4 SALT Planning Strategies
Allowing state and local taxes (SALT) to be fully deductible has been a bedrock principle of our tax code, one of the six deductions on the original 1913 tax return. But the Tax Cuts and Jobs Act (TCJA) changed that.
The TCJA imposed a new federal limit on a taxpayer’s total state and local taxes of $10,000 for single and married taxpayers filing joint returns and $5,000 for married individuals filing separate returns. An unforeseen result is that the SALT deduction limitation has reduced the number of taxpayers who itemize in favor of the new higher standard deductions ($24,400 for married filing jointly, $18,350 for head of household and $12,200 for single and married filing single).
The new law has been unpopular with high-tax states, such as New York, New Jersey and California. Following the TCJA’s passage, some high-tax states implemented strategies to assist their residents in mitigating the effect of the federal SALT deduction limitation.
One approach was the establishment of state charitable funds where the state gives individual taxpayers SALT credits in exchange for contributions to state-run charitable funds. This method was intended to convert non-deductible state and local payments into deductible charitable gifts. The IRS has effectively shut down this scheme in recently issued final regulations for contributions made after Aug. 27, 2018. The regulations provide that a taxpayer who makes payments or transfers property to an entity eligible to receive tax-deductible contributions must reduce his or her charitable deduction by the amount of any state or local tax credit the taxpayer receives or expects to receive. However, there is an exception for SALT credits that do not exceed 15 percent of the contributed amount.
Some states have proposed regulations to help residents that have an ownership in a pass-through entity such as sub-S corporations, partnerships, LLCs and sole proprietorships. The rules would allow the state tax to be paid at the entity level, where there is no SALT limitation, on net taxable income instead of having the owners pay the state tax at the individual level. At this time, Connecticut has passed this type of legislation and New Jersey has a similar proposed bill pending (S-3246). The identical bill, A-4807, was introduced after S-3246.
In another attempt to work around the federal SALT deduction limitation, New York has established an Employer Compensation Expense program that shifts the state income tax from the individual taxpayer to the employer. The employer must have enrolled byDec. 1, 2019, for calendar year 2020.
Last year, New York, Connecticut, Maryland and New Jersey filed a complaint in the U.S. District Court seeking relief to invalidate the SALT deduction limitations on the grounds that the cap violates the U.S. Constitution by interfering with the states’ sovereign authority to decide whether and how much to invest in their residents, businesses and infrastructure. Recently, the Court dismissed the case, finding that the states failed to present any constitutional principle that would bar Congress from exercising its power to impose an income tax without limitless SALT deduction. In addition, the Court held that the cap is not unconstitutionally coercive because it does not meaningfully constrain the states’ exercise of their own sovereign tax powers.
Even though the IRS has issued regulations to end these creative workarounds and the court challenges have not been successful for the states, there are some tax planning opportunities that exist to minimize the impact of the new tax law:
1. Capitalize Carrying Costs
Taxpayers may make an annual election (for certain property) to capitalize carrying charges, including taxes that normally would be deductible (see IRC Sec. 266 and Reg. 1.266-1(c)). This election is helpful when the taxpayer does not itemize or would otherwise receive little or no benefit from deductible taxes.
Example: Dan Jones owns a valuable tract of undeveloped land near Giants Stadium. Property taxes are $5,000 per year. Dan expects to sell the property in a few years. His total state and local taxes currently exceed $10,000 per year.
Dan can elect, pursuant to IRC Sec. 266, to capitalize the property taxes on the property. By making this election, the property taxes increase the basis in his land. Therefore, when Dan sells the land, if there is a gain on the sale, it will be reduced due to his increased basis.
2. Maximize Itemized Deductions
With the increase in the standard deduction, many individuals will not be itemizing deductions as they had in years prior to the TCJA. A strategy may be to itemize deductions one year and the following year take the standard deduction. This can be accomplished by bunching certain expenses into one year including medical expenses and charitable contributions. One method to increase the charitable contributions would be the use of a Donor Advised Fund (DAF). Cash and/or appreciated securities can be transferred into a DAF whereby the taxpayer receives a large charitable contribution deduction in year one. Distributions from the DAF can be made over several years to specified charitable organizations. Whenever the taxpayer is not able to itemize in a future year, he or she may make another transfer to the DAF.
Taxpayers may also want to consider prepaying a month of mortgage interest to increase their total itemized deductions.
3. Deducting Tax Preparation Fees
The TCJA suspended the miscellaneous itemized expense deduction through 2025, which included tax preparation fees. Schedule C and Schedule E taxpayers may be able to allocate a portion of the fee related to the preparation of these schedules and receive a deduction.
4. Transfer of Required Minimum Distribution (RMD) to Charity
This strategy is for taxpayers that generally make charitable contributions but do not have enough itemized deductions. In lieu of taking an RMD, the taxpayer would have the amount directly transferred to the charity. There would be no income tax on the RMD as it was not received by the taxpayer but would satisfy the required minimum distribution obligation.
While the new tax law has been unpopular with high-tax states, a small silver lining exists in that state tax refunds are not includible in income to the extent the SALT deduction was not taken.
James A. Lawrence
James A. Lawrence, CPA, CCPS, is a tax partner at Traphagen & Traphagen CPAs, an affiliate of Traphagen Financial Group. He is a member and past leader of the NJCPA Federal Taxation Interest Group and a past president of the Society's Bergen Chapter.
This article appeared in the January/February 2020 issue of New Jersey CPA magazine. Read the full issue.