One of the more controversial provisions of the Tax Cuts and Jobs Act (TCJA) is the limitation of the state and local tax deduction for taxpayers who itemize deductions on their federal income tax return (aka SALT deduction).
The TCJA limited the SALT deduction to an amount not to exceed $10,000 for married taxpayers filing jointly and $5,000 for single or married taxpayers filing separately. Historically, the SALT deduction was not capped, and it allowed taxpayers to deduct all state and local income taxes, property taxes or sales and use taxes paid.
For example, under current tax law, a New York married couple filing jointly with adjusted gross income of $100,000 will owe approximately $5,000 of New York state tax. The average homeowner in Nassau County, NY, paid approximately $11,500 in property taxes in 2017. If this same New York couple owned a home in Nassau County and itemized deductions, they would potentially lose out on a $6,500 state and local tax deduction under the TCJA.
The SALT deduction limitation generated taxpayer concern in states with high income and property taxes, prompting state lawmakers to examine ways to lessen the impact. Some states attempted to lessen the impact by passing state tax reform and regulations designed to treat certain payments made by taxpayers as charitable contributions for which taxpayers would receive a credit against their state and local taxes.
IRS notice and states’ lawsuit
The Internal Revenue Service (IRS) issued a notice on May 23, 2018, stating that any state legislative proposals aimed at circumventing the SALT deduction would be scrutinized. The IRS also warned that the federal law controls the correct characterization of federal income tax payments, and they will propose regulations to clarify the Internal Revenue Code governance of the tax treatment of such charitable contributions.
In reaction, four states, led by New York, filed a lawsuit against the U.S. Department of the Treasury and the IRS seeking “declaratory and injunctive relief” to prevent the Treasury and the IRS from enforcing the SALT deduction limitation.
The argument that may ultimately need to be decided is whether the SALT deduction limitation is unconstitutional in violation of the Tenth Amendment as it encroaches on a states’ sovereign authority to make their own taxation and fiscal policies without federal interference. Moreover, the complaint alleges that in limiting the SALT deduction, Congress exceeded its taxing powers provided by the Sixteenth Amendment, which inherently prevents the federal government from exercising its power to tax individual incomes without providing a deduction for all or a significant portion of state and local taxes.
Impact on taxpayers
So what impact will this case have for taxpayers? Will this case be decided before next tax season?
Furthermore, what will be the impact of this case on taxpayers in California or other states not included in the lawsuit? Although the Southern District of New York is a federal court, a decision of that court is not automatically binding on other states not within the Southern District. Will other states join this lawsuit?
Taxpayers should proceed and follow the TCJA and the SALT deduction limitation when preparing their 2018 tax returns. If and when this case is decided, it will likely be appealed and ultimately may be set forth to be decided by the U.S. Supreme Court.
A taxpayer who files his or her 2018 federal income tax return correctly and timely will still have an opportunity to obtain a refund and amend a 2018 tax return within the statute of limitation if the SALT deduction is ultimately eliminated. Otherwise, a taxpayer may incur penalties by waiting to file a return until this case its adjudicated or by filing a return claiming the full SALT deduction, which could ultimately be rejected by the IRS. Additional tax, penalties and interest may also apply to taxpayers who file a return in a state, claiming for a state tax credit for monies contributed to a charitable organization or fund.
One thing seems certain: this case is not likely to be settled quickly. Lawmakers will want to consider not only the effects of the SALT deduction limitation provision on taxpayers and states, but also the impact of the TCJA as a whole, the good and the bad. In the meantime, taxpayers should proceed with tax filings as usual and contact their tax advisor with any questions.