Can You Deduct State Income Tax on Federal Taxes?

It is possible to deduct state income taxes on your federal tax return, but limitations apply. This deduction can help reduce your taxable income, potentially lowering your overall federal tax liability. Understanding the specific rules and limitations is important for taxpayers.

General Rules for Deduction

To deduct state income taxes on your federal return, you must itemize your deductions. Itemizing involves listing eligible expenses, such as mortgage interest, medical expenses, and certain taxes, on Schedule A (Form 1040). The standard deduction is a fixed amount determined by your filing status. You should itemize only if your total itemized deductions exceed your standard deduction amount, as you cannot claim both.

The deduction applies to amounts actually paid during the tax year, including state income tax withheld from wages, estimated payments, and any prior year’s state income taxes paid in the current year. This means the deduction is for taxes paid, not necessarily the amount of tax liability incurred for the year. For instance, estimated taxes paid in December for the current year are deductible in the year they were made.

Understanding the State and Local Tax Cap

A key limitation on deducting state income taxes, along with other state and local taxes (SALT), is the cap introduced by the Tax Cuts and Jobs Act (TCJA) of 2017. It established a maximum deduction of $10,000 for state and local taxes, or $5,000 if you are married filing separately. This cap applies to the total of all state and local taxes combined, not just state income taxes.

The SALT cap, effective from 2018 through 2025, impacted taxpayers, particularly those residing in states with high income and property taxes. Before the TCJA, there was no limit on the amount of state and local taxes that could be deducted. This cap meant that many taxpayers, especially those in high-tax areas, could no longer deduct the full amount of their state and local tax payments, leading to a higher federal tax burden for some.

For example, a taxpayer paying $15,000 in state income tax and $8,000 in property tax, totaling $23,000 in state and local taxes, can only deduct $10,000 on their federal return due to the cap. This contrasts sharply with the pre-2018 period where the entire $23,000 could have been deducted. While the $10,000 cap was initially set to expire after 2025, recent legislative changes have temporarily increased this limit to $40,000 for tax years beginning in 2025, with a phasedown for higher-income taxpayers. This temporary increase will gradually rise by 1% each year through 2029 before reverting to the $10,000 limit in 2030.

Types of Deductible State and Local Taxes

The $10,000 state and local tax (SALT) cap encompasses a range of taxes, not solely state income taxes. Taxpayers can deduct a combination of state and local income taxes, state and local real estate taxes, and state and local personal property taxes under this limitation.

Alternatively, taxpayers can choose to deduct state and local general sales taxes instead of state and local income taxes. You must select one or the other, not both. This option can be beneficial for individuals living in states that do not impose an income tax, or for those who made significant purchases during the year, resulting in higher sales tax paid. The Internal Revenue Service (IRS) provides tables for estimating sales tax deductions if actual receipts are not maintained.

Real estate taxes are deductible under the SALT cap. State and local personal property taxes, often assessed on items like vehicles, also qualify for the deduction. These taxes contribute to the overall $10,000 limit, meaning that if your property taxes alone exceed $10,000, you will not be able to deduct any state income or sales taxes.

Claiming the Deduction on Your Tax Return

To claim the deduction for state income taxes and other eligible state and local taxes, you must report these amounts on Schedule A (Form 1040). These taxes are entered in the “Taxes You Paid” section of Schedule A, where you list the total of your state and local income, real estate, and personal property taxes paid during the tax year.

When preparing your tax return, you will need documentation such as your Form W-2, which shows state income tax withheld by your employer. If you made estimated state tax payments or paid a prior year’s state tax liability, records are necessary. Tax preparation software or a tax professional will then apply the $10,000 limitation to the total amount of state and local taxes entered in this section.

Maintain accurate records of all tax payments, as the IRS may request verification of the amounts claimed. The information from Schedule A is then transferred to your main Form 1040, where it contributes to the calculation of your adjusted gross income and ultimately your taxable income. Deciding to itemize and claim these deductions requires careful consideration of your total eligible expenses versus the standard deduction amount.

State-Level Strategies to Address the SALT Cap

In response to the federal state and local tax (SALT) cap, many states have implemented strategies through Pass-Through Entity (PTE) taxes. These state-level PTE taxes allow certain business entities, such as S-corporations and partnerships, to elect to pay state income taxes at the entity level rather than having individual owners pay them directly. The tax paid by the entity is generally deductible as a business expense for federal income tax purposes.

This entity-level deduction bypasses the individual $10,000 SALT cap. When the entity pays the tax and deducts it, the net income passed through to the individual owners is reduced, allowing them a federal tax benefit from state tax payments otherwise limited by the cap. While the tax is paid at the entity level, many state PTE tax laws provide a corresponding credit to the individual owners on their personal state income tax returns, preventing double taxation at the state level.

The Internal Revenue Service (IRS) issued guidance, Notice 2020-75, confirming that entity-level state income tax payments by pass-through entities are deductible in computing the entity’s non-separately stated income or loss, and are not subject to the $10,000 individual SALT cap. This guidance provided clarity and encouraged more states to adopt PTE tax workarounds; over 30 states have enacted such laws. This strategy primarily benefits business owners, as it does not apply to wage earners who do not have an ownership interest in a pass-through entity.