Charitable Funds Tax Credit: States Seek Loopholes in the Federal SALT Deduction Cap

The proposed regulations are subject to a 45-day comment period ending October 11, 2018

By George King Government, Risk Management

Any change to tax policy brings opposition and endorsement from those who prosper and those negatively affected. The Tax Cuts and Jobs Act (TCJA) enacted late last year was no exception. The law reduced the amount taxpayers could deduct in state and local property, income, and sales taxes on a federal tax return to $10,000 – previously, there was no limit. The State and Local Tax (SALT) deduction is set to boost the government balance sheet by about $36 billion in 2018, reaching $90 billion by 2024.

Historically, the SALT deduction has been a valuable tax break for those with high-value properties, those in states with high property taxes where middle-class homes can easily exceed the threshold and those with secondary homes leading to larger property tax bills. As a result, many property owners flocked to their nearest tax office to prepay their 2018 taxes in December and maximize one final full SALT deduction on 2017 tax returns. According to data from CoreLogic, pre-payment activity in California grew by 90 percent, while on the East Coast, prepayments jumped by 300 percent in New Jersey and 191 percent in Massachusetts. These prepayments came despite an IRS advisory opinion, which stated that prepaying 2018 real property taxes in 2017 may be deductible only under certain circumstances.

Recently, four states (Connecticut, Maryland, New Jersey and New York) filed a federal lawsuit to strike down the cap on SALT deductions and are asking the court to declare the cap unconstitutional. While the lawsuit pends in court, states continue to look for loopholes to the law to help constituents offset the deduction cap.

Government

A tax credit from charitable funds appears to be the favored solution. In March, the New York State Budget amended the tax law to facilitate two specific changes: to authorize school districts, counties, and New York City to establish charitable funds and to provide a credit against real property taxes, up to 95 percent of taxpayer contributions to such funds. These provisions are already in effect. Connecticut and New Jersey have since passed similar charitable funds bills, which both went into effect in early July.

California, Illinois, Nebraska, Virginia and Washington also introduced legislation, along with Oregon and Rhode Island, while legislation in Nebraska, Virginia and Washington did not advance. Only bills in California, Illinois and Rhode Island are considered pending at this point. Of these three measures, Illinois appears to be the only state providing for a property tax credit.

However, the federal government is following these advancements and attempts closely, working on ways to shut down potential state workarounds. In late May, the IRS announced that it, along with the U.S. Department of the Treasury, would issue guidance on payments made in exchange for state and local tax credits. In its Notice of Intent, the IRS proposed regulations to address the deductibility of state and local tax payments for federal income tax purposes. Additionally, the notice (Notice 2018-54) reinforced that federal law controls the characterization of payments for federal income tax purposes regardless of how state laws may characterize such payments.

On August 23, 2018, the IRS announced proposed regulations that were then published in the Federal Registrar days later. Now cited as Document 2018-18377, the rule holds that all contributions claimed for purposes of charitable deduction must be reduced by the amount of any corresponding credits received. This clarification would render the SALT workaround “Charitable Fund” legislation ineffective in mitigating the $10K SALT cap.

For example, if a state grants a 70 percent state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer must then reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer’s federal income tax return.

The proposed regulations are subject to a 45-day comment period ending October 11, 2018. If they were to pass, such a ruling would be bad news for those who itemize their tax deductions and may consider moving out of high property tax areas. While for lenders, these regulations will help to mitigate the anticipated mortgage loan administration challenges and complexities of SALT-cap mitigating property tax credits as they determine the correct escrow obligations for borrowers from year to year.

Any change to tax policy can be a headache for lenders and borrowers alike. In the meantime, both parties continue to face uncertainty as the federal and state governments continue to battle out the SALT deduction and its proposed tax credit loopholes.

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