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This article was fact-checked by our editors and reviewed by CPA candidate Janet Murphy, senior product specialist with Credit Karma Tax®.
If you live in a state with high property, income or sales tax, the Tax Cuts and Jobs Act could seriously curb the amount of your federal deduction for state and local taxes.
Tax reform limits the amount you can deduct from your federal taxes to $10,000 ($5,000 if you’re married filing separately) for all state and local taxes combined. SALT taxes include state and local property taxes and either state and local income taxes or state and local sales taxes.
Thanks to the limited deduction, residents of states with high income or real estate taxes could be facing a significant increase in their 2018 tax bill. Some states have tried to help residents get around the impact of the SALT deduction cap by offering state tax credits for contributions made to certain charitable funds. The contributions would — in theory — also be deductible from the taxpayer’s federal taxes.
But recent IRS guidance could spell failure for those state efforts.
SALT and American taxpayers
Since 1913, taxpayers who paid taxes to state and local governments have been able to deduct the full amount of those taxes from their federal taxable income. This deduction is called the SALT deduction, and it allowed taxpayers to reduce the amount of federal tax owed by deducting money they’d already spent on state property taxes, county taxes, and state income tax.
However, the Tax Cuts and Jobs Act, passed in December 2017, temporarily limits the SALT deduction. Under the bill, taxpayers can only deduct a maximum of $10,000 ($5,000 for those married filing separately) for all state and local taxes for tax years 2018 to 2025. This could add up to a significant increase in tax liability for millions of Americans.
In fact, in 19 states and Washington, D.C., the average SALT deduction claimed by taxpayers exceeds the new cap, according to Pew Charitable Trusts.
Some states where many taxpayers could be adversely affected by the $10,000 limit have reacted to it by seeking SALT cap workarounds, hoping to allow residents to continue deducting the full amount of state and local taxes paid through another avenue. The most popular approach involves recharacterizing state or local tax payments as property tax deductions.
While the IRS has released guidance aimed at stopping these workarounds, experts aren’t convinced that this will thwart state efforts to avoid tax increases on residents.
“It’s going to be months, or even years, before we know for sure whether the tax credit workarounds actually work,” advises Carl Davis, research director for the Institute on Taxation and Economic Policy. “The IRS is going to try to stop them, but those efforts are likely to bring a legal challenge from states, like New Jersey.”
SALT cap workarounds so far
The legal wrangling over the SALT deduction has already begun, as Connecticut, New York, Maryland and New Jersey have asked the courts to invalidate the cap and prevent it from taking effect. These states argue that the change to federal tax law is an unlawful infringement on the rights of states to set their own tax policy.
More on the SALT cap lawsuit
The lawsuit filed in July by the states of New York, Connecticut, Maryland and New Jersey claims the SALT deduction cap …
- Is unconstitutional and unprecedented
- Costs taxpayers millions
- Decreases home values in plaintiff states
- Risks people’s home equity, retirement, college education and investments
- Intentionally targets plaintiff states
Learn more about the lawsuit here.
The lawsuit is just one of many ways states are trying to prevent tax increases on residents.
“States are testing the waters by enacting a variety of different tax credit approaches,” Davis says.
In fact, as of August 2018, four states have passed laws providing residents with tax credits for charitable donations, as donations are fully deductible from federal taxable income as long as they don’t exceed 60% of adjusted gross income.
- New Jersey Senate Bill 1893 allows local governments to create charitable funds. Residents who contribute to them can reduce property taxes.
- New York’s 2019 budget also put a tax credit system in place allowing for residents to make a contribution to a fund benefitting health care and education in New York in exchange for a reduction in state taxes.
- Connecticut Senate Bill 11 allows for residents who contribute to community-supporting charitable organizations to receive a credit on their property tax.
- Oregon Senate Bill 1528 provides a credit for both personal and corporate income tax in exchange for contributions made to the Oregon Opportunity Grant Fund.
Connecticut has also proposed a new tax on pass-through entities that’s fully offset by a personal income tax credit, and New York is proposing a new payroll tax that would allow employees to claim a personal income tax credit for their New York income tax liability. It’s possible these proposals could succeed in circumventing the SALT cap, because businesses can deduct state and local taxes with no cap.
Other states are also considering their own bills, most of which take the approach of providing general tax credits for donations. Proposals include SB 227 and the Bridget “Biddy” Mason Golden State Credit Program in California; HB 4237 in Illinois; and a bill in Rhode Island that would allow tax credits in exchange for contributions to the Ocean State Fund.
However, new IRS-proposed guidelines take aim at charitable-deduction workarounds, so the jury’s out on whether states that are considering their own proposals will continue to pursue them.
IRS response to SALT cap workarounds
Even as states were signing SALT cap workarounds into law, the IRS was hard at work on regulations aiming to end this legislative wrangling. In May 2018, it released Notice 2018-54 to warn that new rules would be forthcoming in response to state efforts to thwart the $10,000 limit.
The IRS warned that federal law — not state law — determines whether a payment of funds would be treated as a deductible charitable contribution for federal income tax purposes if that contribution was used to satisfy state and local tax liabilities.
“The IRS doesn’t care what you call something or how you structure it; the IRS cares about what it really is,” says Jared Walczak, a senior policy analyst with the Tax Foundation. “Recharacterizing a tax payment as a charitable contribution doesn’t change the fact that the payment is made in satisfaction of tax liability.”
In August, the IRS released proposed rules that limit the federal deduction taxpayers are eligible to take if they make charitable donations in exchange for state or local tax credits. The IRS guidance makes clear that if taxpayers receive state or local tax credits in exchange for donations, they’ll be required to reduce the charitable deduction claimed on their federal returns by the amount of the state or local credit — unless the credit they receive is 15% or less than the donation amount.
In this guidance, the IRS simply applied a long-standing principle applicable to the deduction of all charitable donations.
“You’re supposed to reduce the amount claimed under the deduction by any benefit received,” Walczak explains. “If you go to a $250 benefit dinner and the fair market value of the dinner is $50, you’re only allowed to claim a $200 deduction. A state tax credit is a benefit and the amount you deduct should be reduced accordingly.”
The IRS provided only a limited exception to this general rule: If a taxpayer receives a state or local tax credit for less than 15% of the amount of the donation to a state- or locally specified charitable fund, the taxpayer will be able to deduct the full amount donated.
How the IRS response affects taxpayers
The IRS took a broad approach in its guidance, so its regulations could affect not just newly created SALT workarounds, but also more than 100 existing programs in 33 states that provide state tax credits for donations.
Within these states — including Alabama, Arizona, Indiana, Iowa, Missouri, Oregon and South Carolina — are long-standing rules providing credits for donating to various organizations, including public institutions, educational institutions, government agencies or funds, or specific nonprofits providing services otherwise offered by the government.
“The IRS said in its May notice that it was going to be looking at all of the charitable contribution plans, state-run and not state-run,” explains Maria Koklanaris, senior tax correspondent for Law 360. “Exempting some and not others may open the agency to litigation.”
Davis believes the broad approach is the right one.
“If the IRS picks and chooses which credits it’s going to crack down on, that opens up the possibility states will find creative ways to structure their credits to get around the IRS regulations,” he says. “The IRS should pursue a broad fix that would impact not just the newest tax credits, but also the longer-running tax shelters that have been exploited by residents of Alabama and South Carolina for years.”
The IRS regulations, however, did not — and cannot — resolve the pending lawsuit challenging the enforcement of the SALT cap. That lawsuit is for the courts to decide. They also did not address other approaches to avoiding the SALT cap, such as the imposition of new payroll taxes.
States may change their approach to seeking a SALT cap workaround in response to the newly issued guidance, so the future remains uncertain for taxpayers concerned about how the new SALT cap will affect their federal tax liability.
If you’re counting on a SALT cap workaround from your state to keep your federal taxes low, you may face an unpleasant surprise at tax time since the IRS has made clear it won’t allow you to take deductions for charitable donations if you received tax credits. Instead of hoping for a favorable IRS ruling, consider alternatives like appealing your property taxes to mitigate the impact of the new limits on state and local tax deductions.
A senior product specialist with Credit Karma Tax®, Janet Murphy is a CPA candidate with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute. You can find her on LinkedIn.