Updated: Dec 6, 2019
The IRS released the final ruling on state-led charitable contributions that circumvent the $10K cap on state and local property taxes. As expected, Senate and House Democrats – most of which represent high property tax states – moved to overturn the ruling.
Before moving on to why this IRS ruling against SALT workarounds is taking the spotlight, it pays to know what this issue is all about.
Should I Worry About This?
If you itemize on your tax return and you made charitable contributions, this ruling may be relevant to your situation. But if you are taking the standard deduction, it won’t affect you. However, it still pays to know what this issue is all about.
Let’s Cover the Basics
The Tax Cuts and Jobs Act of 2017 imposed a $10,000 cap on state and local taxes (SALT). Under old tax laws, you can deduct 100% of the state and local taxes you paid.
Starting in 2018 and until 2025, you can only deduct up to $10K for SALT if you’re married and filing jointly. Single filers and married individuals who file a separate return can deduct up to $5K.
Most taxpayers won’t be affected, but individuals who exceed the cap should feel a significant tax bite.
A Treasury review provides a more accurate picture of what affected taxpayers stand to lose.
For the 2018 tax year, about 10.9 million tax filers won’t be able to deduct $323 billion in state and local tax payments on their federal tax return. On average, anyone who hits the $10K ceiling is bound to lose about $30K in SALT deductions.
Residents in states with high property tax rates like New York, New Jersey, and California were hit hardest.
Shortly after TCJA became effective, these states responded with solutions to help their residents ease the tax burden. Among these workarounds include local charitable contribution programs.
Several states established charitable funds to pay for local services. Taxpayers who donate to these funds receive SALT tax credits. Instead of paying SALT directly to the state, the taxpayer can use these credits to pay for state and local taxes.
At the same time, the taxpayer can deduct the full amount of the donation on his or her federal tax return. Basically, the taxpayer forgoes the SALT deduction which has a $10K limit and write-off the full deduction for your charitable contribution.
What’s the Big Deal About the New IRS Rule on State Charitable Contributions?
To understand why the IRS had to issue a ruling, here’s how it works.
Let’s assume that you owe $85K in state and local taxes and you have two options – pay your tax due as usual or use the charity workaround.
Scenario 1: Pay Your Taxes Directly
Pay $85K in SALT taxes and claim the $10K SALT deduction in your tax return.
Scenario 2: Donate to a State Charity
Contribute to a state-sponsored charity to receive SALT incentives and use your state credits to pay your state and local taxes.
Here’s an idea of how generous these incentives can be. New York, for instance, established to improve the state’s health care and public education. Donors receive 85% state credit based on their total contribution to the fund.
Using this example, if you donated $100K, you should receive a SALT credit of $85K. You can use this $85K credit to pay the taxes you owe your state.
But there’s another advantage.
Since you made a qualified donation, you get to write off the whole $100K as a deduction on your federal tax return.
In reality, the $100K you deduct as a charitable contribution to your tax return is $85K in property taxes and $15K in actual donations.
By simply using the deduction for charitable donations instead of paying claiming the SALT deduction, you circumvent the $10K SALT cap on your federal tax return.
And this is where the magic happens.
How Does the New IRS Rule Work?
The final IRS ruling doesn’t come as a surprise. The agency already issued the initial ruling against these workarounds in 2018.
Based on the final version of the rule, your deduction for charitable contributions will be your total donation less any state credit you receive.
So, if you received $85K tax credits for donating $100K in a state charity, you can only deduct $15K ($100K - $85K) as a charitable contribution on your federal tax return.
Are There Exceptions?
Yes. Taxpayers may still take a deduction in the following cases.
1. You received a dollar-for-dollar deduction
Some states allow you to enjoy a dollar-for-dollar deduction instead of a credit. If you receive a deduction that reduces your state and local property tax instead of a tax credit, you can still claim the full amount of the donation on your tax return.
2. Your state credit is 15%
States offering a tax credit of 15% or less are not covered by these rules.
So, if you received a tax credit of $1.5K for a $10K donation, you can still claim the full $10K deduction for charitable contributions on your federal tax return.
3. You are covered by the safe harbor rules.
Taxpayers who contributed to a state charity and used the credits they received to pay their state and local taxes may qualify under safe harbor rules.
The safe harbor rules allow taxpayers to write off state and local tax of up to $10K based on the credits they received. For instance, you donated $10K to your state and received a tax credit of $8K.
In this case, you can only deduct $2K ($10K - $8K) as a charitable contribution on your federal tax return. But under the safe harbor, you get to deduct $8K as your state and local tax deduction. Since there is a SALT cap, the total deduction you’ll get is only $10K.
The safe harbor rule also covers C Corporations Pass-through entities except for single-member LLCs. These entities may deduct state credits as an ordinary and necessary business expense. For pass-through entities, the credit may be deducted if it is not applied to state or local income tax.
What Are Legislators Doing?
Senate Democrats plan to use the Congressional Review Act to overturn the new IRS Ruling that disallows the deduction for contributions in exchange for state and local tax credits. Under this act, proponents have until mid-December to repeal the ruling. The House of Representatives also passed a similar bill.
If the solution is approved, the IRS will not be able to issue a “substantially similar” ruling. But even if the new rule gets overturned, there’s still an elephant in the room. The IRS may challenge the deduction for charitable contributions under the quid pro quo contributions rule. This rule disallows the deduction for contributions for which the taxpayer received consideration in return. In the case of these state charities, the incentives used to pay SALT taxes may qualify as consideration.
Then there’s the year-end tax talks. SALT rollbacks will also be on the agenda along with other tax issues. It remains to be seen if the IRS ruling gets overturned or not. But it’s better to prepare ahead of time while waiting for the outcome of these petitions.
Revisit Your Tax Strategy – It Pays to Stay Updated
Lawmakers may be finding for fair treatment of high tax states, but the IRS has no plans of backing down either. Now that the ruling on state charitable contributions is out, other state programs with the same purpose may face a similar fate.
With so much uncertainty involving these workarounds, it’s the best time to revisit your tax planning strategy.
Consider other avenues to offset the effect of your limited SALT deduction and improve your tax strategy. If the new rules affect you, consult your tax advisor to know what your options are and what your game plan should be for the next tax year. Contact Bryant McNulty, CPA directly to learn how to optimize your tax strategy.