The IRS has released final regulations related to the SALT limitation imposed by TCJA and the attempts by various states, most notably NY, NJ and CT, to skirt the $10,000 ($5,000 MFS) limitation on the deductibility of state and local taxes. The technique these states attempted to use to get around the limitation was by offering their residents the ability to make a charitable contribution in return for a credit against their state or local taxes, thus converting a limited tax deduction into a fully deductible charitable contribution.
Background for the IRS’ Position:
- Section 170(a)(1) generally allows an itemized deduction for any “charitable contribution” paid within the taxable year to a qualified charity which, under Section 170(c), includes a State, a possession of the United States, or any political subdivision of the foregoing, including the District of Columbia.
- Section 164(a) allows a deduction for the payment of certain taxes, including state and local, and foreign, real property taxes, and state and local income or sales taxes and personal property taxes.
- TCJA limited, for years 2018 through 2025, the itemized deduction for state and local taxes to $10,000 ($5,000 MFS) and does not allow a deduction for foreign real estate taxes.
- In 1986 the Supreme Court held that where the taxpayer receives something in return (quid pro quo) for a contribution, the contribution was not tax deductible.
The IRS proposed regulations in August 2018 that generally require a taxpayer that makes a payment or transfers property to or for the use of an entity described in Sec 170(c) for which the taxpayer receives or expects to receive a state or local tax credit in return for such payment, to reduce their charitable contribution deduction by the credit amount because the arrangement created a quid pro quo benefit. However, if the taxpayer received a state and local tax deduction instead of a credit, this would not be a quid pro quo unless the deduction exceeded the amount of the donor’s payment or transfer.
The proposed regs also included the following de minimis exception: a state or local tax credit is not treated as a quid pro quo if the credit does not exceed 15% of the taxpayer's payment or 15% of the fair market value of the property transferred by the taxpayer.
The final regulations 1.170A-1(h)(3), released in June 2019, generally follow the proposed regulations. However, regarding the 15% exception the final regulations added that it applies only if the sum of the taxpayer's state and local tax credits received, or expected to be received, does not exceed 15% of the taxpayer's payment or 15% of the fair market value of the property transferred by the taxpayer.
In the preamble to the final regulations, the Treasury and the IRS indicated their concern that the regulations could create unfair consequences for some individuals who itemize their deductions and made a charitable contribution in return for tax credits. Consequently, simultaneously with releasing the final regs, the IRS published Notice 2019-12 saying they intend to publish a proposed regulation amending Treasury Regulation § 1.164-3 to provide a safe harbor for certain individuals who make a charitable contribution in return for tax credits. Under the safe harbor, an individual may treat as a payment of state or local taxes for purposes of Sec. 164 the portion of a payment for which a charitable contribution deduction is or will be disallowed under Regs. Sec. 1.170A-1(h)(3). To qualify for the safe harbor, taxpayers must itemize deductions for federal tax purposes and their total state and local tax liability for the year must be less than $10,000. Until the proposed regulations are issued, taxpayers may rely on Notice 2019-12.
The following examples are based on those in Notice 2019-12.
Example #1 – The taxpayer makes a payment of $500 to a local or state-run charity and receives a dollar-for-dollar credit against the taxpayer’s state income tax credit. The taxpayer’s state tax liability is $500 or more. For federal purposes the $500 contribution can be treated as a tax payment subject to the $10,000 SALT limitation.
Example #2 – The taxpayer makes a payment of $7,000 to a local or state-run charity and receives a dollar-for-dollar credit against the taxpayer’s state income tax. Under state law the credit may be carried forward for three taxable years. The taxpayer’s state tax liability for year 1 is $5,000. The taxpayer applies $5,000 of the credit against the year 1 state tax liability and carries the balance forward to year 2 where it is used against the taxpayer’s year 2 state tax liability. The taxpayer’s year 2 state tax liability exceeds $2,000. For federal purposes the contribution is treated as a tax payment, with the $5,000 treated as a year 1 tax deduction and the $2,000 treated as a year 2 tax deduction. Both the $5,000 and $2,000 are subject to the $10,000 SALT limitation.
Example #3 – The taxpayer makes a payment of $7,000 to a local or state-run charity. In return for the contribution, the taxpayer receives a real property tax credit of $1,750, which is 25% of the contribution, and applies it to his $3,500 property tax bill. For federal purposes the $1,750 is treated as a property tax payment subject to the $10,000 SALT limitation. The balance of the contribution, $5,250, can be deducted as a charitable contribution.