IRS finalizes regulation clamping down on SALT workarounds
State and local governments that have enacted workarounds for a $10,000 federal cap on state and local tax deductions for individual taxpayers must seek legislative or judicial relief after the Trump administration Tuesday closed the door on regulatory relief.
The announcement by Treasury and the Internal Revenue Service late Tuesday finalized proposed regulations announced in August without any major changes.
That means state tax credits enacted by New York and New Jersey and considered by other states won’t be usable as workarounds for paying property taxes and state income taxes.
The 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. Local governments have raised concerns that the $10,000 federal cap might make homeowners more sensitive to property tax or income tax increases, perhaps restricting the ability of local governments to raise money to finance infrastructure.
Emily Brock, director of the federal liaison center for the Government Finance Officers Association, described the final rule as disappointing because it “undermines a state or local government exercising its authority to adjust the tax liability of its taxpayers."
“Additionally, it also impairs further application of tax credits on taxpayers’ behalf,” Brock said in an email. “Our comments to the IRS were among the many that reflected these concerns. Unfortunately it’s yet another example of state and local governments bearing the costs of the 2017 tax act.”
Brock said the plans by the IRS to clarify safe harbors from the regulation might allow state and local governments to “proceed with fiscal policies that benefit their taxpayers.”
The final rule also clamps 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.
Only six states of the 18 that have these tax credits prohibit donors from simultaneously claiming a state tax credit and a federal charity deduction, according to Sasha Pudelski, advocacy director of the School Superintendents Association.
The final IRS and Treasury regulations limit a taxpayer who claims a state tax credit to claiming only the portion of their charitable donation not covered by the state.
Under the final regulation, the IRS said a taxpayer who receives a 70% state tax credit of $700 for a $1,000 donation would be left with “a federal charitable contribution deduction of $300.”
State tax credits of 15% or less are exempted. And the regulation does not limit deductions, which reduce taxable income, unlike tax credits, which are more generous because they directly reduce taxes owed.
“The IRS has allowed these charitable funds for decades and is only now banning them because states like New Jersey sought to utilize them and establish its own,” said Sen. Robert Menendez, D-N.J. in a press statement. “With the Trump administration closing off every avenue to mitigate the damage from the Trump tax law, this underscores the need to pass legislation like my SALT Act to fully restore the state and local tax deduction.”
Menendez is one of several congressional lawmakers from the Northeast who have proposed legislation to repeal the SALT cap, but prospects for passage are dim given that Republicans who passed the cap still maintain majority control of the Senate.
The House Ways and Means Committee plans to hold a hearing on the $10,000 cap the last week in June, spokeswoman Erin Hatch said last week.
U.S. District Court Judge J. Paul Oetken in Manhattan has scheduled oral arguments for June 18 in a federal lawsuit filed by New York, New Jersey, Connecticut and Maryland last July arguing that the SALT cap has encroached on their sovereign authority to determine their own taxation and fiscal policies.
The cap on the federal SALT deduction “disregards fundamental constitutional restraints that prevent the federal government from interfering with the states’ sovereign authority to make their own choices about whether and how much to invest in their own residents, businesses,” the states said in a court filing.
A tandem controversy predating the SALT cap involves state laws that created 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.
To a lesser extent, state charitable deductions for other purposes such as land conservation easements, also have been part of the controversy.
But some tax watchdog groups such as the Tax Foundation and the Institute on Taxation and Economic Policy in Washington, D.C., have commended the IRS for taking action.
Davis said in an email Tuesday evening, The IRS was wise to reject most of the requests for special treatment received from private school groups. I agree completely that the approach taken here is ‘more sound, comprehensive and administer-able than alternatives where donations to different types of entities would be treated different.”
Davis added, “It would have been egregious to give longstanding private school tax schemes a free pass from this regulation while cracking down on the copycat laws more recently enacted in a few blue states.”
The final regulations, which apply to contributions made after Aug. 27, 2018, and are effective Aug. 12, “largely adopt the rules in the proposed regulations,” the IRS said.
“The Treasury Department and the IRS continue to consider issuing future guidance on a number of issues raised by commenters,” the IRS said.
A coalition that includes the U.S. Conference of Mayors, the National League of Cities, the National Association of Counties, the Government Finance Officers Association and the International City/County Management Association sent the IRS a letter in October saying “the proposed regulations would hinder the ability of governmental entities to effectively, efficiently and economically serve their communities.”
The effort by the Trump administration to provide a regulatory framework for enforcing the $10,000 cap began shortly after the Tax Cuts and Jobs Act was enacted in December 2017.
The Treasury and IRS announced May 23, 2018, they planned to issue regulations, noting in the announcement “federal law controls the characterization of the payments for federal income tax purposes regardless of the characterization of the payments under state law.”
An IRS public hearing on the proposed regulation held in November highlighted the breadth of the SALT cap’s impact.
Marc Egan, director of government relations for the National Education Association, attributed the SALT cap to a drop in home sales in the Northeast.
Rabbi Abba Cohen, vice president of federal affairs for Agudath Israel of America representing orthodox Jewish schools, said the IRS regulation should not get involved in school choice issues that have been decided by states.