Tax practitioners aren’t the only ones grappling with how to navigate the new complex rules of the 2017 Tax Act. State officials of high-tax states, too, have been busy considering options to help mitigate the effects of the limitations placed on the federal SALT (state and local taxes) deduction, which is capped at $10,000 under the new law.
Tax filers are no longer allowed to deduct the state and local taxes they pay in excess of a total of $10,000 on their federal tax returns. For high-tax states like California, New York, New Jersey, Illinois, Wisconsin, Maryland, Oregon, Minnesota and Rhode Island, this is no small matter; the possibility of a mass exodus of residents is real. However, a number of states are tackling this head on as they consider options to mitigate the effects of the higher taxes on their residents.
Some states already allow their residents to make a charitable contribution to a state fund in which the taxpayer receives an attractive tax credit in return. Several of these states are re-promoting this option. Other states are considering adding it as a work-around the SALT cap. For example, if a filer has paid $35,000 in state and local income taxes in 2018, only $10,000 of that is deductible on the federal tax return. The other $25,000 is not. Therefore, if the filer makes a charitable contribution of $25,000 to help support a state program, he will receive a state tax credit for that amount, offsetting the $25,000 excess he cannot take as a SALT deduction.
But there’s more. Because the taxpayer is considered to have made a qualified charitable contribution under federal tax law, he can also secure a federal income tax deduction, as well, on his charitable contribution of $25,000. This is what we call a two-fer.
Making charitable contributions to states in this fashion is already sanctioned by the federal tax code, even if the taxpayer receives a separate tax benefit from the state in the form of tax credits.
Take a landowner, for example. She may live in a state that allows for tax credits when land is preserved under the federal tax rules of IRC section 170(h). That is, the landowner has the ability to place a qualifying conservation easement on her property and receive not only a very large federal income tax deduction — potentially wiping out federal taxes altogether — but she may also benefit from state tax credits for doing so. In some cases, even local property taxes may be discounted or eliminated entirely when a conservation easement under the federal rules applies.
Taxpayer Beware: IRS Notice 2018-54
Although these approaches to mitigating the effects of SALT limits are allowed under the code, the IRS recently released IRS Notice 2018-54 in which it warns taxpayers to avoid work-arounds for the federal income tax SALT deduction limits. The Notice states that the IRS will be releasing proposed regulations to address these work-arounds. We don’t know exactly what that means yet. Stay tuned.
Domestic Asset Protection Trusts May Eliminate SALT Limits for Some Taxpayers
In the meantime, some high-end practitioners say that it is possible for certain taxpayers who live in high-tax states to consider the use of a domestic asset protection trust (DAPT) to help minimize SALT taxes.
A DAPT — sitused in states that are friendly to debtors — protect assets from the claims of creditors. In addition, these trusts do not have a fiduciary state income tax; thus, its appeal as a planning vehicle to minimize taxes associated with the new SALT limits. The thinking is to have property that would otherwise be subject to the SALT limits, owned by the DAPT. Since the trust protects capital gains and ordinary income earned by the trust assets from state income tax, with exceptions, the use of a DAPT to own assets may be a viable alternative to a work-around for the SALT limits.
There are only 16 states that allow these types of trusts. For a taxpayer to establish one of these trusts outside of his home state, it is imperative that he has ties to that state — such as a vacation home or other property he owns.
Nevada may be one of the friendlier states of the 16 when it comes to asset protection trusts because there are no exceptions to creditor reach. That is, establishing the trust in Nevada, for example, means a taxpayer can keep his money out of the hands of ex-spouses claiming alimony and child support — even creditors with pre-existing tort claims. In other states, these creditors can reach any trusts, even an asset protection trust.
Stay tuned for more updates on the impact of tax law changes.
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