You probably know that a new tax reform law went into effect this year. The new tax law (Tax Cuts and Jobs Act) contains lots of controversial changes. One of the biggest changes was a drastic reduction in the amount of state and local taxes you can deduct from your federal income taxes. Before 2018, if you itemized your deductions, you could deduct the full amount of local and state property taxes and income taxes you paid. There were no limits on this deduction. These deductions were great for higher income people; especially those who owned expensive homes and lived in states with high property taxes. Now, as a result of tax reform, you can deduct a total of $10,000 in state and local taxes each year. That's it. And you can't carry over undeductible amounts to future years. For example, if you pay $20,000 in state and local tax, you can only deduct $10,000. The other $10,000 is undeductible forever.
This change primarily affects "blue states" – those in the northeast and far west. These states generally have higher property values and higher property taxes and state income taxes than red states. For example, the average state and local tax deduction in New York, New Jersey and California are about $20,000. Of course, blue states also tend to vote Democratic – a fact not lost on the Republicans who passed the tax reform bill. Several blue states have been trying to implement workarounds to allow state residents to make up for the loss of state and local tax deductions. One workaround involves the federal income tax deduction for charitable contributions, which tax reform did not change. Charitable contributions are still 100 percent deductible for taxpayers who itemize, up to 60 percent of their income.
So, several blue states had a bright idea. They would establish state or local-run charities and allow residents to contribute a portion of their state income taxes to them. In return for such contributions, taxpayers would get a credit against their state income taxes. These taxpayers would then deduct the amount of their charitable contribution from their federal income taxes. States that have enacted, or are seriously considering passing, such a workaround include California, New York, New Jersey, and Maryland. For example, if a California resident's state and local taxes were $15,000, he or she would pay the first $10,000 as usual. Then give the remaining $5,000 of their state income taxes to the state-run charity as a tax-deductible charitable contribution. That would give the taxpayer a total $15,000 federal income tax deduction – the $10,000 state and local tax deduction and the $5,000 charitable deduction. However, the IRS has told the blue states "not so fast." It has released proposed regulations that prohibit this strategy. The regulations provide that, if a taxpayer receives a state income credit for a charitable contribution, the amount of the contribution eligible to be claimed as a charitable contribution on the person's tax return must be reduced by the amount of the credit. The only exception to this rule is for state tax credits that do not exceed 15 percent of the amount contributed to the charity.
Here's how the proposed IRS rules would work. Say you live in California and donate $5,000 of your state income taxes to the state charity. In return, you receive a $5,000 state income tax credit. The IRS will not allow you to deduct the full $5,000 as a charitable contribution on your federal income tax return. At most, you can deduct 15 percent of $5,000, or $750. The federal restriction doesn't help much for the loss of the full state and local tax deduction. To put it mildly, the blue states are not happy. Several have sued the IRS in court claiming the $10,000 cap on the state and local tax deduction is unconstitutional. Good luck with that.