High Tax States and the New Tax Bill - Will You be Rescued?
Much has been made of the effect that the new tax bill is having on taxpayers that live in high tax states, and rightfully so. Residents of NY, CA, NJ, IL and other high tax states face significant losses of itemized deductions specifically due to the new $10k SALT (state and local tax) cap. Will states come up with creative solutions to combat some of these changes? They might or they might not, but they are certainly trying!
SALT - Remind me what that is again?!
First, just to make sure we're all on the same page, I'll quickly explain the new SALT cap. In years prior to 2017, individual taxpayers (individual meaning non-business) could deduct their state and local taxes on their federal return as itemized deductions. These taxes included anything withheld from your paycheck for your state or locality as well as any local or state taxes you paid in as estimates, with your extensions or when your return was due. There was no limit on the amount of these taxes that could be included as itemized deductions. Additionally, you could deduct real estate taxes as an itemized deduction. There was no cap for this either. However, effective January 1, 2018 as part of the TCJA (Tax Cuts and Jobs Act), these state and local income taxes as well as real estate taxes are subject to a combined $10k limit. This limit lasts for the next 7 years or until a new tax bill is written (I know you can't wait for that!). As an example, if your state taxes plus local taxes plus real estate taxes total $25k, you can only deduct $10k. In high tax states, many taxpayers will take a big hit because of this new rule.
In New York, Governor Cuomo is working on a some maneuvers that would help alleviate the tax blow many of his constituents will feel over the next several years. Other high tax states, such as California and Illinois, are using some of these ideas as a guide and developing some of their own. There does seem to be good communication between many of the high tax states allowing for idea sharing. The ability for some of these ideas to both pass IRS muster and be broadly implemented is being debated and will continue to be the biggest hurdles in the states' quests to provide some relief to their residents.
Real Estate Taxes as Charitable Contributions?
As many of you are probably aware, there was a mad dash for folks to pre-pay their real estate taxes before the TCJA went into effect. The IRS has issued guidance that prepayments cannot be deducted in 2017, however, the definition of prepayment is not as straightforward as you would think. That, however, is not something I am going to elaborate on here. The ability to prepay was an effort that Cuomo got involved in and he tried to get municipalities to issue tax bills early to allow for prepayment. For 2018 and beyond, Cuomo is considering a plan which would essentially switch real estate tax payments to mandatory payments to a 'charitable fund'. Instead of paying your real estate taxes to your locality, you would make a payment to that locality's charitable fund and the locality would then use those funds for various public services. An interesting approach to say the least and one that is successfully used in a couple of places throughout the country. The usage in other, much smaller, places is why proponents think it might pass muster. However, when a state like NY really thrusts this onto the radar, the IRS may take a much harder look and conclude that it is not allowed. That is what many experts believe will happen. An essential question is 'would this set-up be adequate to convince the IRS that these 'charitable donations' aren't simply real estate taxes by another name'. If the IRS did go along with it, implementation would no doubt be a bear. The devil will certainly be in the details if this approach has any chance of succeeding.
More Payroll Tax, Less Withholding Tax?
Wait...what does that even mean? As it stands now, when you receive a paycheck, you have a slew of items deducted from your gross pay to arrive at your net check. Among those are federal withholding tax, FICA and FICA MED (payroll taxes) and state/local withholdings. As discussed at the outset, state and local taxes plus real estate taxes are now capped at a maximum deduction of $10k per year. However, payroll taxes are still fully deductible for employers. Cuomo has proposed that employers restructure their pay scales and pay a new 'payroll tax' to NYS instead of withholding state and/or local taxes from employees. This would allow the employers to deduct the expense and the employees would no longer have a deduction to lose on their personal returns. This would be very difficult for employers to institute as it would require significant pay scale restructuring to keep both employees and employers on even footing with where they were in 2017. However, it would be a very viable option for smaller businesses and for high earners within certain larger companies (assuming that there would be no restriction preventing this from only being implemented for certain employees). A small business, especially one in which the owner was the only employee, could easily maneuver to implement such a change, potentially resulting in a much higher post-tax tax home $$$. There is less consensus amongst experts on this approach as far as the IRS stance is concerned. The ability of employers to implement this new structure would likely be the biggest roadblock to success.
I know...you're thinking 'I just read all that but will any of it really happen?' The answer is 'I have no idea'. What we do know is states such as NY, CA and other high tax states are trying to develop some workarounds to help their residents. Even if they do develop plans that are reasonable and pass muster with the necessary taxing authorities, it is unlikely we will see anything implemented in 2018 as we are quickly approaching the midpoint of the year (of course, the TCJA got rammed through with handwritten notes in the margins and no time for implementation, so anything is possible).
It is important that the states develop some kind of relief as the high tax rates are driving residents, and businesses, to move to other states where living is more affordable. NY, and others, needs to entice its residents to stay put. These ideas, and others still being worked on behind closed doors, are potential paths to resident retention and strong state economies.
Adam Ditsky, CPA
President, Ditsky Strategic