New Jersey Governor Phil Murphy signed legislation this past Friday (May 4, 2018) which attempts to work-around the state and local tax deduction limitation imposed by the Tax Cuts and Jobs Act, which was enacted in December of 2017. Under that federal legislation, the aggregate state and local tax deduction (which includes state income, property and sales tax) an individual taxpayer may claim is limited to $10,000 per year. New York already has their version of a work-around on the books, as Governor Andrew Cuomo approved a bill April 12 (yet to be signed into law).
Here’s how it works…
In New Jersey
The New Jersey legislation allows municipalities to establish “charitable funds” which New Jersey residents can donate to in exchange for a property tax credit up to 90 percent of the donation. The idea is that the taxpayer is making a charitable contribution to a qualified charitable organization and therefore should get a federal charitable contribution deduction as well as a reduction in their local property tax. This essentially converts an otherwise limited state tax expense to a charitable contribution with the same out-of-pocket. Many New Jersey municipalities have already signed on. According to the legislation, eligibility for this property tax credit will be allowed for fiscal years beginning on or after January 1, 2018.
In New York
New York will allow a taxpayer to donate to state-operated charitable funds. To the extent the taxpayer donates to certain health care and educational funds the state will allow for up to an 85 percent credit against New York State tax. Similar to New Jersey, this converts state income tax deductions into charitable contribution deductions. Effective, January 1, 2019, the New York state income tax credit would be allowed for amounts contributed during the preceding tax year.
Here’s the problem…
The IRS and the U.S. Treasury are well aware of the states’ attempts to work-around the federal law. Treasury Secretary Steven Mnuchin has previously stated that the federal government will challenge them. Taxpayers who take advantage of these state work-arounds should understand the risks. First, under federal law, a charitable deduction is not permitted to the extent any taxpayer receives a benefit in exchange for their donation. Therefore, the IRS may disallow the charitable deduction for taxpayers who receive a state tax credit in exchange for their donation to the state charitable fund. Second, if the IRS determines a deduction to be invalid it may assess penalties and interest to the extent that federal income tax is understated. In addition, taxpayers may incur professional fees responding to IRS inquiries and notices. Therefore, taxpayers who attempt to use these new state work-arounds may very well end up paying more, not less. It should also be noted that the states implementing these work-arounds will bear almost none of the risk, while taxpayers who use them may have to deal with the headaches and additional costs noted above.
We are hopeful that the IRS will issue guidance in the near future addressing these matters. As guidance is published we will keep you informed.