Act now to save on your 2017 federal income tax.
Tax dodge: Deduct five quarters of state tax in one year. Sounds fishy, but it works. This gimmick has surfaced as the dust settles on the Trump tax commotion.
Normally, you claim 12 months of state taxes as a deduction on your federal return. This year only, you can come out ahead by claiming 15 months’ worth. To make this work, just mail in your Jan. 15 payment for estimated state income taxes immediately.
Bob Meighan, a tax expert at TurboTax publisher Intuit, explains why. In the legislation that is likely to become law soon, he says, “the deduction for state taxes is pretty much going away. So the payment in January is wasted as a deduction.”
Not everyone is in a position to use the loophole. Only those now itemizing deductions—that’s about 30% of taxpayers—can benefit. Also, says Meighan, anyone who falls prey to the alternative minimum tax will gain nothing from the early payment.
But itemizers who didn’t get hit with the AMT in 2016 (just look at line 45 of your 1040) stand a good chance of avoiding AMT in 2017. They are likely to come out ahead by accelerating their state payments.
You can get a clearer picture by having your accountant run what-if scenarios for your 2017 state and federal returns. Use your best guesses on what your W2 wages and other income will be and what your mortgage interest and charity deductions will be.
If you do your own taxes, don’t procrastinate. Buy the software now and type in those numbers yourself. See what happens when you move your final 2017 estimated state tax from the Jan. 15, 2018 slot to the Sept. 15, 2017 slot. If you are self-employed, so that your entire state tax bill is covered with your estimated payments, the effect could be large.
How does it shake out that you can get away with five quarters of deductions? We’ll illustrate by assuming that John Q. Taxpayer lives in Illinois and has an income and a state tax obligation that don’t change much. He’s been sending in $1,000 per quarter of estimated state income tax.
If it weren’t for the new tax law, this is what would happen. Taxpayer made his final payment of 2016 Illinois tax in January 2017. He made the first three payments for 2017 taxes in April, June and September. He would deduct those four amounts, totaling $4,000, on his 2017 federal return. The final Illinois payment for 2017 would be made in January 2018 and would go on his 2018 federal return.
But now the law is changing. Beginning next year, the federal deduction for state and local taxes will be capped at $10,000. Mr. Taxpayer is well beyond that cut-off. So a payment he makes next month will, as Meighan says, go to waste. If he makes it today, he can claim it as a 2017 deduction. Like most people, Taxpayer uses cash accounting, which means claiming expenses when they are paid rather than when they accrue.
So, five quarters get deducted in one year. Why couldn’t Taxpayer pull that stunt under the old law? He could have, but there would be no point. He’d be raising his deduction in one year but lowering it the next.
Using TurboTax, I ran a test case for a hypothetical Illinois couple who each make $150,000 a year but don’t owe AMT. Accelerating the $1,000 final Illinois estimated tax saves them $330. That’s because they are in a 33% federal bracket.
The AMT comes into play because once you get into that red zone you aren’t allowed to deduct state taxes. If you paid any AMT in 2016 you’ll probably get hit again in 2017. In that case prepaying your January state tax bill won’t hurt you, but it won’t help, either.
What happens if you overshoot the state estimated amounts and wind up with a state refund for 2017? Under the existing tax law, it’s clear what happens. The refund goes onto your 2018 return as an income item, but only to the extent that you got a tax benefit by deducting that amount the previous year. It’s close to a wash, assuming your federal tax bracket remains the same. Not exactly a wash, because of a kinky surtax that goes under the name Pease. But close to a wash.
The new law repeals Pease. That’s nice, but there’s another provision that complicates the situation. It says that you can’t take a deduction in 2017 for a payment of your 2018 state tax obligation. It’s aimed at schemers who were plotting to send in a check now for their entire 2018 state tax bill.
What is the IRS going to do about modest refund amounts? It isn’t clear. Possibly they will get the old treatment (the refunds become 2018 income), or possibly there will be some clawback of any advantage taxpayers got (by, say, deducting in this year’s 39.6% bracket and taking the income into next year’s 37% bracket).
My advice: Get as close as you can to nailing your 2017 state tax obligation, all the while paying attention to what happens on line 45 of your federal return. But if you overdo it you probably won’t be worse off.
Related story: The Dec. 31 Deadline For A Clever Roth IRA Move.
Originally published at Forbes