22.   Taxes

Table of Contents

    * Reminder
    * Introduction
          o Indian tribal government.
    * Useful Items - You may want to see:
    * Tests To Deduct Any Tax
    * Income Taxes
          o State and Local Income Taxes
          o Foreign Income Taxes
    * General Sales Taxes
    * Real Estate Taxes
          o Real estate taxes for prior years.
          o Examples.
          o Form 1099-S.
          o Real Estate-Related Items You Cannot Deduct
    * Personal Property Taxes
    * Taxes and Fees You Cannot Deduct
    * Where To Deduct

Reminder

Limit on itemized deductions. If your adjusted gross income is more than
$145,950 ($72,975 if you are married filing separately), the overall amount
of your itemized deductions may be limited. See chapter 29 for 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 you cannot deduct.

This chapter covers:

    *

      Income taxes (state, local, and foreign),
    *

      General sales taxes (state and local),
    *

      Real estate taxes (state, local, and foreign),
    *

      Personal property taxes (state and local), and
    *

      Taxes and fees you cannot deduct.

Use Table 22-1 as a guide to determine which taxes you can deduct.

At the end of the chapter is a section that explains which form you use to
deduct the different types of taxes.
Business taxes.   You can deduct certain taxes only if they are ordinary
and necessary expenses of your trade or business or of producing income.
For information on these taxes, see Publication 535, Business Expenses.

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 that is recognized
by the Secretary of the Treasury as performing substantial government
functions will be treated as a state for this purpose. Income taxes, real
estate taxes, and personal property taxes imposed by that Indian tribal
government (or by any of its subdivisions that are treated as political
subdivisions of a state) are deductible.

Foreign taxes.   These are taxes imposed by a foreign country or any of its
political subdivisions.

Useful Items - You may want to see:

Publication

    *

      514 Foreign Tax Credit for Individuals
    *

      530 Tax Information for First-Time Homeowners

Form (and Instructions)

    *

      Schedule A (Form 1040)
      Itemized Deductions
    *

      Schedule E (Form 1040)
      Supplemental Income and Loss
    *

      Form 1116
      Foreign Tax Credit

Tests To Deduct Any Tax

The following two tests must be met for any tax to be deductible by you.

    *

      The tax must be imposed on you.
    *

      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 your spouse owns property and pays real estate taxes on it, the
taxes are deductible on your spouse's separate return or on your joint return.

The tax must be paid during your tax year.   If you are a cash basis
taxpayer, you can deduct only those taxes actually paid during your tax
year. If you pay your taxes by check, the day you mail or deliver the check
is the date of payment, provided the check is honored by the financial
institution. 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 contest a tax liability and are a cash basis
taxpayer, you can deduct the tax only in the year it is actually paid.

   If you use an accrual method of accounting, see Publication 538,
Accounting Periods and Methods, for more information.

Income Taxes

This section discusses the deductibility of state and local income taxes
(including employee contributions to state benefit funds) and foreign
income taxes.
State and Local Income Taxes

You can deduct state and local income taxes. You can elect to deduct state
and local general sales taxes instead of state and local income taxes.
Exception.    You cannot deduct state and local income taxes you pay on
income that is exempt from federal income tax, unless the exempt income is
interest income. For example, you cannot deduct the part of a state's
income tax that is on a cost-of-living allowance that is exempt from
federal income tax.

What To Deduct

Your deduction may be for withheld taxes, estimated tax payments, or other
tax payments as follows.
Withheld taxes.   You can deduct state and local income taxes withheld from
your salary in the year they are withheld. For 2005, these taxes will be
shown in boxes 17 and 19 of your Form W-2. You may also have state or local
income tax withheld on Form W-2G (box 14), Form 1099-MISC (box 16), or Form
1099-R (boxes 10 and 13).

Estimated tax payments.   You can deduct estimated tax payments you made
during the year to 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, you made an
estimated state income tax payment. However, the estimate of your state tax
liability shows that you will get a refund of the full amount of your
estimated payment. You had no reasonable basis to believe you had any
additional liability for state income taxes and you cannot deduct the
estimated tax payment.

Refund applied to taxes.   You can deduct any part of a refund of
prior-year state or local income taxes that you chose to have credited to
your 2005 estimated state or local income taxes.

   Do not reduce your deduction by either of the following items.

    *

      Any state or local income tax refund (or credit) you expect to
receive for 2005.
    *

      Any refund of (or credit for) prior year state and local income taxes
you actually received in 2005.

However, part or all of this refund (or credit) may be taxable. See Refund
(or credit) of state or local income taxes, later.

Separate federal returns.   If you and your spouse file separate state,
local, and federal income tax returns, you each can deduct on your federal
return only the amount of your own state and local income tax.

Joint state and local returns.   If you and your spouse file joint state
and local returns and separate federal returns, each of you can deduct on
your separate federal return part of the state and local 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.
However, you cannot deduct more than the amount you actually paid during
the year. You can avoid this calculation if you and your spouse are jointly
and individually liable for the full amount of the state and local income
taxes. If so, you and your spouse can deduct on your separate federal
returns the amount you each actually paid.

Joint federal return.   If you file a joint federal return, you can deduct
the total of the state and local income taxes both of you paid.

Contributions to state benefit funds.    As an employee, you can deduct
mandatory contributions to state benefit funds that provide protection
against loss of wages. Mandatory payments made to the following state
benefit funds are deductible as state income taxes on Schedule A (Form
1040), line 5.

    *

      California Nonoccupational Disability Benefit Fund.
    *

      New Jersey Nonoccupational Disability Benefit Fund.
    *

      New Jersey Unemployment Compensation Fund.
    *

      New York Nonoccupational Disability Benefit Fund.
    *

      Rhode Island Temporary Disability Benefit Fund.
    *

      Washington State Supplemental Worker's Compensation Fund.
    *

      West Virginia Unemployment Compensation Fund.

  
Caution
Employee contributions to private or voluntary disability plans are not
deductible.

Refund (or credit) of state or local income taxes.   If you receive a
refund of (or credit for) state or local income taxes in a year after the
year in which you paid them, you may have to include the refund in income
on Form 1040, line 10, in the year you receive it. This includes refunds
resulting from taxes that were overwithheld, applied from a prior year
return, not figured correctly, or figured again because of an amended
return. If you did not itemize your deductions in the previous year, do not
include the refund in income. If you deducted the taxes in the previous
year, include all or part of the refund on Form 1040, line 10, in the year
you receive the refund. For a discussion of how much to include, see
Recoveries in chapter 12.

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 U.S. tax under the foreign earned income exclusion or
the foreign housing exclusion. For information on these exclusions, see
Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. For
information on the foreign tax credit, see Publication 514.
General Sales Taxes

You can elect to deduct state and local general sales taxes, instead of
state and local income taxes, as an itemized deduction on Schedule A (Form
1040), line 5. Generally, you can use either your actual expenses or the
state and local sales tax tables to figure your state and local general
sales tax deduction. See the Instructions for Schedule A (Form 1040), line
5, for details.
Real Estate Taxes

Deductible real estate taxes are any state, local, or foreign taxes on real
property levied for the general public welfare. You can deduct these taxes
only if they are based on the assessed value of the real property and
charged uniformly against all property under the jurisdiction of the taxing
authority.

Deductible real estate taxes generally do not include taxes charged for
local benefits and improvements that increase the value of the property.
They also do not include itemized charges for services (such as trash
collection) to specific property or people, even if the charge is paid to
the taxing authority. For more information about taxes and charges that are
not deductible, see Real Estate-Related Items 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. The corporation should provide you with a
statement showing your share of the taxes. For more information, see
Special Rules for Cooperatives in Publication 530.

Buyers and sellers 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, but not including, the date of sale. The buyer is
treated as paying the taxes beginning with the date of sale. This applies
regardless of the lien dates under local law. Generally, this information
is included on the settlement statement provided at the closing.

   If you (the seller) cannot deduct taxes until they are paid because you
use the cash method of accounting, and the buyer of your property is
personally liable for the tax, you are considered to have paid your part of
the tax 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. However, you
must also include the amount of that tax in the selling price of the
property. The buyer must include the same amount in his or her cost of the
property.

  You figure your deduction for taxes on each property bought or sold
during the real property tax year as follows.

Worksheet 22-1.
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 (for leap years, divide line 2 by 366) 	.
4. 	Multiply line 1 by line 3. This is your deduction. Enter it on Schedule
A (Form 1040), line 6 	 
Note. Repeat steps 1 through 4 for each property you bought or sold during
the real property tax year.

Real estate taxes for prior years.   Do not divide delinquent taxes between
the buyer and seller if the taxes are for any real property tax year before
the one in which the property is sold. Even if the buyer agrees to pay the
delinquent taxes, the buyer cannot deduct them. The buyer must add them to
the cost of the property. The seller can deduct these taxes paid by the
buyer. However, the seller must include them in the selling price.

Examples.   The following examples illustrate how real estate taxes are
divided between buyer and seller.

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 7, was $620. The tax on their new home, bought
on May 3, 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 a 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
127 days (January 1 to May 6, 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 	126
3. 	Divide line 2 by 365 (for leap years, divide line 2 by 366) 	.345
4. 	Multiply line 1 by line 3. This is your deduction. Enter it on Schedule
A (Form 1040), line 6 	$214

Since the buyers of their old home paid all of the taxes, Dennis and Beth
also include the $214 in the selling price of the old home. (The buyers add
the $214 to their cost of the home.)

Dennis and Beth owned their new home during the real property tax year for
243 days (May 3 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 	243
3. 	Divide line 2 by 365 (for leap years, divide line 2 by 366) 	.666
4. 	Multiply line 1 by line 3. This is your deduction. Enter it on Schedule
A (Form 1040), line 6 	$488

Since Dennis and Beth paid all of the taxes on the new home, they add $244
($732 paid less $488 deduction) to their cost of the new home. (The sellers
add this $244 to their selling price and deduct the $244 as a real estate tax.)

Dennis and Beth's real estate tax deduction for their old and new homes is
the sum of $214 and $488, or $702. They will enter this amount on Schedule
A (Form 1040), line 6.

Example 2.

George and Helen Brown bought a new home on May 3, 2005. Their real
property tax year for the new home is the calendar year. Real estate taxes
for 2004 were assessed in their state on January 1, 2005. The taxes became
due on May 31, 2005, and October 31, 2005.

The Browns agreed to pay all taxes due after the date of purchase. Real
estate taxes for 2004 were $680. They paid $340 on May 31, 2005, and $340
on October 31, 2005. These taxes were for the 2004 real property tax year.
The Browns cannot deduct them since they did not own the property until
2005. Instead, they must add $680 to the cost of their new home.

In January 2006, the Browns receive their 2005 property tax statement for
$752, which they will pay in 2006. The Browns owned their new home during
the 2005 real property tax year for 243 days (May 3 to December 31). They
will figure their 2006 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 	243
3. 	Divide line 2 by 365 (for leap years, divide line 2 by 366) 	.666
4. 	Multiply line 1 by line 3. This is your deduction. Claim it on Schedule
A (Form 1040), line 6 	$501

The remaining $251 ($752 paid less $501 deduction) of taxes paid in 2006,
along with the $680 paid in 2005, is added to the cost of their new home.

Because the taxes up to the date of sale are considered paid by the seller
on the date of sale, the seller is entitled to a 2005 tax deduction of
$931. This is the sum of the $680 for 2004 and the $251 for the 122 days
the seller owned the home in 2005. The seller must also include the $931 in
the selling price when he or she figures the gain or loss on the sale. The
seller should contact the Browns in January 2006 to find out how much real
estate tax is due for 2005.
Form 1099-S.   For certain sales or exchanges of real estate, the person
responsible for closing the sale (generally the settlement agent) prepares
Form 1099-S, Proceeds From Real Estate Transactions, to report certain
information to the IRS and to the seller of the property. Box 2 of the form
is for the gross proceeds of the sale and should include the portion of the
seller's real estate tax liability that the buyer will pay after the date
of sale. The buyer includes these taxes in the cost basis of the property,
and the seller both deducts this amount as a tax paid and includes it in
the sales price of the property.

  For a real estate transaction that involves a home, any real estate tax
the seller paid in advance but that is the liability of the buyer appears
on Form 1099-S, box 5. The buyer deducts this amount as a real estate tax,
and the seller reduces his or her real estate tax deduction (or includes it
in income) by the same amount. See Refund (or rebate), later.

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 may not be able to deduct the total amount placed in escrow. You
can deduct only the real estate tax that the third party actually paid to
the taxing authority. If the third party does not notify you of the amount
of real estate tax that was paid for you, contact the third party or the
taxing authority to find the proper amount to show on your return.

Tenants by the entirety.   If you and your spouse held property as tenants
by the entirety and you file separate federal returns, each of you can
deduct only the taxes each of you paid on the property.

Divorced individuals.   If your divorce or separation agreement states that
you must pay the real estate taxes for a home owned by you and your spouse,
part of your payments may be deductible as alimony and part as real estate
taxes. See Taxes and insurance in chapter 18 for more information.

Minister's and military personnel 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.

Refund (or rebate).   If you receive a refund or rebate in 2005 of real
estate taxes you paid in 2005, you must reduce your deduction by the amount
refunded to you. If you receive a refund or rebate in 2005 of real estate
taxes you deducted in an earlier year, you generally must include the
refund or rebate in income in the year you receive it. However, you only
need to include the amount of the deduction that reduced your tax in the
earlier year. For more information, see Recoveries in chapter 12.

  
Tip
If you did not itemize deductions in the year you paid the tax, do not
report the refund as income.

Table 22-1. Which Taxes Can You Deduct?
  	You Can Deduct 	You Cannot Deduct
Income Taxes 	State and local income taxes.
Foreign income taxes.
Employee contributions to state funds listed
under Contributions to state benefit funds.
One-half of self-employment tax paid. 	Federal income taxes.
Employee contributions to private or voluntary
disability plans.
State and local general sales taxes (if you choose to deduct state and
local income taxes).
General Sales Taxes 	State and local general sales taxes. 	State and local
income taxes (if you choose to deduct state and local general sales taxes).
Real Estate Taxes 	State and local real estate taxes.
Foreign real estate taxes.
Tenant's share of real estate taxes paid by
cooperative housing corporation. 	Taxes for local benefits (with exceptions).
Trash and garbage pickup fees (with exceptions).
Rent increase due to higher real estate taxes.
Homeowners association charges.
Personal Property Taxes 	State and local personal property taxes. 	Import
duties.
Other Taxes 	Taxes that are expenses of your trade or business
or of producing income.
Taxes on property producing rent or royalty
income.
Occupational taxes. See chapter 28. 	State and local sales and use taxes.
Federal excise taxes, such as telephone taxes
(see Taxes and Fees You Cannot Deduct).
Per capita taxes.
Fees and Charges 	Fees and charges that are expenses of your trade or
business or of producing income. 	Fees and charges that are not expenses of
your trade or business or of producing income, such as fees for driver's
licenses, car inspections, parking, or charges for water bills (see Taxes
and Fees You Cannot Deduct).
  	  	Fines and penalties.
Real Estate-Related Items You Cannot Deduct

Payments for the following items generally are not deductible as real
estate taxes.

    *

      Taxes for local benefits.
    *

      Itemized charges for services (such as trash and garbage pickup fees).
    *


      Transfer taxes (or stamp taxes).
    *

      Rent increases due to higher real estate taxes.
    *

      Homeowners' association charges.

Taxes for local benefits.   Deductible real estate taxes generally do not
include taxes charged for local benefits and improvements tending to
increase the value of your property. 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 only 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.

  Taxes for local benefits may be included in your real estate tax bill. If
your taxing authority (or mortgage lender) does not furnish you a copy of
your real estate tax bill, ask for it. You should use the rules above to
determine if the local benefit tax is deductible.

Itemized charges for services.    An itemized charge for services to
specific property or people is not a tax, even if the charge is paid to the
taxing authority. For example, you cannot deduct the charge as a real
estate tax if it is:

    *

      A unit fee for the delivery of a service (such as a $5 fee charged
for every 1,000 gallons of water you use),
    *

      A periodic charge for a residential service (such as a $20 per month
or $240 annual fee charged to each homeowner for trash collection), or
    *

      A flat fee charged for a single service provided by your government
(such as a $30 charge for mowing your lawn because it was allowed to grow
higher than permitted under your local ordinance).

  
Caution
You must look at your real estate tax bill to determine if any
nondeductible itemized charges, such as those just listed, are included in
the bill. If your taxing authority (or mortgage lender) does not furnish
you a copy of your real estate tax bill, ask for it.

Exception.   Service charges used to maintain or improve services (such as
trash collection or police and fire protection) are deductible as real
estate taxes if:

    *

      The fees or charges are imposed at a like rate against all property
in the taxing jurisdiction,
    *

      The funds collected are not earmarked; instead, they are commingled
with general revenue funds, and
    *

      Funds used to maintain or improve services are not limited to or
determined by the amount of these fees or charges collected.

Transfer taxes (or stamp taxes).   Transfer taxes and similar 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.

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

Personal property tax is deductible if it is a state or local tax that is:

    *

      Charged on personal property,
    *

      Based only on the value of the personal property, and
    *

      Charged on a yearly basis, even if it is collected more or less than
once a year.

A tax that meets the above requirements 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.

If the tax is partly based on value and partly based on other criteria, it
may qualify in part.

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 because it is based on the value. The remaining $17
($.50 × 34), based on the weight, is not deductible.
Taxes and Fees You Cannot Deduct

Many federal, state, and local government taxes are not deductible because
they do not fall within the categories discussed earlier. Other taxes and
fees, such as federal income taxes, are not deductible because the tax law
specifically prohibits a deduction for them. See Table 22-1.

Taxes and fees that are generally not deductible include the following items.

    *

      Estate, inheritance, legacy, or succession taxes. However, you can
deduct the estate tax attributable to income in respect of a decedent if
you, as a beneficiary, must include that income in your gross income. In
that case, deduct the estate tax as a miscellaneous deduction that is not
subject to the 2%-of-adjusted-gross-income limit. For more information, see
Publication 559.
    *

      Federal income taxes. This includes taxes withheld from your pay.
    *

      Fines. You cannot deduct penalties for violation of any law,
including forfeiture of related collateral deposits.
    *

      Gift taxes.
    *

      License fees. You cannot deduct license fees for personal purposes
(such as marriage, driver's, and dog license fees).
    *

      Per capita taxes. You cannot deduct state or local per capita taxes.
    *

      Social security. This includes social security, Medicare, or railroad
retirement taxes withheld from your pay.
    *

      Social security and other employment taxes for household workers.
However, the social security and other employment taxes you pay on the
wages of a household worker may qualify as medical or child care expenses.
For more information, see chapters 21 and 32.

Many taxes and fees other than those listed above are also nondeductible,
unless they are ordinary and necessary expenses of a business or income
producing activity. For other nondeductible items, see Real Estate-Related
Items You Cannot Deduct, earlier.
Where To Deduct

You deduct taxes on the following schedules.
State and local income taxes.    These taxes are deducted on Schedule A
(Form 1040), line 5, even if your only source of income is from business,
rents, or royalties. You must check box a on line 5. If you deduct these
taxes, you cannot elect to deduct general sales taxes.

General sales tax deduction.    These taxes are deducted on Schedule A
(Form 1040), line 5. You must check box b on line 5. If you elect to deduct
these taxes, you cannot deduct state and local income taxes.

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), line 8, or as a credit against your U.S. income tax
on Form 1040, line 47. To claim the credit, you may have to complete and
attach Form 1116. For more information, see chapter 37, the Form 1040
instructions, or Publication 514.

Real estate taxes and personal property taxes.    These taxes are deducted
on Schedule A (Form 1040), lines 6 and 7, unless they are paid on property
used in your business in which case they are deducted on Schedule C,
Schedule C-EZ, or Schedule F (Form 1040). Taxes on property that produces
rent or royalty income are deducted on Schedule E (Form 1040).

Self-employment tax.    Deduct one-half of your self-employment tax on Form
1040, line 27.

Other taxes.    All other deductible taxes are deducted on Schedule A (Form
1040), line 8.