Effort to roll back SALT cap runs out of options

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States fighting a legal battle against a $10,000 cap on the federal deduction for state and local taxes ran out of viable options Monday when a federal judge dismissed a lawsuit filed by four states claiming the cap impinged on their constitutional sovereignty.

The 37-page ruling by U.S. District Court Judge J. Paul Oetken in Manhattan cited the 1988 Supreme Court decision in South Carolina v. Baker that “rejected the claim that Congress had overstepped its constitutional authority when it eliminated a longstanding federal tax exemption for interest earned on state-issued bearer bonds.”

Judge Oetken also rejected claims that the so-called SALT cap will cause a drop in home values that will reduce property tax revenue and limit the ability of state and local governments to raise taxes.

“As in Baker, the parties seeking to impose a limitation on the federal government’s plenary tax power in this case have made a strong showing that Congress has historically exempted certain income from federal taxation,” the judge wrote. “But also as in Baker, those parties have failed to identify a persuasive basis for reading such an exemption into the Constitution itself.”

In addition, the ruling cited two previous actions by Congress that have limited the SALT deduction indirectly.

The ruling came on the heels of a June action by Treasury and Internal Revenue Service that finalized a regulation preventing states from using workarounds.

It effectively leaves the states seeking relief from the cap with no more near-term avenues to contest it. Legislative repeal by Congress is not a viable option because the Republican majority that enacted the 2017 tax law still controls the Senate.

In recent years taxpayers itemizing on their federal tax returns had the choice either deducting sales taxes or claiming a combination of property taxes along with state and local income taxes.

In addition, in 1990 Congress enacted the Pease limitation that set a cap on deductions claimed by high-income households.

The $10,000 limit on the SALT deduction caused an estimated 10.88 million individual taxpayers to lose $323.1 billion in tax deductions for the 2018 tax year, the Treasury Inspector General for Tax Administration reported in February.

The impact has been the greatest in high income, high tax states where many residents pay substantial property taxes and income taxes.

Judge Oetken said in his ruling, however, that “states remain free to exercise their tax power however they wish.”

“To be sure, the SALT cap, like any other feature of federal law, makes certain state and local policies more attractive than others as a practical matter,” he wrote. “But the bare fact that an otherwise valid federal law necessarily affects the decisional landscape within which states must choose how to exercise their own sovereign authority hardly renders the law an unconstitutional infringement of state power.”

State and local governments are concerned that the $10,000 SALT cap will limit their ability to enact future tax increases to pay for public services, including infrastructure projects financed by bonds.

The first opportunity for repeal of the SALT cap prior to its December 2025 sunset date would be in early 2021 if Democrats can achieve an election trifecta of gaining majority control of both chambers of Congress as well as the White House in the November 2020 election.

In the meantime, New York Gov. Andrew Cuomo said an appeal of the ruling is under consideration.

New York was joined in the lawsuit by New Jersey, Connecticut and Maryland.

“I am in close coordination with other impacted states to consider next steps,” Connecticut State Attorney General William Tong tweeted Monday evening.

State tax credits enacted by New York and New Jersey as workarounds for paying property taxes and state income taxes were severely limited by the IRS and Treasury regulations finalized in June.

A taxpayer who receives a 90% state tax credit of $900 for a $1,000 donation can claim a federal charitable contribution deduction of only $100.

State tax credits of 15% or less are exempted. The limitation also does not apply to deductions that reduce taxable income.

But the rule does clamp down on older state tax credits of up to 100% for private school donations, often to scholarship funds, which can be used by donors to also claim federal charity deductions.

Six states of the 18 that had these tax credits prior to the 2017 federal tax law had prohibited donors from simultaneously claiming a state tax credit and a federal charity deduction.

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SALT deduction State and local finance State taxes Washington DC