SALT Deduction: How State & Local Taxes Reduce Federal Liability

It’s a common point of confusion, but to clarify upfront: state and local taxes aren’t actually included in the calculation of your federal income tax in the way that income is. Instead, they are potentially deductible. This distinction is crucial for understanding how these taxes interact with your federal tax liability. The reason we discuss state and local taxes in the context of federal income tax is because, for many years and still to a limited extent today, taxpayers have been allowed to deduct certain state and local taxes when calculating their federal taxable income. This deduction, often referred to as the state and local tax (SALT) deduction, effectively reduces the amount of income that is subject to federal income tax.

Think of it this way: your federal income tax system is designed to tax your income at the federal level. However, the government recognizes that individuals and families also bear a significant tax burden at the state and local levels. These can include property taxes, sales taxes, and state and local income taxes. To mitigate what could be perceived as “double taxation” – being taxed by both state/local and federal governments on the same income – the federal government has historically allowed taxpayers to deduct some of these state and local taxes from their federal taxable income.

The rationale behind allowing this deduction is multifaceted. Firstly, it acknowledges the reality of fiscal federalism in the United States. State and local governments provide essential services like education, infrastructure, public safety, and sanitation. These services are funded through state and local taxes. Allowing a deduction for these taxes at the federal level can be seen as a way to implicitly support these state and local government functions by reducing the overall tax burden on citizens. It’s a form of federal recognition of the financial responsibilities borne at lower levels of government.

Secondly, the deduction promotes a degree of fairness and equity in the federal tax system. Without the SALT deduction, taxpayers in states with higher state and local taxes would effectively have a higher overall tax burden compared to those in states with lower taxes, even if their pre-tax income were the same. The deduction helps to level the playing field to some extent, recognizing that the cost of living and the tax environment can vary significantly across different states and localities.

Historically, taxpayers could deduct the full amount of their state and local property taxes, real estate taxes, personal property taxes, and either state and local income taxes or general sales taxes. This deduction was a significant benefit, particularly for taxpayers in states with higher tax rates or higher property values. However, the Tax Cuts and Jobs Act of 2017 brought about a major change. This legislation placed a limit of $10,000 per household on the total amount of deductible state and local taxes. This cap significantly reduced or eliminated the SALT deduction benefit for many taxpayers, especially those in high-tax states.

Despite the limitation, the principle of the SALT deduction remains relevant. It still acknowledges the interaction between different levels of taxation in the U.S. system. Even with the cap, taxpayers who pay state and local taxes, particularly property taxes and state income taxes, should be aware of the potential to deduct up to $10,000 of these taxes when filing their federal income tax return. This deduction is typically claimed as an itemized deduction on Schedule A of Form 1040.

In conclusion, while state and local taxes aren’t directly “included” in the calculation of your federal income tax in the sense of being added to your income, their deductibility is a critical aspect of the federal tax system. This deduction, even with its current limitations, reflects a historical and ongoing recognition of the tax burdens borne at state and local levels, aiming to mitigate double taxation, promote fiscal federalism, and foster a degree of fairness in the overall tax system. Understanding the SALT deduction, its history, and its current limitations is an important element of financial literacy for anyone navigating the complexities of the U.S. tax landscape.