Talking Tax Reform - Part VIII

There has been a lot of talk about the limit placed on what's being referred to as the SALT deduction under the Trump Tax Plan.  SALT is an acronym for State And Local Taxes and they go on this part of the tax return.

Starting in 2018, the amount you can deduct on line 8 is being limited to $10,000.  People with high levels of wages living in states with a high tax rate have been able to deduct the state taxes withheld from their pay.

IRS data shows that taxpayers in California, Connecticut and New York have the highest percentage of their residents claiming this deduction.  Kevin de Leon, who is President Pro Tem of the California State Senate has introduced legislation that is an attempt to work around the limitation of this deduction.  The bill, which has passed the Senate, would create a non-profit California Excellence Fund.  Taxpayers who make a charitable contribution to the fund would receive a credit against their state tax liability of 85% of the amount of their donation.

I don't see this working for the same reasons that limit the deduction for other charitable contributions.  If you purchase a ticket to a fundraiser where there is entertainment offered, the price you would have paid for just the entertainment is deducted from the cost of the ticket in calculating the amount you get to deduct as a contribution.  By this logic, if you're going to get a tax credit worth 85% of your donation, then 85% of your donation would not be deductible.

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There is an unintended consequence to this change in the SALT deduction that few have realized just yet.  For 2017, taxpayer can take a deduction for SALT and if they get a refund of some of the state income taxes they paid, that refund becomes taxable income for 2018.  That is to adjust the amount of the 2017 deduction that they were actually entitled to.

The problem arises when someone is being taxed by two different states.  I use this situation when teaching classes on state taxes.  The client lives in California but spent the year on an assignment in another state with an income tax.  Under the concept of taxing income at the source, that state is going to impose their tax on that income, even though the client is a nonresident.  But California is also taxing that income.

To avoid double taxation, California allows the client to claim a credit for taxes paid to the other state.  The employer of this client withheld $25,000 in California income tax during the year.  The employer did not withhold one dime for taxes in the other state.  At the end of the year, the client owes $20,000 to the other state and $20,000 to California.

California gives the client a credit of $20,000 for taxes paid to the other state and the client receives a refund of the entire $25,000 that was withheld.  The client pays $20,000 to the other state.

All of that happened in 2017.  Next year, that $25,000 refund is taxed by the federal government, since it was deducted on the 2017 federal tax return.  The problem is that the client cannot take a full deduction for the $20,000 paid to the other state.

So the client got a deduction for $25,000 in state taxes paid in 2017, pays $20,000 in 2018 to the other state, gets taxed on the entire $25,000 CA refund received in 2018, but can deduct only $10,000 of what was paid to the other state in taxes in 2018.  They will wind up paying federal income tax on $10,000 more than they should have.