|Tax Cuts and Jobs Act – SALT Deficiency
The Tax Cuts and Jobs Act (TCJA) introduced significant changes to the tax code—the most since 1986. The main difference between the two laws was that the 1986 legislation was a bipartisan effort, while the TCJA was not. Tax reform in 1986 was enacted after a tremendous amount of negotiation and consideration of potential consequences, intended or not. This was President Reagan and Senator O’Neil at their very best.
The 2017 Act was passed in several months with no bipartisan support and little consideration of potential consequences.
I say this because there are numerous errors, ambiguities, and inconsistencies that will take bipartisan support to correct or clarify. The question is, will nine Democratic Senators support the corrections or clarifications? Only time will tell. Important to taxpayers and investors is when there is so much uncertainty, there is opportunity.
While we certainly want to stimulate your awareness and discussion of the implications of TCJA, please consider that the regulations are still being drafted—so our interpretations of the Act are just that until the regulations have been drafted.
We have studied the TCJA and see tremendous opportunities for individuals and corporations to reduce their tax burden. Over the next several months, we will bring you our interpretations of the TCJA and how they may affect you, your business and your clients.
The first area we will discuss is the very unsexy topic of state and local taxes, also known as SALT. Here is a bit of a history lesson on SALT—the deductibility of state and local taxes has its origin in the civil war! SALT was included in the Financing Revenue Act of 1862 which helped finance the Civil War. It was also introduced in the Revenue Act of 1913.
Think of this – the deduction was introduced because there was a fear that high level of Federal taxes might deplete all state resources. This seemed to make sense when the highest marginal rate was 77% in 1918 and 94% in 1944. Keep in mind the top marginal rates from 1951 until 1964 remained at 91-92%. The deduction of state and local taxes before calculating your federal obligation prevented the combined rates from exceeding 100 percent.
During the years since, certain taxes have been added and certain taxes have been deleted from the deduction. The deductions for mortgage interest and property taxes are designed to incentivize home building and home ownership. The deduction for state and local sales taxes is designed to incentivize taxpayer consumption.
As it stands today, the deduction for state and local taxes includes the following:
1. A deduction for state and local property tax, and
2. A deduction that can be used for either state income taxes or state sales taxes, whichever is higher.
The SALT deduction is one of the largest federal tax expenditures with an estimated revenue cost of $96 billion in 2017. More than 95% of those who itemize deductions claimed the deduction in 2014, 28% of all taxpayers, according to the Tax Policy Center. As you can see, these are large numbers.
The TCJA capped the amount of the deduction at $10,000 for all SALTs per tax return for years after 2017, adding to the marriage penalty. This obviously impacts high earners from high income tax states such as New York and California. However, less obviously, this significantly impacts generally high tax states like New Jersey and Illinois as well as low or no income tax states that are dependent on sales and property taxes such as Florida, Texas, and New Hampshire.
Filers in California, New York, New Jersey, Illinois, Texas and Pennsylvania have claimed more than half the value of the deduction for SALTs.
In 2016, the Tax Policy Center analyzed the effects of curbing or eliminating the deduction. Their study found that only a small number of households making under $100,000 would be impacted, whereas an average household earning $1,000,000 would get a tax increase of over $46,000, or over 4.6%. This study accounted the effect of the Pease limitation, which has been phased out, and Alternative Minimum Tax, which has been increased under TCJA.
Of course, this is for an “average” household earning $1,000,000. Now imagine a very above average family with $10,000,000 in AGI and living in California with equally high property taxes to go with 13.3% marginal income tax rate. Assuming these taxes combine to result in a total 15% SALT burden, and at a 37% marginal federal tax rate, these people are facing over $500K ADDITIONAL federal taxes – more like $555K additional or over 5.5% of their total earnings.
Consider your own personal situation—I live in Charlotte, North Carolina. I am one of the 4.1 million who pay more than $10,000 in property taxes (ATTOM Data Solutions per CNN Money). I think you get the point—there are a lot of us who will pay additional federal income taxes due to the capping of the SALT deduction.
Sure, the high-income states are obvious targets for these deductions. What many haven’t considered is the impact of not being able to deduct high sales taxes, property taxes or other SALTs beyond state income taxes. Heck, 0% state income tax Texans are learning they have a Texas size tax increase heading their way.
State legislatures are attempting to design work-arounds to make their high-income-earners whole. These range from creating charitable investment funds, to changing payroll that doesn’t sound too appealing at the outset.
Beyond these questionable efforts, there are very limited options available to help individuals relieve their tax burden. Diving into the weeds of what Congress legislates and the IRS allows we find few strategies for high income taxpayers remain. One of the main ones results from an investment in a real estate partnership with an option for a conservation purpose as defined in IRC Section 170, enacted and enhanced by Congress to provide tax incentives to conserve land and preserve historic properties. Assuming all the i’s are dotted, and t’s are crossed, the results may be worth your consideration.
Don Deans CPA/PFS