Deducting State Tax on Form 8560 NIIT, line 9b

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There are many Intuit forums and many comments on this issue.  The deductibility of State taxes as an investment expense on Form 8560, line 9b.  This issue usually comes to the foreground when there is large capital gains issue.  Most notably, the sale of a personal residence.  Some how the IRS has reasoned that your personal residence is an investment and capital gains should be taxed as an investment.  They do offer a "generous" exclusion the shields $250,000(or $500,000) from capital gains taxes, but the way housing prices have increased over the last 10-20 years has exposed many taxpayers to some large tax “surprises”.  And besides the capital gain issues, there is relatively new, Net Investment Income Tax(NIIT) tax of 3.8% that can create an additional tax burden.  The discussion boils down to wether a State income tax can be deducted as an investment expense on Form 8560.  There are two "theories" on how this should be treated on a tax return but, apparently there no official guidance from the IRS.

As I search for guidance, I offer my opinion and recommendation.  Schedule A allows for the deduction of certain local and state taxes, but only to filers that itemize on Schedule A.  This State income tax amounts are added to some other state taxes and capped at $10,000 on Schedule A.  Due the rapid increases in property taxes, many taxpayers that itemize never realize any benefit from deducting State income taxes because their property taxes are more than the $10,000 cap.  "Theory" #1, is that only the amount of itemized state income taxes($10,000 max) can be used as an expense on Form 8960, line 9b.  This seems incongruous to me.  The two entries are not related to one another in any way.   What tax principle does this align with?  None that I know of.

I support the accepted tax doctrine that expenses paid to produce income, are deductible, and should be followed here.  Just like the expense deductions allowed on Schedule C, Schedule E, Schedule F, and many other tax forms.  I therefore offer, "Theory" #2, that State income taxes are an expense related to producing income and, should be fully deductible on Form 8560 for the purpose of calculating the 3.8% NIIT tax.  This approach also works for all taxpayers whether they itemize or not, so that discussion is moot.  So, I recommend this interpretation.  It, aligns with accepted tax doctrine, it eliminates any dependence on itemizing vs not itemizing, and it includes all taxpayers.

Does anyone out there have any guidance or clarification this issue from the IRS?

Bill Bevan, EA