There’s an unpleasant surprise awaiting homeowners who plan to use the standard deduction rather than itemize on their federal income tax next year. They could easily find themselves paying more in state income taxes in 2018 than 2017 because of the tax reform act.
State and federal income taxes are closely tied. Some 41 states and the District of Columbia start the tax calculations by linking to a form of income in federal tax returns.
Thirty states begin with adjusted gross income (AGI) from taxpayers’ federal forms; AGI includes all taxable income before including deductions, exemptions and credits. Eight states use taxable income (the amount after all adjustments).
For individuals, the centerpiece of the new federal tax law is the huge increase in the standard deduction from $12,000 for an individual to $24,000 for a married couple.
Millions of middle-class homeowners will find that the new standard deduction is greater than their itemized deductions, including the mortgage interest deduction so that they will choose the standard deduction. However, states have not raised their standard deductions.
How homeowners who win on federal taxes can lose at the state level
State tax laws require taxpayers who use the standard deduction on their federal taxes to do the same on their state taxes.
Homeowners who choose the standard deduction on their federal taxes will not be able to itemize. Those who do itemize will be able to itemize and use deductions like the mortgage interest deduction and deductions for property and sales taxes.
Most states haven’t capped or limited these popular deductions, but the new federal tax law does.
Seven states (Colorado, Idaho, Maine, Minnesota, North Dakota, South Carolina and Vermont) conform to the new federal standard deduction, so taxpayers who take the federal standard deduction of $12,000 for an individual and $24,000 for married couples, can take the same amounts on their state taxes so taxpayers who itemized last year may get a lower state tax.
Most states have their own standard deductions, and generally, they are much smaller than the new federal standard deduction of $24,000 for a joint return.
Illinois has no standard deduction at all, but it allows homeowners to take additional exemptions for taxpayers age 65 or older, legally blind or both, and if total household income is less than $65,000.
Thus, homeowners in the other 43 states who take the big federal standard deduction are stuck with the lower state standard deduction and cannot itemize at the state level.
For example, a California homeowner with $21,000 in itemized deductions will be able to deduct only $3,000 from his state tax if he choses the standard deduction on his federal return.
If he had itemized at the federal level, he could deduct $3,000 less on his federal return ($24,000-$21,000) and $21,000 more on his state taxes.
If he did not itemize at the federal level, he would realize $3,000 more on his federal taxes, but he would have to take the state standard deduction of $3,000.
It’s possible that homeowners whose deductions are less than the standard deduction but itemized would more than make up the difference on their state taxes.
Windfall for states
A recent study by The PEW Charitable Trust “highlighted the significance of this federal-state connection by examining the impact on state revenue of eliminating 42 major federal personal income tax provisions and reducing federal tax rates to hold total federal revenue constant.”
It found that state income tax revenue would increase by about 34 percent. Changes for individual states would vary widely, from less than 5 percent to more than 50 percent.
Some states will enjoy massive windfalls as a result.
In Colorado, state tax revenues are expected to increase between $196 million and $340 million next fiscal year.
Maryland’s Bureau of Revenue estimated its state taxes would bring in $450 million more in state taxes and $300 million more in local taxes every year.
Most states whose tax codes conform to the federal system will do the best, according to a recent white paper from the Tax Foundation.
Maine, which conforms to the personal exemption but applies a state-defined standard deduction, will realize the greatest windfall.
Most states benefit from changes to deductions for mortgage interest and moving expenses, while 24 states and the District of Columbia, which could see their local property tax deductions capped at $10,000, would see a further revenue increase.
The seven states (Colorado, Maine, Minnesota, North Dakota, Oregon, South Carolina and Vermont) that use federal taxable income as their income starting point are the most likely to experience revenue losses.
Missouri, which will adopt the much-higher federal standard deduction, may also see a loss in revenue as taxpayers choose the new deduction.
Many state legislatures are currently debating what to do. Some may do nothing and use the unexpected income to offset future state tax increases.
States that decide to conform to the federal law by raising their standard deduction as much as the federal increase will fight their tax revenues, which they may not be able to afford.
The changes in the new federal tax law, especially the increase in the standard deduction, will raise state taxes for homeowners who previously itemized in most states. Taxpayers who take the federal standard deductions must also take their state’s standard exemption, which will increase their state taxes in 2018 over 2017.
Homeowners whose itemized deductions, including their mortgage interest deduction, total slightly less than the federal standard deduction might be better off itemizing at both the federal and state levels.
Most state legislatures are reviewing the impact the new federal law will have on their state tax codes and revenue. Some may make changes in their laws this year.
The closer that a state’s income tax conforms with the federal tax code, the more revenue a state will gain, and its taxpayers will lose due to the new federal tax law.
Steve Cook is a communications consultant and editor of Real Estate Economy Watch.