Tax deductions: Your questions answered

George W Bush would never raise taxes, oh no. But according to a trial balloon

being floated today in the New

York Times and a few weeks ago in the LA

Times, he might eliminate tax deductions, especially those which

overwhelmingly benefit those notoriously blue states New York and California.

The federal deduction for state and local taxes, we’re told, is alone worth

$46 billion a year.

Despite having an extra three weeks to write the story, the New York Times

piece, by Ian Urbina, still doesn’t really add anything to the LA Times story:

in fact, it raises one enormous question which it doesn’t even attempt to answer.

The way this deduction works is that you don’t need to pay federal income tax

on money which you’ve already given to the state in the form of state and local

income tax. If you earn $100,000 a year and you pay $5,000 of that in state

and local taxes, you pay federal income tax not on your full $100,000 income,

but only on the $95,000 which is left over.

According to a New York City official quoted in the New York Times piece, the

change would mean that New Yorkers "could expect an 11 percent increase

in the amount they pay the IRS," because they take deductions not only

for New York State taxes but also for New York City taxes.

Then, however, things get confusing. According to the New York Times, "the

change would affect about 3.2 million households in New York"; the LA Times

is more useful, saying that those 3.2 million households comprise 37% of all

tax filers in the state.

Both papers quote Bruce Bartlett, a former Treasury official. In the LA Times,

he says that "it’s one of the biggest deductions most people have on their

tax returns". But in fact, even in New York and California, "most

people" turns out to be just 37% of tax filers.

This makes little sense to me. If you pay federal income tax, then you pay

state income tax. If state income tax is deductible, how come 63% of filers

fail to deduct it? I’ve been poring over my 2003 tax returns, and not only can’t

I find the deduction anywhere, I can’t even find a place where I might be able

to claim it.

Thanks to ehow.com,

however, I’ve worked out what’s going on here. Americans have a choice on their

tax returns: they can either itemize deductions, or they can claim the standard

deduction, which last year was $4,750 for single people like me, $9,500 for

married couples filing jointly, or $7,000 for people who qualify as "head

of household". After I worked out my adjusted gross income, I then subtracted

$4,750 from it along with $3,050 for each person dependent on me, which in my

case was just me alone. So my taxable income, on line 40 of my 1040 tax return,

was actually $7,800 lower than my adjusted gross income, on line 35. And that’s

actually the minimum amount by which adjusted gross income is decreased.

It’s possible to reduce your adjusted gross income by more than that, by itemizing

your deductions. The main ones are mortgage interest, state and local taxes,

and charitable contributions. If you add all those things up and they come to

more than your standard deduction ($4,750 in my case), then you should itemize.

Most people, however, don’t. Since I don’t have a mortgage and I paid much less

than $4,750 in state and local taxes, I was better off taking the standard deduction,

even after accounting for my stunning generosity to sundry charities.

All of which raises another question, however. If people stop being able to

deduct state and local taxes on their federal tax returns, more of them will

take the standard deduction instead. So while the LA Times says that "the

deduction is valued at $46 billion" this year, it’s not clear whether that

number represents the total amount of state and local taxes deducted from federal

tax returns, or whether it represents the amount of money that the federal government

would receive if the deduction was abolished.

What’s more, it certainly seems that New York City officials are being alarmist,

not for the first time.

What with all the other deductions people can take, and the continued existence

of the standard deduction, I simply can’t imagine that New Yorkers would pay

the IRS 11% more if the state and local tax deduction is abolished. I, for instance,

along with 63% of other New Yorkers, wouldn’t see my federal income tax rise

at all. But as ever, when it comes to questions about taxes, reporters tend

to find it much easier to quote duelling officials than to uncover the actual

truth of the matter.

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14 Responses to Tax deductions: Your questions answered

  1. Jen says:

    Okay, if I’ve understood your interpretation correctly, you fail to see how this affects NYers, yes? As a former Californian and relatively newbie NYer, I think the issue is this: those who live in NYC generally rent apartments. Renters do not have the option of itemizing deductions (there are exceptions for those who have unusual circumstances like medical bills above 7.5% AGI or whatever, but it’s rare). Hence, NYC dwellers will not feel the change.

    Here’s the thing, though. NYC dwellers are very unique. The housing market here is unlike any other market in this country. In every other market, people traditionally buy their homes or condos. So, people who are used to itemizing deductions to include home mortgage interest, etc., will be detrimentally affected by this change. (Btw, they will not simply pay the standard deduction – their itemized deduction will be still be larger than that. They will, hoever, now pay ‘taxes on taxes’ essentially.) In addition, this will act as one more deterrent to buying homes in the future (and perhaps even fuel those bubble theorists more).

    One of the major benefits of home ownership is the ability to write off mortgage interest, property taxes AND state/local taxes in order to reduce your AGI. It’s all part of ‘the American Dream’…that keeps getting chipped away.

    BTW, if I’ve misinterpreted your basic point and it’s simply that the writers are not being detailed-oriented enough with the numbers, fine, but it makes no difference. As a homeowner in NY and a former homeowner in CA, where local and state taxes are significantly higher than any other regions in the country, this pisses me off greatly.

  2. Felix says:

    Jen — I think it’s a stretch to include mortgage interest tax relief as part of the American Dream. There is really no prima facie reason why mortgage interest should be tax deductible while mortgage principal is not and rent is not. Really, it mainly benefits the big banks, because there’s an incentive to stretch out your mortgage payments and to continually refinance, so that you’re only ever paying mortgage interest and not paying down principal.

    And the main person I was attacking was the New York City official who said that residents of NYC would see their federal taxes rise by 11%. That, I think, is simply wrong.

    And paying both federal and state income tax on your income is not paying taxes on taxes — it’s paying taxes on income. There are many taxes which aren’t deductible, including sales taxes. There’s no particular reason why state income taxes, unlike most other taxes, should be deductible.

    As for acting as a deterrent to buying homes, it’s more of a deterrent to taking out a large mortgage, which is similar, but not identical. Many New Yorkers could pay for their apartments in cash but don’t, simply because of the tax implications. Given that they can’t realistically expect the return on their investments to be higher than their mortgage rate, there’s something a bit fucked up about that.

  3. nycbert says:

    I partially disagree with you. The tax benefit of mortgage interest is a big part of the attraction of homeownership.

    Imagine you have a mortgage to the old confirming limit of 333,700USD at 6.00% and 30year fixed. With a twenty percent down payment this gives a purchase price of around 415,000USD. You will have a monthly payment of 2001USD per month with 19,809USD going to interest payment and 4077USD to principal in the first year. Of course the numbers will shift slowly over time.

    With the current rules assuming your state and local taxes are over the 9,500USD limit for married couples and an assumed tax rate of 33% for state, local and federal of around 33% (some assume 38% if you in the highest tax bracket) this tax deduction has a value of about 6,500USD in the first year or about 450USD per month. It is a big difference if I have effective costs of 2001USD or 1451USD per month. Just eliminating the deductibility of mortgage interest could potentially reduce prices of real estate priced between 300,000USD and 600,000USD of about 20% percent assuming 80% financing is the norm. For cheaper or more expansive real estate I assume different tax effects like for example AMT and so on would dominate. I didn’t look into this.

    Of course this is not what is suggested. It is suggested to eliminate the deductility state and local tax. If it is not possible to deduct state and local tax and I assume I only have mortgage interest to deduct, 9500USD of mortgage tax would be used to replace the standard deduction. The tax benefit would now be 33% of about 10,000USD or about 275USD per month. Instead of paying effectively 1450USD under the proposed rules 1726USD would be the effective monthly cost and increase of about 20% in the first year. For the difference in the tax deductions of 300USD you would need to finance 50,000USD at 6.00% and 30year fixed. Therefore 300USD per month or 50,000USD more financing would have a substantial effect on real estate prices.

    The deductibility of mortgage interest is meant to make home ownership more attractive. Of course this had an effect on real estate prices. If this a sound policy is a different question, but it is the status quo. Changing this tax rule will have an effect on home ownership for a certain section of real estate.

  4. MemeFirst says:

    Abolish mortgage tax-deductibility!

    John Berry is right: as he says in a very compelling column this week, it’s time to scrap the personal income tax deduction for home mortgage-interest payments. I said as much a few months ago: There is no prima facie…

  5. Shaun says:

    Heres a story, My wife and I make 117,000 in NYC, renting costs 18,000 annual daycare is 5,000 annual, 3200 for p/t classes and another 30,000 to city state and federal, cigarettes are 7.50 a pack and going up, gas is 3.50 a gallon and going up, and city and state sales tax comes to 8.375% on just about everything I buy. just the taxes and cost come to 56,200, leaving 60,000 disposable income that also goes to the highest utility bills in the county and the other taxes I mentioned. Do you know how hard we have worked for our salaries? we would be better off making 40K a year each in any other state. I dont have my tax info in front of me but the City and State income taxes are definitely a contributing burden to the federal taxable income.

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