The expansion of property tax rebates in the new state budget has once again raised the question of whether the rebate is effectively taxable on federal returns.

The answer is yes — but only for those New Yorkers who claim itemized deductions for property taxes. As explained below, most homeowners itemize their deductions for federal purposes, because the combination of deductible expenses (principally state income and property taxes, charitable contributions and mortgage interest) typically exceeds the $10,300 standard deduction amount. However, fewer middle-income homeowners itemize for New York State income tax purposes, because their deductible expenses on state tax returns (same as federal, but excluding state income taxes) more often do not exceed the state standard deduction of $15,000.

Therefore, for most homeowners, the rebate will effectively be “taxable” by the feds. Many, especially those in the higher income levels qualified for the rebate, will find that the savings is also taxed by the state.

[UPDATE: The interpretation in this commentary is based on the opinion provided by the Internal Revenue Service more than two years ago to New York City officials in connection with Mayor Bloomberg’s $400-per-homeowner property tax rebate, which for tax purposes is comparable to the state property tax rebate. The IRS memo can be downloaded here.]

Example: the Jones family

Joe and Debbie Jones of Albany claim an itemized deduction for federal and a standard deduction on their state return. They pay $5,000 in total property taxes this year and receive a $400 property tax rebate check in the fall. For federal tax purposes, the Jones can only claim $4,600 in property taxes paid on their 2007 federal returns. (Note: the effect would be precisely the same if the city of Albany itself had cut the Jones’ property tax by the same amount; either way, their deduction would be $400 smaller, and that $400 savings would be subject to federal tax.) But on their state return, the standard deduction is fixed at $15,000 for all married-joint filers; thus, the rebate makes no difference in the Jones’ tax.

If Mr. and Mrs. Jones itemized for state income tax purposes — i.e., claiming a state deduction for propery taxes — the rebate would also be taxed by the state. Conversely, if they took the standard deduction for federal purposes — claiming no deduction for property taxes — the rebate would make no difference in their taxable income.

What about regular School Tax Relief (STAR) tax breaks? Since STAR is functionally a homestead exemption that reduces the amount of school taxes paid by a homeowner, the STAR savings also is effectively added back to the income of those homeowners who itemize their deductions — but not those who choose a smaller, standard deduction. (For New York City residents, the main STAR savings comes in the form of a city income tax cut that is always added back to federal taxable income.)

Note: although both checks come from Albany, the property tax rebate is treated differently from a New York State personal income tax refund. For all taxpayers, a state income tax refund is always added back to taxable federal income in the year when it is received, regardless of whether the filer claims a standard or itemized deduction.

Who itemizes?

The proportion of tax filers claiming itemized deductions increases with income — as does the likelihood of owning a home.

According to 2004 Internal Revenue Service data for New York State, the percentage of tax filers claiming an itemized deduction for property taxes was 47 percent in the $50,000-$75,000 income range; 68 percent in the $75,000-$100,000 range; 81 percent in the $100,000-$200,000 range; and 86 percent among those earning more than $200,000 in adjusted gross income. On the state level, well over two-thirds of filers claimed in the $50,000-$65,000 income range claimed a standard deduction on their New York State returns. However, state itemized returns were filed by 55 percent of those earning from $75,000 to $100,000. Among those earning between $100,000 and $200,000, 62 percent claimed itemized deductions on their state tax returns (and, presumably, on their federal returns as well).

In the absence of more detailed data, it is possible to make the following educated guesses:

• Most New York homeowners with incomes over $75,000 claim itemized deductions on their federal returns and thus will find that their newly increased property tax rebate is effectively “taxed” at the federal level.
• Homeowners who claim a standard deduction on both federal and state returns — and whose federal taxes will thus be unaffected by the rebate — are likely to be concentrated in non-metropolitan upstate regions, where average incomes (and property taxes) are lower.
• Elderly homeowners, who tend to have lower incomes and paid-up mortgages, are more likely to use a standard deduction on both state and federal returns and thus are less likely to have their rebates taxed.
• Most married homeowners are in either a 15 or 25 percent marginal tax bracket at the federal level. Those who itemize will thus effectively lose up to one-quarter of their rebate to federal taxes.