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High-Tax States Face an IRS Smackdown

Dan Caplinger, The Motley Fool

Tax reform is a year and a half old now, but there's still plenty of argument about some of its more controversial provisions. One of the hardest-fought changes to the tax laws that took effect in 2018 was the limitation on deductions for state and local taxes, also known as SALT. Having previously been unlimited, the maximum SALT deduction for the 2018 tax year was $10,000.

Elected officials in high-tax states took offense at the SALT limitation, arguing that the measure singled out their residents. Several of those states looked at workarounds designed to help preserve the favorable economic impact from the previous tax law. Yet Treasury officials identified those moves as being specifically designed to promote tax avoidance, and they went to work on regulations designed to thwart the move from high-tax states. The result was the release of final regulations this week that take away the lion's share of the federal tax break that state officials were hoping to provide for their residents.

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Image source: Getty Images.

A look back at the SALT debate

Arguments about the new tax law's SALT limitations go back to the initial drafting of tax reform legislation. Previous law had no limit on SALT deductions for property taxes, and taxpayers could choose either sales tax or state income tax and add that amount to the total deduction they took. Some legislators wanted to cut the SALT deduction in full, while others wanted it preserved in its then-current form. The eventual bill set the $10,000 limitation as a middle ground.

Several high-tax states responded by establishing charitable funds that would accept donations for state and local government use. They also offered state tax credits for such donations, effectively encouraging resident taxpayers to substitute donations for paying their ordinary state tax bills. The hope of California, New Jersey, and New York, and other states that looked at such provisions was that the donations would qualify for the charitable deduction, which generally allows taxpayers to deduct up to 60% of their income depending on how the receiving charity is established.

What the IRS final regulations say

However, federal officials were quick to fight back. Last year, the IRS said that it would propose temporary regulations seeking to limit dramatically the federal tax deduction of donations to these state charitable funds. After collecting input from the public, the IRS went forward with final regulations that keep most of what it had initially suggested.

The rules essentially treat state tax credits that one receives in exchange for a donation to a state charitable fund in the same way as other benefits received directly from charities in exchange for gifts. For instance, under long-standing charitable law, if you make a $500 donation to a charity and it gives you a promotional item worth $100 because of your gift, then you can generally deduct only $400, reflecting the value of what you got back. Similarly, if someone makes a $1,000 donation to a state charitable fund and gets an $800 state tax credit, the new IRS regulations would limit the charitable gift to the $200 difference.

However, in an attempt to allow some states to preserve less extreme tax credits to encourage giving, the regulations allow for a safe harbor. If the amount of tax credits received is 15% of the amount donated or less, then the credits won't count against the charitable deduction. So changing the example above, if you made a $1,000 donation in a state that provided a $150 state tax credit, you'd get to keep the credit while still getting to deduct the full $1,000, rather than the $850 difference.

The fight isn't over

Even with final regulations due to take effect in the near future, high-tax states continue to lobby against the SALT deduction limitation. As the run-up to the 2020 presidential election continues, taxpayers can expect the issue to remain an important one with voters, especially in those states that have seen the biggest impact from the limitation.

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