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If you itemize deductions on your income tax return, you can deduct either state and local income taxes paid, or sales taxes paid. You can deduct whichever is larger. For most taxpayers, it will make more sense to deduct the state/local income taxes paid. For those living in states with no income tax or for those who made a very large purchase subject to sales tax, the deduction for sales taxes paid will be more advantageous.

Included in your deduction for state income taxes paid will be whatever amounts were withheld on your paychecks and reported on your W-2, any state taxes paid during 2007 for a prior year amount owed, any state tax estimates paid during 2007, any state tax refund from a prior year that you elected to have applied to 2007 taxes. You should not deduct any penalties or interest paid related to your state income taxes. Those are not deductible.

In order to deduct sales tax paid, you should keep receipts to substantiate the amount you are claiming. In the event that you do not have receipts to substantiate the actual amount of sales tax paid, you can use the amounts allowed by the IRS on their sales tax tables.

Tracy L. Coenen, CPA, MBA, CFE performs fraud examinations and financial investigations for her company Sequence Inc. Forensic Accounting, and is the author of Essentials of Corporate Fraud.