Putting a Cap Back on the SALT Deduction
The IRS caps state-level SALT deduction limitation workarounds involving charitable donations in exchange for state tax credits.
The words “tax workaround” might be defined as a way that taxpayers try to bypass paying taxes they view as excessive. The Tax Cuts and Jobs Act (TCJA) created a state and local taxes (SALT) deduction cap of $10,000, leading many taxpayers who deducted more than this amount to consider inventive ways around the limit. The SALT cap was particularly a concern for taxpayers in certain states with higher income and/or property tax rates.
Applying established quid pro quo-based limitations on deductible charitable contributions, the IRS limits one particular workaround designed to convert nondeductible state taxes into deductible charitable contributions.
The IRS puts an end to one SALT limitation workaround strategy
Recent Treasury regulations addressed the conversion of nondeductible state taxes into deductible charitable contributions. These states set up nonprofit organizations eligible to receive tax-deductible charitable donations. The state would then provide a credit to donors that they could apply against their tax bill, usually their property tax bill.
For example, State A would set up an eligible charity (Charity B). State A offered a real property tax credit equal to 75% of the amount donated to Charity B. Consequently, if a resident of State A donated $8,000 to Charity B, he or she would receive a $6,000 property tax credit. Further assume that this person would otherwise pay $16,000 in state and local taxes. After the donation and applying the credit, he or she will pay $10,000 in other state and local taxes and $8,000 to the charity.
Here, the goal for the taxpayer would be to claim $10,000 as a SALT deduction as well as an $8,000 charitable deduction on Schedule A (Form 1040) for a total $18,000 in combined deductions. After the new regulations, the taxpayer’s available charitable deduction is limited to $2,000 (the 25% of the donation that doesn’t offer a credit for state property taxes).
States that set up this credit system likely believed that it would enable taxpayers to convert the nondeductible state and local tax ($6,000 in the example) into a charitable deduction. Without the credit, the taxpayer would pay $16,000 in state and local taxes, $6,000 of which would be nondeductible as a result of the SALT cap and the taxpayer isn’t eligible for charitable deductions.
New regulations use existing charitable contribution law to cap SALT deduction workarounds
The regulations limit the benefit of this strategy. They specify that as a quid pro quo, the taxpayer’s charitable deduction will be limited based on the amount of any benefit received in return for the contribution. They are essentially identical to proposed regulations on this issue submitted earlier for public comments.
Applying the regulations to the above example, the taxpayer’s available charitable deduction would be $2,000 rather than $8,000 (i.e., the 25% of the donation that’s not eligible for the credit). An IRS Notice also offers a safe harbor to taxpayers to elect to treat the state credit amount received as a deductible SALT payment in the year the donation is paid instead. This safe harbor potentially benefits taxpayers who do not reach or exceed the $10,000 SALT cap, since the credited amount is not eligible for the charitable deduction.
From a tax benefit perspective, this limitation makes sense, as the quid pro quo rule has long applied in the context of charitable donations. However, the states that set up these programs had reason to believe that a full deduction might be available for their citizens, as several states had set up similar charitable programs prior to the TCJA’s passage, and the IRS had not previously challenged taxpayers who claimed a full deduction for these contributions. Nonetheless, the IRS revised its position, and these prior programs are also impacted by these regulations; they are not grandfathered as eligible for any exception to this quid pro quo limitation.
These new rules address one of the many questions that arose following the TCJA’s passage, and it likely will not be the last issue left to the IRS to resolve in the wake of the sweeping 2017 tax law. After all, for the tax expert, every new tax law change represents a new tax planning opportunity. In the wake of the largest change to the tax code in more than a generation, such opportunities abound.
For more information on SALT and state tax refunds, see the Insights article, When is a state refund taxable? The TCJA raises some questions.
Editor’s note: Connecticut, Maryland, New Jersey, and New York filed suit against the IRS over the regulations limiting the charitable deduction, described above. The case was dismissed by a federal judge on Sept. 30, 2019.