The IRS proposed regulations (the Proposed Regulations; available here) on August 23, 2018, that would largely block state efforts to circumvent new limitations on income tax deductions for state and local taxes and would affect many current state tax programs.
The Proposed Regulations would apply not only to New York and New Jersey legislation passed in response to the Tax Cuts and Jobs Act (described below) but also to many preexisting state tax credit programs. However, the rules described below would not apply to contributions made on or before August 27, 2018; therefore, deductions for prior contributions are unaffected and taxpayers have a very limited window to make new contributions to existing programs.
Tax Cuts and Jobs Act – Limitation on Deductions for State and Local Taxes
Effective for tax years beginning on or after January 1, 2018, the new federal tax law—referred to as the Tax Cuts and Jobs Act—strictly limits an individual's deduction for state and local taxes. Individual taxpayers who itemize their deductions may deduct only up to $10,000 in total state and local taxes. This limitation disproportionately affects taxpayers who live in high-tax states, including New York, New Jersey, and California.
There is no similar cap on the allowable deduction for charitable contributions by taxpayers who itemize their deductions. As a result, New York and New Jersey passed legislation (and several other states, including California, have taken steps toward passing similar plans) that would allow taxpayers to make contributions to a charitable fund established by a municipality and receive a credit against state taxes for those contributions (85% in New York and 90% in New Jersey).
For example, a New Jersey taxpayer with a property tax bill of $20,000 who lives in a municipality that establishes a qualifying fund could—instead of paying $20,000 of property tax—make a contribution of $20,000 to a charitable fund. The taxpayer would obtain a credit of $18,000 against his/her property taxes, leaving only $2,000 due and giving the taxpayer a charitable deduction—essentially creating a workaround of the state and local tax deduction limitation. While the taxpayer still would have to pay $2,000 that would be subject to the overall $10,000 federal cap on state and local tax deductions, the hope was that he/she would be able to deduct the full $20,000 charitable contribution. The municipality, in turn, would receive $20,000 in the charitable fund plus $2,000 in property taxes from the taxpayer.
The Proposed Regulations – Disallowance of a Federal Deduction for the Contribution
The Proposed Regulations block the efforts of states to circumvent the limitation in the Tax Cuts and Jobs Act by eliminating a taxpayer's federal charitable deduction in many circumstances. Under longstanding principals of federal tax law, a taxpayer who makes a charitable contribution—but who receives a material benefit in exchange for the contribution (i.e., a quid pro quo)—may deduct only the net value of that contribution. However, that rule generally has not been applied when the benefit received by the taxpayer who makes a donation is the reduction in his or her taxes.
The Proposed Regulations, however, would apply the quid pro quo rules to state tax credit programs as follows:
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A charitable deduction only will be allowed to the extent a contribution to a charity exceeds the amount of state tax credit generated by the contribution. In the example above, the New Jersey taxpayer only will be able to claim a $2,000 federal charitable contribution tax deduction on his or her federal return. The $18,000 New Jersey credit would be treated as a quid pro quo received in exchange for the contribution and thus not deductible as a charitable contribution.
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The Proposed Regulations do not apply to state tax deductions, only credits. If, instead of receiving a $18,000 credit, the New Jersey taxpayer described above only was able to deduct the $20,000 contribution against his/her New Jersey taxes, he/she still would be able to claim a charitable deduction for federal income tax purposes equal to the full $20,000 contribution. But, of course, the taxpayer's benefit would be relatively modest because it would be limited to the tax (federal and New Jersey) that otherwise would have been imposed on $20,000.
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The Proposed Regulations also carve out state credits of 15% or less of the contributed amount and allow taxpayers who receive credits below that threshold to claim the full charitable deduction for federal income tax purposes. This carve-out is designed to protect state programs that offer relatively modest credits in exchange for contributions to schools or hospitals.
It is widely expected that states and/or taxpayers will challenge the Proposed Regulations. In July, a group of states sued the Trump administration, arguing that the new cap on deductions for state and local taxes unfairly targets them—and it is unlikely that those states now will go quietly.
However, taxpayers in all states should be aware that under the Proposed Regulations, no deduction will be allowed for a charitable contribution if the taxpayer receives a state tax credit of 15% or more in exchange for the contribution.
