In August 2018, the U.S. Department of the Treasury proposed a rule limiting the types of charitable contributions taxpayers are permitted to deduct on their federal income tax returns. This rule was a direct—and directed—response to tax laws recently enacted by high-tax states like New York and New Jersey in an effort to avoid the new federal limit on state and local tax (SALT) deductions. But it may wind up having some collateral consequences for other states.
The Tax Cuts and Jobs Act of 2017 limited the SALT deduction to $10,000. Taxpayers in states with hefty property taxes or state income tax rates were previously permitted to take a SALT deduction of their total state and local tax outlays, reducing their federal income tax burden. For taxpayers who were accustomed to deducting $15,000 or more prior to 2017, this change functioned as a major tax hike.
Because the SALT deduction cap disproportionately impacted taxpayers in high-tax states, a couple of these states—New York and New Jersey—quickly enacted state tax schemes that would permit taxpayers to make a charitable contribution to a state-treasury-run fund in lieu of paying property taxes. This approach preserved the state's own tax base while also ensuring state residents wouldn't be walloped with a huge federal tax bill on April 15, 2018.
The federal government responded by issuing several advisory opinions instructing state taxpayers that the U.S. Treasury, not state legislators, was the final arbiter of what constituted a "state and local tax." This means that tax returns that claim an unusually high amount in state charitable contributions might draw some extra scrutiny or even trigger an audit. And taxpayers in other states that haven't enacted SALT workarounds but already offer generous tax incentives for charitable donations may feel the impact of the most recent Treasury regulation.
This fight isn't over—a Treasury regulation doesn't have the same force of law as a Congressional resolution or a U.S. Supreme Court decision. It's likely that states like New York, New Jersey, and others may sue the Treasury Department for its perceived intrusion into how they classify certain charitable contributions. But the continued back-and-forth between states and the Treasury Department could make the 2018 tax season a challenging one for tax preparers in SALT-deduction-heavy states.