This section discusses the deductibility of state and local income taxes, employee contributions to state benefit funds, and foreign income taxes.

State and local income taxes. You can deduct state and local income taxes. However, 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. Deduct state and local income taxes withheld from your salary in the year they are withheld. For 1998, these taxes will be shown in boxes 18 and 21 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 11), or Form 1099-R (boxes 10 and 13). Deduct payments made on taxes for an earlier year in the year you pay them.

Deduct estimated tax payments you made during the year under a pay-as- you-go plan of 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.

Deduct any part of a refund of prior-year state or local income taxes that you chose to have credited to your 1998 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 1998.
• Any refund of (or credit for) prior year state and local income taxes you actually received in 1998.

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 line 10 of Form 1040, 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, you do not have to include the refund in income. If you did deduct the taxes in the previous year, include all or part of the refund on line 10, Form 1040, in the year you receive the refund. For a discussion of how much to include, see Recoveries in chapter 13.

Separate 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.

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

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. If you and your spouse are jointly and individually liable for the full amount of the state and local income taxes, you and your spouse can deduct on your separate federal returns the amount you each actually paid.

Table 24-1. Which Taxes Can You Deduct?

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 line 5 of Schedule A (Form 1040).

• California.
• New Jersey.
• New York Nonoccupational Disability Benefit Fund.
• Rhode Island Temporary Disability Benefit Fund.
• Washington State Supplemental Workmen's Compensation Fund.

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

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, get Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. For information on the foreign tax credit, get Publication 514.

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