Take advantage of the sales tax deduction

By Kay Bell

Most states and cities get a good portion of their operating revenue from sales taxes tagged onto just about everything you buy. But on the federal level, Uncle Sam lets taxpayers use those taxes to help reduce their IRS bills.

The sales tax deduction is particularly welcomed by taxpayers in states that do not collect income taxes but do levy state sales taxes. It also could benefit taxpayers who face substantial local sales taxes. Even some residents of states with both types of taxes might find the sales tax deduction is more valuable to them than the income tax write-off.

Most people typically pay more in state income taxes than in state and local sales taxes. But double check just in case. Depending on your state's income tax rate and how much you made (and paid), your sales tax amount could be greater.

But regardless of your state's tax collection practices, to take full advantage of the sales tax deduction, you have to know exactly how to file for it and just which taxes you can claim.

Choosing your deduction method

The process begins with your answers to two filing questions. First, do you plan to itemize? If so, then which write-off -- sales taxes or income taxes -- will give you the biggest break?

Deciding whether to itemize deductions or claim the standard amount is always a key tax-time choice. The Internal Revenue Service says that most people take the standard deduction. It's easy to claim; there are no forms or work sheets to fill out and each year the standard deduction increases, thanks to inflation adjustments.

But if you use the standard deduction, you can't take the sales tax break. To claim the sales taxes you paid, you must itemize.

There is one exception on 2010 returns for filers who bought a new vehicle in 2009 and, under a temporary law were able to add sales tax on the vehicle to their standard deduction amount. If that sales tax wasn't paid until 2010, those auto buyers can use this option this filing season by filing Schedule L.

For most taxpayers, though, the choice is standard or itemized deductions. If sales taxes are your only deductible expense, then it's not worth it to itemize. This one itemized deduction will likely be much less than your standard deduction, and you always want to take the largest tax deduction amount you're allowed.

Taxpayers who itemize expenses will have to decide which option -- deducting sales taxes or income taxes -- will give them the biggest break.

Writing off the right amount

Then there's the issue of just how much in sales taxes you can claim. If you have the documentation, there is no limit on the deduction amount.

Even if you don't have all your receipts, you still might be able to recreate many of your sales tax payments. William Abrams, a partner in the law firm Abrams Garfinkel Margolis Bergson LLP, with offices in California and New York, notes that many types of records, such as credit card statements, are available online. By accessing them, he says, taxpayers could improve the accuracy of their annual sales-tax computations.

The actual receipt calculation might be worthwhile if you made a lot of purchases last year. Scenarios involving costly and taxable expenditures include:

* You bought a lot of electronic equipment.

* You moved to your first or a new home and furnished it.

* You bought expensive jewelry, such as an engagement ring.

* You paid for the wedding that followed that ring purchase.

"You're more likely to have kept receipts for these items for insurance purposes or because they were mind-boggling," says Bob D. Scharin, senior tax analyst from the Tax and Accounting business of Thomson Reuters. "Basically, you're looking for spending that's disproportionate to your income."

Most filers, however, will claim the amount that the IRS has figured for them in special sales-tax tables; one for each applicable state. The deduction amounts are based on the average consumption by taxpayers, taking into account filing status, number of dependents, adjusted gross income and rates of state and local general sales taxation.

The IRS tables with standard sales tax deduction amounts can be found in the Schedule A instructions. The IRS also offers an online sales tax deduction calculator.

Counting all your income

But even with the tables, it's not quite that simple. In using the data, you need to keep a couple of things in mind to get the biggest deduction.

First, don't rely solely on your 1040 information when you read the table. The figure you enter on your federal return is taxable income, but Scharin says that the sales tax table amounts are based on total income, not just your adjusted, taxable income. You should take nontaxable income amounts into account for sales tax deduction purposes, he says, because the larger your total income, the larger your sales tax deduction.

These other types of income include municipal bond or other tax-exempt interest, workers' compensation, nontaxable combat pay, the nontaxable portion of Social Security and other retirement benefits, as well as the nontaxable parts of an IRA, including a Roth IRA distribution.

Also, most of the tables only cover the state rates. "If you have a local sales tax, which many people don't realize, you could be sacrificing some of the deduction if you use only the table amount," says Scharin.

To account for local sales taxes, you're going to have to do some extra calculating. If you're not using tax software, a work sheet, also in the Schedule A instructions, will help you determine the correct number.

You also could have some extra math to do if you lived in different states that collected sales taxes. In this case, you must determine each state's sales tax amount to arrive at your appropriate, combined deduction.

Sales taxes you paid on the purchase of motor vehicles, boats, aircraft and, in some cases, building materials for a substantial addition to or renovation of an existing structure also can be counted on top of your sales tax table and local tax amounts. These additional amounts will be accounted for in the previously mentioned sales tax work sheet.

While all these considerations will definitely mean more work for some taxpayers, Scharin says, "If you went this far and you're itemizing, you might as well get your full deduction."