay. If a buyer is obligated to pay taxes under a land contract but fails to pay, the owner who pays the tax may deduct the payment if the tax is assessed to him or her.

Buyer of foreclosed property. If you buy realty at a tax sale and you do not receive immediate title to the property under state law until after a redemption period, you may not be able to deduct payment of realty taxes for several years.

16.8 Automobile License Fees

You may not deduct an auto license fee based on weight, model, year, or horsepower. But you may deduct a fee based on the value of the car as a state or local personal property tax (Line 7 of Schedule A) if these three tests are met: (1) the fee is an ad valorem tax, based on a percentage of value of the property; (2) it is imposed on an annual basis, even though it is collected more or less frequently; and (3) it is imposed on personal property. This third test is met even though the tax is imposed on the exercise of a privilege of registering a car or for using a car on the road.

The majority of state motor vehicle registration fees are not ad valorem taxes and do not qualify for the deduction. Various states and localities impose ad valorem or personal property taxes on motor vehicles that may qualify for the deduction. Contact a state or local authority to determine whether a license fee qualifies.

16.9 Taxes Deductible as Business Expenses

That a tax is not deductible as an itemized deduction does not mean you may not deduct it elsewhere on your return. For example, you may generally deduct property taxes incurred as a cost of doing business on Schedule C. Here are some other examples:

If you pay excise taxes on merchandise you sell in your business, you deduct the tax as a business expense. If you pay Social Security taxes (FICA) on your employees’ wages, you deduct the tax as a business expense on Schedule C. If you pay sales tax on business property, you add the tax to the cost of the property for depreciation purposes. If the tax is paid on nondepreciable property, the tax is included in the currently deductible cost. If you pay sales tax on a deductible business meal, the tax is deductible as part of the meal costs, subject to the 50% cost limit (20.24).

Note: If you are not a material participant in the business, your Schedule C expenses are subject to passive activity limitations; see Chapter 10.

Above-the-line deduction for 50% of self-employment tax. One-half of the self-employment tax figured on Schedule SE is deductible as an above-the-line adjustment to gross income on Line 27 of Form 1040 (45.3). This is not a business expense and is not deductible on Schedule C.

16.10 Foreign Taxes

You may deduct your payment of foreign real property taxes and income and excess profits taxes as itemized deductions. Where you pay foreign income or excess profits tax, you have an election of either claiming the tax as a deduction or a credit. Claiming the credit may provide a larger tax savings (36.13).