The SALT deduction or State and Local Tax deduction you pay certainly reduces your taxable income when you claim an itemized deduction on the federal tax returns. However, this post informs you of seven specific situations where this deduction is not permitted. If you are new to this topic, please read “What is SALT deduction?“
Video on State and Local Tax Deductions Under Federal Law
1. State and Local Tax Deduction Limitation Courtesy TCJA
The Tax Cuts and Jobs Act, or TCJA, set a cap on the SALT deduction. According to IRC §164(b)(6), starting from the tax year 2018, the SALT deduction for individual taxpayers is limited to $10,000 ($5,000 for married taxpayers filing separately). This limitation applies to the total of SALT, sales, and property taxes; any taxes paid above this limit are not deductible.
2. Taxes Paid or Accrued for Business or Investment Purposes
Certain state and local taxes paid or accrued in carrying on a trade, business, or income-producing activity are not allowed as SALT deductions. Instead, these taxes must be treated as a business expense under IRC §164(a). Such taxes include state income taxes on business income, property taxes on rental properties, and sales taxes on business purchases.
3. Taxes Paid or Accrued in Connection with a Tax Shelter
As per Revenue Ruling 84-135, state and local taxes paid or accrued in connection with a tax shelter are not allowed as a SALT deduction.
A tax shelter is a financial arrangement or investment strategy that aims to reduce or minimize taxpayers’ taxable income and tax liability. Tax shelters can be legal or illegal, depending on whether they follow the tax regulations set forth by the Internal Revenue Service (IRS) and other tax authorities.
Instead, these taxes are treated as a tax shelter expense and are subject to the limitations and restrictions applicable to tax shelter investments.
4. Foreign Taxes Paid or Accrued
The SALT deduction does not apply to foreign taxes paid or accrued. According to IRC §164(a)(3), foreign taxes are excluded from the deductible state and local tax list. Instead, taxpayers may be eligible for a foreign tax credit or deduction under IRC §901 or §164(a)(3) for certain taxes paid or accrued on their foreign income.
5. Fines, Penalties, and Interest by State
State and local taxes in the form of fines, penalties, or interest are not deductible as SALT. In Revenue Ruling 79-410, the IRS clarified that any amount paid as a fine or penalty to a governmental authority due to the violation of a law is not allowed as a SALT deduction. Additionally, interest payments on tax underpayments or late charges are not deductible.
6. Taxes Paid on State-Exempt Income
If a taxpayer receives income exempt from federal income tax, any state or local taxes paid on that exempt income are disallowed as a SALT deduction. As per IRC §265(a)(1), no deduction is allowed for any expenses, including taxes, that are allocable to tax-exempt income.
7. State and Local Taxes Claimed as Credits
If a taxpayer claims a state or local tax credit for taxes paid, the amount of the credit may reduce the allowable SALT deduction. In Revenue Ruling 2011-26, the IRS clarified that if a taxpayer claims a state tax credit for taxes paid to another state, the taxpayer must reduce their SALT deduction by the amount of the credit.
Understanding the situations where SALT deductions are disallowed while computing federal taxes is essential to ensure accurate tax filings. By knowing these regulations, taxpayers can avoid potential tax errors and possible penalties associated with noncompliance.
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