How to Deduct State Taxes on Your Federal Tax Return

In most states, tax season isn’t a one-and-done undertaking. You have to file both a federal return and a state return, unless you live in one of the nine states that don’t tax wages.

But there’s a silver lining to paying state taxes: They could help reduce your federal tax burden. Here’s what you need to know about making the state taxes you pay work for you.

Itemize your deductions

To claim state taxes on your federal tax return, you must itemize your tax deductions using Form 1040. You can then deduct state and local taxes you paid from your adjusted gross income. That lowers your federal taxable income, and therefore your federal tax bill, based on your federal income tax bracket.

Deductible taxes can include state income tax, sales tax and property tax you paid, as well as estimated tax, which is what you owe on income not subject to withholding. The local payments you can deduct depend on where you live. Public treasuries fund operations for each state and each state establishes its own rules for how to fund the treasury, including the tax type and tax rate. For instance, 14 states in the country allow cities, counties and municipalities to establish additional revenue codes for residents and workers. That means residents in those states also pay local taxes they can deduct.

Know which state and local taxes to claim

You can deduct state income tax or state sales tax, but you can’t deduct both. Your online tax software gives you the option to enter the information in both categories, but deducting state and local income taxes paid is usually the better deal in states where there is an income tax. The state sales tax deduction is also worth exploring if you bought a car or made another major purchase during the tax year, or if you live in a state with a high tax rate.

If you decide to deduct state sales tax from your federal return, you can either estimate your annual payments using the IRS sales tax deduction calculator, or you can deduct the actual amount based on the receipts for your purchases.

You can also deduct the real estate tax you pay based on the value of your home and personal property tax you pay on your car or other vehicles you own.

What happens when you get a state tax refund?

If you deduct your state income tax one year, and receive a state tax refund the next year, you will probably have to report it as income. In that case, you will receive a Form 1099-G outlining the refund amount — and so will the IRS.

If you file Form 1040, check the State and Local Income Tax Refund Worksheet  in the form’s instructions for line 10 to figure out how much of the refund, if any, to include in your income. Or, let your tax software or tax preparer work it out for you.

You can avoid paying tax on a state refund by choosing not to itemize your deductions, or by deducting only state sales tax from your income.