Should You Take This Tax Break?

If you live in one of nine states with no income tax on wages, here's some good news: A new law lets you deduct state and local sales tax on your federal return. The break is good only for this tax season and next, unless Congress acts to extend it. For everyone else, the new law gives you the option of deducting either your state and local sales tax or your state and local income tax -- but not both. As a result, you'll have to crunch some numbers to see which deduction gets you the most savings.

If you pay state income tax, chances are you'll come out ahead with the income tax deduction. But there are exceptions. Big spenders should run the numbers. So should residents of states, including Illinois and Michigan, where income tax rates are lower than the sales tax rate, says John Logan, senior state tax analyst at CCH Tax & Accounting in Riverwoods, Ill. Here are answers to some questions about how the sales tax deduction works.

I haven't saved my receipts. Can I claim the sales tax deduction?

Yes. The Internal Revenue Service gives you two ways to claim this deduction. The first is to use your actual expenditures. The alternative is to rely on the tables in the IRS' Publication 600 (available at Look up your home state -- since sales tax rates vary, so do the deductions. The amount you deduct will also depend on your family's size and adjusted gross income (with a few nontaxable items, such as tax-exempt interest, added). For example, the tables allow an Illinois resident with four exemptions and $120,000 in adjusted income to deduct $1,611.

What about local sales taxes?

Since the IRS tables are based solely on state sales tax rates, those who pay local sales tax will have to do some extra math using the worksheet in Publication 600. Give the Illinois family above a Chicago address, for instance, and it can claim an extra $644.40 in deductions for local sales tax payments. That brings the deduction to $2,255.40.

What if I bought a big-ticket item?

If you bought a boat, car, truck, or other item listed in Publication 600 or leased a motor vehicle, add the sales tax you paid to the table amount you're allotted. With a $30,000 car purchase, the Chicago family's total sales tax deduction comes to $4,880. That exceeds the $3,600 state income tax deduction allowed on $120,000 of taxable income.

Should I save receipts in 2005?

It's worth saving your receipts if you think you spend more than the IRS tables assume. To figure that out, start by looking up your deduction in Publication 600. Then, divide by your state's sales tax rate. Since Illinois has a 6.25% sales tax rate, the Illinois family would divide $1,611 by 0.0625. The result -- $25,776 -- represents what the IRS expects an average Illinois family of four with $120,000 of adjusted income to have spent in 2004, excluding big-ticket purchases. If this family spends more, it's likely to net a fatter sales tax deduction on its 2005 return by booking actual expenditures.

What if I moved?

Calculate a combined sales tax deduction covering the states you lived in. Say you spent the first 250 days of 2004 in Illinois. Start with the $1,611 Illinois deduction. Then, multiply by the portion of the year you lived in Illinois -- or 250 days divided by the 366 days in 2004. The result, $1,100, is the Illinois sales tax you can claim. Repeat this exercise with the other states you lived in, and add the results to get your total deduction.

When computing the alternative minimum tax, how is the new deduction treated?

As is the case with the state and local income tax deduction, the AMT wipes out the sales tax deduction, says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young.

Do all purchases qualify?

No. Some states levy special taxes on items such as hotel rooms and restaurant meals that generally aren't deductible, CCH's Logan says. But if in your state you pay different rates on food, clothing, medical supplies, and motor vehicles, you can still generally claim a deduction for the amount you paid, says William Massey, senior tax analyst at tax information provider RIA.

I live in a state with a high income tax rate. Should I bother doing the math?

In some situations, you still might do better with the sales tax. If you have a lot of tax-free municipal bond income, you may pay so little in income tax that the sales tax deduction is the better alternative, says Alfred Peguero, partner at PricewaterhouseCoopers. If this was a year of big purchases, you may also come out ahead by deducting sales taxes. When in doubt, do the numbers.

By Anne Tergesen

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