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Tax reform could hit certain states harder than others

  • Residents of states like California, Connecticut, New Jersey and New York could face a bigger tax bill with proposed changes to state and local tax and mortgage deductions.
  • Effects of the changes will vary depending on a family's size, income and which deductions they are still eligible to take.

Residents of states with higher tax rates — like California, Connecticut, New Jersey and New York — might be facing bigger tax bills if the Republicans' tax reform is kept in its current form.

Now that the Senate passed a sweeping tax reform bill, proposed changes to state and local tax and mortgage deductions could be especially damaging to those residents. State and local taxes (also known as SALT) include state sales tax, property and real estate taxes. Individuals can currently deduct those taxes as an itemized deduction.

"The change to the state and local tax deduction would reduce disposable income for many taxpayers, likely outweighing the positive effect of lower federal rates on consumption in many communities and states," said Nick Samuels, a vice president at Moody's Investor Service.

"The SALT change would also reduce financial flexibility by increasing political resistance to tax increases at the state and local level. The overall negative effect would be felt most sharply in high-tax states such as California, New York, and New Jersey," he added.

"The bottom line is for families in these particular states... the loss of deductions will impact them much more than families in states with lower state income taxes and real property taxes." -Chris Raulston, Raymond James

The original Senate version of the tax reform bill proposed eliminating all SALT deductions. The House of Representatives' version of the bill proposed repealing the SALT deduction except for real estate taxes of up to $10,000.

An amendment to allow the deduction of up to $10,000 in state and local property taxes will now be included in the Senate tax bill, Senator Susan Collins, R-Maine, tweeted on Friday.

The tax reform legislation also proposes changes to the mortgage interest deduction. Currently, individuals can deduct up to $1 million in mortgage debt.

The House tax reform plan proposes capping the deduction at $500,000 in mortgage debt for newly purchased homes. But a deduction of up to $1 million in mortgage debt would be maintained for current homeowners.

The Senate plan does not include changes to the mortgage interest deduction.

Lawmakers are working to come up with one tax reform bill.

"The operating assumption would be that the Senate's provisions will be controlling," said Jared Walczak, senior policy analyst at the Tax Foundation.

The loss of SALT and mortgage deductions could result in a bigger hit for residents of certain states, according to Chris Raulston, a wealth strategist at Raymond James.

"The bottom line is for families in these particular states that have not only higher state tax rates and higher state income taxes and real property taxes, the loss of deductions will impact them much more than families in states with lower state income taxes and real property taxes," Raulston said.

Effects of the changes would vary depending on the size of the family, their income and the standard deduction they would be allowed to take under the plan's revised individual income brackets. Some lower and middle income taxpayers could be made whole if the doubling of the standard deduction offset the elimination of the personal exemption and itemized deductions, Raulston said.

But the same might not be true for larger families, he said. That's because the elimination of deductions and exemptions — such as for the family's mortgage, number of family members or state income and real estate taxes — might amount to more than the increased standard deduction.

"It's pretty brutal and there's no way to hide other than moving to Utah or Nebraska." -David Edwards, Heron Wealth in New York City

The effect of the proposed elimination of the alternative minimum tax — a separate tax system for income and deductions aimed at the wealthy — is also something to consider, said Tim Steffen, director of advanced planning at Baird Private Wealth Management.

"When you combine the loss of the state income tax deduction with the loss of the AMT, it could be a wash for a lot of high income individuals," Steffen said.

States may also rethink their approach to revenue and spending with the increased risk of losing high-income residents, he said.

"The fear of a mass exodus from these states is probably a little overstated," Steffen said. "Maybe over a longer period of time there would be more impact, but it shouldn't be immediate."

Financial advisor David Edwards, president of wealth management firm Heron Wealth in New York City, said all of his high-income clients are looking at a tax increase after they lose the standard deduction, deductions on state and local taxes and breaks on real estate taxes and health care expenses.

"It's pretty brutal and there's no way to hide other than moving to Utah or Nebraska," Edwards said.

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