By Brian Janecke, CFP®, CPA, Tax Planning Strategist
Historically, taxpayers have been able to reduce their federal tax liability by taking the state and local tax (SALT) deduction. The SALT deduction is composed of either state income or sales tax (whichever is greater), in addition to any real estate and personal property taxes paid during the tax year. Because SALT payments are largely flexible with regard to timing, taxpayers have been able to accelerate or delay payments in order to maximize their associated deduction in a given year. But when the Tax Cuts and Jobs Act was signed into law last year, the amount that taxpayers could deduct for SALT was drastically limited. This article details how the rules related to SALT payments and deductions have changed under the new tax bill, and it explores ways that some taxpayers may still be able to take advantage of them.
Changes under the new bill
One item that has not changed is that taxpayers must be in a position to itemize their tax deductions if they want to realize a benefit from SALT payments. But one of the key changes of the new law was to increase the amount of the standard deduction—from $6,350 to $12,000 for an individual and from $12,700 to $24,000 for a married couple filing jointly. As shown in Exhibit 1, 70% of taxpayers were already claiming the standard deduction rather than itemizing. This higher limit will increase what most taxpayers are able to deduct and generally simplify the filing process, for both taxpayers and the government.
But for those taxpayers who aren’t able to exceed this new higher limit, it will no longer make sense to itemize their deductions. This means that the tax benefit of certain activities—charitable giving, for example, or SALT payments—will fall away. Also, because of two additional changes in the new bill, it will be even more difficult to exceed the limit of the standard deduction. First, many miscellaneous expenses (such as advisor fees, tax preparer fees, custodial fees, and others) are no longer deductible. Second—and more significantly—the SALT deduction, which was previously uncapped, is now limited to $10,000. When the bill was signed into law at the end of last year, many taxpayers were advised by their accountants to pay real estate taxes in 2017 to the extent possible, in order to take the uncapped deduction in that tax year. However, prepaying real estate taxes toward future liabilities was quickly met with disapproval by the IRS, which clarified that amounts deducted must be associated with a real estate assessment.
Who will be impacted
With an understanding of changes brought by the new law, let’s take a look at which taxpayers will be impacted the most.
- Preliminary data compiled by the IRS for 2016 reflects that 72.6% of total SALT deductions were claimed by taxpayers with an adjusted gross income of over $100,000.1 The regressive nature of the SALT deduction will cause those with higher amounts of taxable income to be most impacted by the new $10,000 limit.
- Taxpayers who live in a state with a high tax burden will no longer be able to offset their federal tax liabilities to the extent that they used to. Exhibit 2 ranks the individual states based on the SALT deduction as a percentage of adjusted gross income. The states expected to be hit the hardest are New York, New Jersey, Connecticut, California, Maryland, Oregon, and Washington, D.C.2
- The new law comes with a built-in marriage penalty. Married taxpayers filing jointly have the same $10,000 SALT deduction limitation as a single taxpayer. For those that try to circumvent this by filing separately, each spouse will only be allowed to take $5,000 on their tax return.
- Taxpayers who own multiple properties have historically gotten a deduction for all of the real estate taxes associated with them. Because owners can now only deduct a limited portion of those real estate taxes, the cost of owning multiple properties will effectively increase.
Opportunities under the new bill
What options remain for taxpayers to reduce their federal tax burden by utilizing the SALT deduction? There are not many but, for a small subset of taxpayers, a few opportunities do still exist.
For those paying a considerable amount of state and local tax, there is likely no change to be made with your tax payments. Whether through state withholding, quarterly state income tax payments, or real estate taxes, you will hit the $10,000 limit each year before taking into consideration any timing of payments made at the end of the year. So this will be more of a fixed component in an attempt to itemize your deductions. With that in mind, you might want to consider delaying or accelerating your limit-free itemized deductions (e.g., deductible medical, investment interest, mortgage interest, and charitable contributions) where possible, in order to exceed the standard deduction threshold and maximize your itemized deduction in a given year.
For those who do not anticipate reaching the $10,000 SALT limit annually, think about timing your SALT payments in coordination with your other itemized deductions (to the extent possible). As the following case study illustrates, doing so may allow you to increase your overall deduction.
SALT payments: A case study
John is a single taxpayer who has always paid his real estate taxes before the new year in order to claim a deduction in the current year. He expects to have $4,000 in state income tax withholding annually. His real estate taxes total $3,000 per year, and his mortgage interest is $2,500. He has also committed to giving $1,600 annually to the church he attends, for the next two years. In Exhibit 3, we assume John makes equal payments in Year 1 and Year 2. If he pays his real estate taxes of $3,000 in December as usual, along with his pledge to the church, he has total deductions of $11,100 to itemize. However, because the standard deduction is now $12,000 for single taxpayers, John is not able to itemize his deductions and effectively loses the tax benefit of his charitable gift and his SALT payments.
Exhibit 4 assumes John instead delays paying his real estate taxes and the pledge to his church by a few weeks, moving them into Year 2. He still takes the $12,000 standard deduction in Year 1, but by doubling up his real estate taxes in Year 2, he meets the $10,000 SALT limit, taking full advantage of the amount he is allowed to deduct. Additionally, because his itemized deductions now exceed the standard deduction, he is able earn the tax benefit of the charitable gift, which has also been consolidated into one year. So, he deducts $15,700 in Year 2, increasing his total deductions across both years by $3,700.
The changes in the Tax Cuts and Jobs Act are substantial, especially related to SALT payments. For those who have deducted SALT payments in the past, it is important to look at how the new bill will impact your situation when filing in 2018. Your advisor and team at RMB are happy to address any questions you might have, in conjunction with your accountant where necessary or desired.