The IRS Wants to Make It Hard to Deduct State Taxes

New IRS rules limit state charitable donations that were aimed at preserving SALT deductions that were lost as a result of the Tax Cuts and Jobs Act.

By , J.D.

The Tax Cuts and Jobs Act (TCJA), the massive tax reform law that took effect in 2018, made a major change in the long-time deduction for state and local taxes (SALT taxes), including property taxes. For the first time ever, a cap was placed on this deduction. Starting in 2018 and continuing through 2025, homeowners may deduct a maximum of $10,000 of their total payments for:

  • property tax, and

  • state income tax or state and local sales tax.

This $10,000 limit applies to both single and married taxpayers and is not indexed for inflation.

SALT Deduction Limit Unpopular

This has been one of the most unpopular provisions in the new tax law. It reduced the value of the state and local tax deduction by 87%. It most affected higher-income homeowners in states with high real estate values and high property taxes. These homeowners were located primarily in the more liberal "blue" states like New York, New Jersey, and California. Requiring these homeowners to pay the full cost of state and local taxes, instead of being able to deduct them all for federal tax purposes, made it harder for states to raise revenue. It also encourages high income people to move to states with lower taxes.

States Attempt Workarounds to Preserve SALT Deductions

Legislators in several states came up with several ingenious ideas to get around the cap. One of the most talked about was allowing taxpayers to donate to a special state charitable fund, which would be used to help run state and local government services. Contributors could claim a charitable contribution for the donation on their federal taxes, and get a credit against their state taxes.

This would effectively convert a nondeductible state-tax payment into a fully deductible charitable contribution. Taxpayers who itemize may deduct charitable contributions up to 60% of their income.

New York set up two state funds and collected $93 million in 2018.

Example: Anderson pays $20,000 in property tax each year on his Manhattan townhouse. He also pays $10,000 in state income tax. Because of the new tax law, he may deduct no more $10,000 of his property tax on his federal tax return. Under the New York scheme, he may also contribute $10,000 to the state charitable fund. In return, he gets a state tax credit that reduces his state tax liability by $8,500. He then deducts the $10,000 contribution as a charitable gift on his federal tax return. So he effectively deducts his entire $20,000 in property tax from his federal taxes.

IRS Regulations Limit State Charitable Workarounds

To put it mildly, the IRS hasn't been pleased with this idea, viewing it as a subterfuge to get around the new tax law. The IRS has now issued final regulations that pretty much put the kibosh on the scheme. (IRS Reg. 1.170A-1(g).) The IRS regulations treat state tax credits like New York's the same as other benefits donors receive from charities in exchange for gifts. Normally, you have to reduce a charitable contribution deduction by the value of anything you get in return. For example, if you make a $1,000 donation to a charity and get a $200 bottle of wine in exchange, you can generally deduct only $800. Likewise, under the new regulations, if you make a $1,000 donation to a charitable fund like New York's and get a $800 state tax credit, you get only take a $200 charitable deduction.

However, the IRS regulations do allow states to keep relatively small tax credits. If the amount of tax credits a taxpayer receives is 15% of the amount donated or less, the credits won't count against the charitable deduction. For example, if you make a $1,000 donation in a state that provides a $150 state tax credit, you're allowed to deduct the full $1,000 rather than the $850. But with such a small state tax credit, you likely would not come out ahead by making a contribution to a state charitable fund.

The final IRS regulations are effective August 11, 2019 but apply to contributions made after August 27, 2018.

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