High-tax states plan workarounds to the federal SALT deduction

  • The GOP tax code caps the SALT deduction at $10,000.
  • But the average SALT deduction for taxpayers in New York, New Jersey and California has been about $20,000.
  • Politicians in blue states across the country are devising ways to workaround the federal code.
Residents wait in line to pay taxes at the Fairfax County Government Center December 28, 2017 in Fairfax, Virginia.
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Residents wait in line to pay taxes at the Fairfax County Government Center December 28, 2017 in Fairfax, Virginia.

Officials in New York, New Jersey and California are working to reshape their tax codes to ease residents' pain from new limits to federal deductions for state, local and property taxes.

Starting this year, the Tax Cuts and Jobs Act, the GOP's new tax code, caps taxpayers' deductions on their property, state and local incomes taxes (SALT)  at $10,000.

But in 2015, the average New Yorker's SALT deduction was more than $22,000. In New Jersey and California, the average deductions were around $18,000.

Previously, there was no limit on the extent to which taxpayers could deduct these local levies. The change means many residents in these states — and many others — will now pay more to the federal government. (See chart below.)

"We're attempting to come up with ways to negate and blunt the harsh and unfair Republican tax policy," said Kevin de León, the Democratic leader of the California State Senate.

To combat the new SALT deduction cap, politicians are proposing creative concepts. Some of the ideas include granting a charitable deduction — which remains uncapped — after filers pay property taxes. Another idea does away with income taxes and applies a statewide payroll tax to be paid for by employers — which is deductible to them.

"The whole intent is to ensure that you get the benefit of the deduction you would otherwise lose," said Joseph Bankman, the Ralph M. Parsons Professor of Law and Business at Stanford Law School.

The White House has expressed its disapproval.

"I hope that the states are more focused on cutting their budgets and giving tax cuts to their people in their states than they are in trying to evade the law," said Steven Mnuchin, U.S. Treasury Secretary, at a press briefing this month.

"The whole intent is to ensure that you get the benefit of the deduction you would otherwise lose." -Joseph Bankman, Professor, Stanford Law School

However, Robert Mujica, New York's budget director, said it's impossible for the state to not react.

"What Washington did to New York was say 'We're going to basically change the laws entirely and upend your system, oh, and by the way, don't make any changes to adjust to it'," he said.

Here's how three key states are working to combat the new tax law.

California  

California State Senate leader Kevin de Leon.
Michael Tullberg | Getty Images
California State Senate leader Kevin de Leon.

In early January, California Senate leader de León introduced a bill that would allow residents to pay some of their state taxes to the California Excellence Fund, a state charity. In turn, taxpayers would be able to deduct the amount of their charitable contribution on their federal returns.

So if, say, a San Francisco resident's SALT taxes were $15,000, they could pay the first $10,000 as normal, and then contribute the remaining $5,000 of their state tax bill to the California Excellence Fund as a charitable donation. That would then make their total SALT taxes deductible.

"It means sitting down with an accountant in December instead of March." -Brian Galle, Professor of law, Georgetown University

"It's pretty easy," said Brian Galle, a law professor at Georgetown University who specializes in taxation. "It follows a mechanism that many taxpayers have done every year."

What might require adjustment is that people would have to figure out their taxes months earlier than they're used to. That's because people would need to know their state tax bill and make that charitable contribution before the end of the year to receive the benefit.

"It means sitting down with an accountant in December instead of March," Galle said.

Educating Californians about the system would be a major part of the plan, de Leon said.

New York  

New York Governor Andrew Cuomo.
Drew Angerer | Getty Images
New York Governor Andrew Cuomo.

Absent of any changes, the state estimates that New Yorkers would pay an additional $14 billion a year in taxes.

So earlier this month, New York Gov. Andrew Cuomo ordered the Department of Taxation and Finance to craft ways for the state to respond to the GOP tax bill. The department emerged with a slew of proposals to reshape New York's taxation.

"All of them are designed to give back to New Yorkers what the federal government took away," Mujica said.

The first proposal basically mirrors California's plan. Residents would contribute their SALT taxes beyond the $10,000 cap to a state charity, and therefore make their entire bill eligible for deduction.

The other major proposal would shift income taxes to payroll taxes — or from employees who can no longer deduct taxes to employers who still can.

Employers, facing a higher tax bill, would most likely reduce wages. But the state would give employees a wage credit, which would be deductible.

"What Washington did to New York was say 'We're going to basically change the laws entirely and upend your system, oh, and by the way, don't make any changes to adjust to it'" -Robert Mujica, Director, New York State Division of the Budget

So if an employee makes $75,000 a year, and the employer lowers her salary to $65,000 because it's now paying a new payroll tax, the state would give the employee a wage credit for $10,000. The employee is back where she started (at $75,000) — but now she has her state taxes shielded from federal taxation.

This proposal could reach more people than the charitable deduction, Galle said.

"You might be benefiting all your constituents," he said. "Not just the ones who itemize." Although it might require workers to accept an immediate pay cut.

Mujica said these proposals are a top priority for the state.

"We'd like to get legislative drafted in the next few weeks," he said.

New Jersey

On Jan. 5, Rep. Josh Gottheimer, D-N.J., proposed a plan that would allow homeowners to make up for lost property tax breaks by taking a charitable deduction.

Towns and cities would establish charitable funds to pay for public services, including schools and law enforcement. Homeowners could make contributions to these funds. The municipality would provide homeowners a tax credit to offset that donation. Then on a federal tax return, the homeowner can take a charitable deduction for the contribution.

Homeowners who already pay their property taxes monthly, wrapped in with their mortgage payment, would have to work with their lenders to ensure that there would be less or no property tax paid.

Three towns in New Jersey — Fair Lawn, Paramus and Park Ridge — are already designing plans based on this concept.

In response to Mnuchin's comments, Gottheimer said there's already a precedent for this idea. He pointed to an IRS memo that allowed contributions to a state tax credit program to be considered charitable contributions.

Gottheimer also said there are existing plans in a number of states that give taxpayers a credit for contributing to public funds that give money to local causes.

Challenges ahead

The Internal Revenue Service headquarters in Washington, D.C.
Andrew Harrer | Bloomberg | Getty Images
The Internal Revenue Service headquarters in Washington, D.C.

The IRS told CNBC that it's not issuing any statements on these proposals as of now — but the ideas are receiving a fair share of criticism from elsewhere.

"It's the kind of thing that emerges in an ivory tower with not much thought about the practicality," said E.J. McMahon, a conservative economist and founder of the Empire Center for Public Policy.

But California Senate leader de León said the California Excellence Fund was modeled after a bill passed in 2014 that permits Californians to donate to a state general fund to support students' higher education. Those donors receive a tax credit for their federal returns.

Similar systems also already exist in red states like Alabama and Arizona, he said.

"It's very clear that we already have many states using this model," de Leon said. "If they change this all of a sudden — after this egregious tax policy was passed by the Republicans  —  it would smack of utter politics."

Residents fill out paper work and use locked drop boxes to pay their taxes at the Fairfax County Government Center December 28, 2017 in Fairfax, Virginia.
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Residents fill out paper work and use locked drop boxes to pay their taxes at the Fairfax County Government Center December 28, 2017 in Fairfax, Virginia.

Still, critics say that what's being proposed is different from those existing programs.

"These [existing program] contributions produced an actual charitable benefit, whereas the proposals involve a pure tax swap," said Jared Walczak, senior policy analyst at the Tax Foundation. "The IRS requires that charitable contributions have genuine charitable intent and a charitable outcome."

McMahon pointed out that any value you receive from a charitable donation is not deductible. He provided an example: If a person at a silent auction bought a vacation that's worth $2,000, but paid $4,000 for it, he could only deduct $2,000 — because the other half was not charity, but rather a benefit he reaped.

The idea of a dollar-for-dollar tax credit, then, would fly in the face of this policy, he said.

"It's the kind of thing that emerges in an ivory tower with not much thought about the practicality." -E.J. McMahon, Founder, Empire Center for Public Policy

Galle, however, said tax benefits are not considered income, or value in the traditional sense.

"The legal bar for finding that a state tax benefit creates federal income is very high," he said.

New Jersey's proposed program and others like it may pass the charitable intent smell test depending on how they're structured, advocates said.

"Let's say you could direct some of the money you paid — if you could say that it went to cops, to schools — then it's not really a tax, it's a charitable contribution," said Stanford Law School's Bankman. "With current taxes, none of the money can be directed. But here it can be."

Mujica said he is not worried about challenges from the federal government.

"We're going to draft legislation that can withstand any legal tests," he said.

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