If you or any of your clients were hoping for a legal way to get around the relatively new federal $10,000 limit on state and local tax (SALT) deductions, forget about it.
The IRS has just issued final regulations on charitable contributions and state and local tax credits that essentially nix the most popular idea behind such workarounds: recharacterizing most of the state and local taxes as a charitable contribution to a specific fund that would then qualify for a federal tax deduction and state tax credit.
“The regulations prevent charitable contributions made in exchange for state tax credits from circumventing the new limitation on state and local tax deductions,” according to a statement from the U.S. Treasury.
As a result of the 2017 tax cut legislation, the federal government capped the deduction for state and local taxes at $10,000, which affected residents, especially homeowners, in high-tax states like New York and New Jersey. Both states subsequently passed laws that allowed the charitable contribution workaround, though New Jersey required that local governments create the charitable funds. Now those workarounds are essentially dead.
Under the final IRS regs, a taxpayer contributing to a fund able to receive tax-deductible contributions after August 27, 2018, must reduce their federal charitable contribution by the state tax credit received.
The IRS, in its new final regulation, gives the example of a taxpayer contributing $1,000 to a state tax-deductible fund that grants a 70% state tax credit for the contribution, worth $700. That taxpayer would then have to reduce the federal charitable deduction by $700, leaving only a $300 federal tax deduction. No reduction in the federal deduction is required if the state tax credit is set at 15% or less.
A more relevant example for those living in high-tax states would be a taxpayer owing $20,000 in state and local taxes who pays $10,000 into a state charitable fund to make up for the SALT deduction limit. If the taxpayer receives a $9,000 tax credit for that contribution, she would only be entitled to a $1,000 federal tax deduction.
“This is an application of the quid pro quo doctrine,” writes Jared Walczak, a senior policy analyst at with the Center for State Tax Policy at the Tax Foundation, in his analysis of the IRS ruling. “If you expect to receive a benefit from a contribution, then it is not truly charitable.” He tells ThinkAdvisor that a taxpayer contributing to such a workaround fund “could end up paying more in taxes and potentially face a penalty.”