Updated: Dec 9, 2019
That’s right – the Tax Cuts and Job Act (TCJA) placed a limitation on the amount of state and local taxes (SALT) individuals can deduct on their tax returns. Not only are taxpayers concerned with how this limitation will play out, but several states have expressed outrage towards the change: something which could alter how local citizens are taxed. But before we discuss the details of the limitation, let’s take a moment to delve into what SALT represents.
For this deduction, taxpayers can include state and local taxes such as sales, income, personal property, and real property that are paid during the year. All of these taxes are documented on the individual’s Schedule A as itemized deductions. Before the TCJA, taxpayers were allowed to deduct the full amount paid for state and municipal property taxes on top of income or sales taxes. Now, that deductible amount is capped at $10,000 for individual taxes and $5,000 for married taxpayers filing separately. (Note that state and local taxes paid by businesses are still fully deductible.)
This is bad news for a lot of states, especially those with high income and property taxes (namely New York, New Jersey, Connecticut, and California). Since many taxpayers living in these states will not be able to fully deduct all of their state taxes with the $10,000 cap, local government leaders decided to try and create ways to circumvent the limitation. For example, New York devised a system where local taxpayers could convert local property taxes into charitable contributions (which are fully deductible for federal tax purposes). Other states are proposing variations on state and local charitable trusts or funds which would accept payments in satisfaction of state and local tax liabilities and be labeled as charitable contributions for taxpayers.
What seemed like a brilliant plan turned to dust when the Internal Revenue Service (“IRS”) released a notice (Notice 2018-54) stating that the Treasury will “propose regulations addressing the federal income tax treatment of transfers to funds controlled by state and local governments that the transferor can treat in whole or in part as satisfying state and local tax obligations.” Furthermore, the IRS declared that the ensuing regulations will clarify that the Internal Revenue Code governs the federal income tax treatment of these transfers — not the label used by states. Additionally, the IRS is moving towards a substance-over-form principle to determine whether payments intended for state and local tax liabilities are not repackaged as charitable contributions.
Although the proposed regulations have not been released, taxpayers should be wary of how they characterize their taxes. While the state governments had great intentions, the IRS warned citizens in the notice: “taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.” So, with this cautionary statement in mind, beware of falling into any state government schemes or traps that could backfire. Beware of the SALT cap!