For 2018-2025, the Tax Cuts and Jobs Act (TCJA) imposes a new limitation on itemized state and local tax (SALT) deductions: $10,000 or $5,000 for those who use married filing separate status. The powers that be in several high-tax states immediately began trying to “work around” (meaning evade) the new limitation.
One brainstorm was to give folks SALT credits in exchange for purported “charitable contributions” to state-run “charitable funds.” This would magically convert non-deductible SALT payments into a deductible “charitable donation.” Shazam! Such schemes offer citizens the choice of: (1) making tax payments to state and local governments and living with the federal SALT deduction limitation or (2) making what you — in a display of unbridled optimism — believe are federally deductible payments to state-run charitable entities in exchange for SALT credits. Great idea, right? Not according to the IRS.
New IRS regulations dash wishful thinking
In an unsurprising development, recently issued IRS regulations disallow such “charitable deduction” schemes. Under the regulations, the amount that would otherwise be deductible as a charitable contribution on your Form 1040 is generally reduced by the amount of any SALT credit that you receive or expect to receive.
However, the regulations allow exceptions for dollar-for-dollar state income tax return deduction deals and deals that generate SALT credits that do not exceed 15% of the contributed amount. More on these exceptions later.
In any case, allowable SALT deductions for 2018-2025 remain subject to the TCJA annual limitation of $10,000 or $5,000 for folks who use married filing separate status.
Disallowance rule
The new IRS regulations stipulate that if you make a contribution to a charitable entity, you must reduce your federal charitable deduction by the amount of any SALT credit that you receive or expect to receive in return for the contribution. This is a longstanding rule that the new regulations simply restate: you must reduce charitable write-offs by the value of any goodies received in return for your contributions. Nothing new here.
Example 1: The State of New Yorksey promises an 80% state income tax credit for amounts contributed to a state-run charitable entity. Being an exceedingly optimistic individual who itemizes deductions, you happily contribute $10,000 to the charitable entity in 2019 and receive your rightful $8,000 state income tax credit. However, the IRS says you must reduce your 2019 itemized charitable deduction by the $8,000 credit, which leaves you with a $2,000 charitable deduction. So you get no federal income tax benefit from the $8,000. Sorry.
Exceptions to disallowance rule
The new IRS regulations grant exceptions for contributions to charitable entities that produce dollar-for-dollar state income tax return deductions and for contributions that produce SALT credits of no more than 15% of the contributed amount.
Example 2: Dollar-for-dollar deal. On your state income tax return, you receive a $10,000 deduction for contributing $10,000 to a state-run charitable entity. Under this dollar-for-dollar deal, you are not required to reduce your federal charitable deduction on Form 1040. So you get a $10,000 federal itemized charitable write-off, but you cannot treat any of the $10,000 as a deductible SALT payment on Form 1040.
Example 3: 15% credit deal. You make a $10,000 contribution to a state-run charitable entity and receive a $1,500 SALT credit. On your Form 1040, you can claim the full $10,000 as a federal itemized charitable deduction, since the SALT credit did not exceed 15% of your charitable contribution.
Safe-harbor rule
In conjunction with the new regulations, the IRS also established a safe-harbor rule, according to IRS Notice 2019-12. The safe-harbor rule allows individuals who make payments to charitable entities in exchange for SALT credits to treat the payments as SALT payments for purposes of claiming federal itemized SALT deductions on Form 1040. This treatment is allowed as long as the resulting SALT credit is applied, consistent with applicable state or local law, to offset your SALT bill.
Please understand that the safe-harbor rule does not allow you to dodge the 2018-2025 TCJA limitation on federal itemized deductions for SALT payments: $10,000 or $5,000 for those who use married filing separate status. See the following example.
Example 4: Safe-harbor rule in action. In 2019, you pay $5,000 to a state-run charitable entity. In return, you receive a dollar-for-dollar SALT credit. You claim the $5,000 credit on your 2019 state income tax return.
Under the IRS safe-harbor rule, you can treat the $5,000 payment as a SALT payment for federal itemized deduction purposes, subject to the TCJA limitation for 2018-2025. Under that limitation, you cannot deduct more than $10,000 for SALT payments on your 2019 Form 1040, or $5,000 if you use married filing separate status. So the safe-harbor rule only allows you to deduct what you could have deducted anyway with a straightforward SALT payment. Rats.
The last word
There you have it. The IRS has unsurprisingly nixed state-run “charitable contribution” schemes that are intended to “work around” the TCJA limitation on federal itemized SALT deductions for 2018-2025. Dang it! Wishful thinking is often contradicted by painful reality, and this is yet another illustration of that principle.
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