Personal Finance

Blue states file suit against IRS over rules on SALT workarounds

Key Points
  • The Tax Cuts and Jobs Act applied a $10,000 cap on taxpayers’ ability to deduct their state and local taxes, spurring some states to establish charitable funds.
  • In June the IRS and Treasury released rules that would largely put a stop to these new charitable funds.
  • New Jersey, New York and Connecticut are now suing the IRS over the new regulation.
New Jersey Governor Phil Murphy speaks after taking the oath of office in Trenton, New Jersey, January 16, 2018.
Lucas Jackson | Reuters

New Jersey is suing the Internal Revenue Service, challenging new rules that would block states' attempts to get around a new $10,000 cap for state and local tax deductions.

The state's governor, Democrat Phil Murphy, announced the lawsuit on Wednesday morning, naming Treasury Secretary Steven Mnuchin among the defendants.

"As I said when the IRS rule was finalized in June, it was nothing more than a gut punch to the middle-class New Jersey families who know that the Trump tax plan is a complete sham," Murphy said at a press conference in South Orange, New Jersey.

"It was a complete and total utter politicization of the federal tax code," he said.

New York and Connecticut have also joined the suit, which was filed in the Southern District of New York.

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This same court is hearing another lawsuit filed last year by these three states, plus Maryland, against Mnuchin and the Treasury, challenging the $10,000 SALT cap itself.

When the Tax Cuts and Jobs Act of 2017 imposed a $10,000 limit on deductions for state and local income, sales and property tax that itemizers could claim on their federal returns, New Jersey, New York and Connecticut responded with a workaround.

The three states passed legislation that would permit municipalities to establish charitable funds to pay for local services and offer property tax credits to incentivize homeowners to give.

This way, the taxpayers could write off the payment as a charitable deduction on their federal tax returns.

In June the IRS and Treasury blocked this strategy, saying that the receipt of a state or local tax credit in return for making this contribution would be a "quid pro quo."

Separately, the village of Scarsdale, New York, has also filed suit against the tax agency and Mnuchin, pushing back against the new rules.

Quid pro quo

The Internal Revenue Service (IRS) headquarters in Washington, D.C.
Janhvi Bhojwani | CNBC

The new rules from the IRS would reduce the amount of the federal deduction a taxpayer can claim for a charitable contribution to one of these funds.

For example, if you received an 85% state tax credit for donating to a state fund, you would only be able to claim 15% of your contribution on your federal tax return.

In effect, it would greatly reduce the amount residents in high-tax states can claim.

Consider that, in 2016, New Yorkers writing off state and local taxes took an average SALT deduction of $21,779, according to the Tax Policy Center.

Meanwhile, in New Jersey and Connecticut the average deductions were $18,092 and $19,563, respectively.

Preexisting programs

FreezeFrameStudio | E+ | Getty Images

The new state "workaround" programs aren't the only ones that would be affected by the new IRS rules.

There are more than 100 existing state charitable tax-credit plans in 33 states, according to a research paper authored by a group of tax law professors. They range from private school tuition scholarships to conservation easements.

Earlier this year, some of those programs — including the Alabama Opportunity Scholarship Fund and the Exceptional SC program in South Carolina — reported a slowdown in contributions due to ambiguity around whether the IRS would permit taxpayers to deduct the full amount donated.

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Alabamans and South Carolinians contributing to those scholarship programs are eligible for a dollar-for-dollar tax credit on their state return.

Whether the final rule will ultimately deter people from donating to these funds remains to be seen.

"If you're really passionate about private school vouchers in Georgia, you donate and you still get 100% of your donation back," Carl Davis, research director at the Institute on Taxation and Economic Policy, told CNBC. "You just won't get a federal tax deduction on top of it."