[REN #528] IRS Crackdown on SALT Deduction “Gimmicks”

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Picture of person writing tax for Real Estate News for Investors Podcast Episode #528

The IRS says it will not tolerate “gimmicks” to get around the new $10,000 limit on SALT deductions. The new Tax Reform law is often seen as punishing high-tax states that are predominantly Democratic, like New York and California, because local taxes beyond that cap are no longer deductible on federal returns. That’s prompted an effort by lawmakers in those states to come up with workarounds, but the IRS is putting its foot down, and saying “no way.”

The SALT deductions are state and local tax deductions that include property tax, state income tax or sales tax, and mortgage interest. By capping the deductions at $10,000, many taxpayers are facing a big increase in their tax burden. Several states are working on ways to get around this new limit, but the IRS is flexing its muscles with a warning. It says in part, “Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.” [1]

As the New York Times reports, the notice was issued ahead of any legal review process and the issuing of a formal response by the IRS. But, the intentions of the IRS are clear – it plans to meet any efforts by states to bypass the new SALT caps with more than a slap on the wrist.
 

State Strategies to Avoid SALT Caps

Connecticut, New Jersey, New York, and Oregon have already implemented new strategies for taxpayers to get around the federal limit on SALT deductions. California is lagging behind the other states on workaround strategies, but there are two pieces of legislation working their way through Sacramento. It may be surprising that California wasn’t the first one to get a workaround approved, but a senior policy analyst with the Tax Foundation, Jared Walczak, told the Chronicle, “It’s in the best interest of the state and taxpayers not to rush forward, with so much uncertainty.”

That uncertainty has increased with the IRS warning that states will not be allowed to implement strategies that sidestep federal rules on SALT caps. The issue will likely be tied up in court as states challenge the constitutionality of the tax rules, and the IRS attempts to assert its authority over states. New York, New Jersey, and Connecticut plan on filing a lawsuit based on what they say are violations against states’ rights and the Equal Protection clause of the U.S. Constitution.

In the meantime, states are moving forward with their workaround plans. New York was the first to come up with a strategy that will give taxpayers a choice between two options. One lets property owners convert property taxes into charitable contributions which are fully deductible, with no caps. The other is a bit more complicated, and is still being finalized. It will give taxpayers a way to convert their state income tax into a payroll tax which would be paid by their employers. The employers would then deduct those taxes from their own federal tax bill.
 

California SALT Workarounds

California lawmakers are also working on two options. A Senate bill would give taxpayers a way to divert local tax payments into a charitable fund called the “California Excellence Fund” which pays for various state services. Taxpayers would get a tax credit that’s equal to 85% of their contributions, and is fully deductible under Federal tax rules, with no cap. The Fund would keep the other 15%. Lawmakers had made it a 100% tax credit at first, but felt that could be easily challenged as something other than a charitable donation.

That bill has been approved by the Senate but, according to the Chronicle, it hasn’t gotten anywhere in the Assembly. And, the Assembly is working on a second option, that involves a state tax credit for taxpayers who donate to any public school in the Cal Grant program or any public charity that’s enrolled in the tax credit program. The taxpayer would get a credit equal to 80% of the donation. The school or charity would get 10% and the other 10% would be put into the state’s general fund. [3]
 

IRS Crackdown

The IRS does intend to issue new regulations to address how Uncle Sam will treat these charitable funds and whether contributions made under new state rules will be deductible under federal tax laws. The agency said, the law is based on “substance over form” principles which means that if the federal government determines that so-called charitable contributions made into these state funds are really a way to avoid the cap on state and local tax deductions, then they will not not qualify as federal tax deductions.

Whatever comes of this won’t be resolved quickly however. Legal experts are anticipating a lengthy legal and political battle between the IRS and some states. There’s a lot at stake on both sides. The L.A. Times reported, the average state and local deduction, taken by more than 6 million Californians in 2015, was more than $18,000. New York and Connecticut were the only states with a higher average deduction. That represents a lot of money that’s now going into Uncle Sam’s pockets under the new tax rules. And it’s important for the federal government to keep that cash flow to help offset those huge tax cuts given to business and corporations [2].

Tax experts believe that state’s may have an strong legal standing, however, to turn local tax liability into valid charitable donations. Seven tax experts from Stanford, the University of California, and other law schools published a paper that concludes that taxpayers can reduce state tax liability with these donations that also reduce federal tax obligations.

The IRS already allows deductions for contributions to dozens of charities. And, as the L.A. Times reports, “It would be difficult for the IRS to draft regulations that allow those programs to continue while invalidating efforts like those of California and New York to use credit for state and local taxes.”

Links:

[1] IRS Notice

[2] Chronicle Article

[3] L.A. Times Article

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