Surprise! The IRS Objects to Tax-Saving Measures
Keeping your hard-earned money in your own pocket may be getting even harder, if the IRS has its way.  On May 23, it took issue with a variety of proposals designed to help taxpayers who might owe more in taxes because of a controversial provision in the Tax Cuts and Jobs Act.

The provision limits a taxpayer’s deduction for state and local income taxes (SALT), property taxes, and sales taxes to $10,000. What some lawmakers saw as a straightforward, across-the-board provision, others saw as an unfair burden for Americans living in high-tax states, most of which tend to vote for Democratic candidates.

State officials, eager to keep their constituents happy, quickly came up with some creative alternatives to the SALT deduction. Some municipalities in New York and other high-tax states allowed residents to make 2018 tax payments in 2017. By making early payments, taxpayers hoped to avoid the $10,000 cap, which went into effect January 1, 2018, and instead deduct the amounts paid for 2018 on their 2017 tax returns, in accordance with the tax code still in effect for that year.

The IRS, however, issued guidance on December 27, 2017, saying that only 2018 taxes that had been assessed prior to payment would be deductible. Some states sent letters to the IRS to advocate on behalf of their residents. New Jersey took things further, according to the Bloomberg News SALT Talk Blog, and changed its property tax statutes retroactively.

New legislation passed in several states allowed taxpayers to make charitable contributions, which remain fully deductible under the Tax Cuts and Jobs Act, in amounts equivalent to various state and local taxes owed. For example, A law passed in New Jersey would allow municipalities to establish charitable funds into which taxpayers could donate the amounts due on their property taxes in exchange for a state tax credit worth 90% of that amount. New York State’s omnibus budget bill also created charitable funds as well as a payroll tax that would take the place of a state income tax and reduce the tax burden for many New Yorkers. A bill awaiting the signature of Connecticut’s governor would allow town to establish “community-supporting organizations” that would collect “contributions” from residents in lieu of local taxes. 

Under a bill passed by the California Senate, residents could qualify for a personal income tax credit equal to 85% of their contributions to the newly created California Excellence Fund. The California Assembly has a similar bill in the works, with credits equal to 80% of an individual’s contributions to select public charities or to K-12 schools, colleges, and universities in the existing Cal Grant program.

Clearly, lawmakers in these high-tax states are concerned about how the Tax Cuts and Jobs Act could adversely affect property values and their constituents’ happiness.

What’s next remains uncertain.  The IRS says a full recommendation will be forthcoming and that it “will assist taxpayers in understanding the relationship between federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments.”

New Jersey’s governor believes that earlier tax credit laws may help the states that recently created new charitable funds defend themselves against the IRS. 

The Bond Buyer article on this subject mentioned a report by eight law professors who had recently determined that 33 states have already enacted a variety of other tax credits which were upheld by the IRS and the courts. The list included three states – Alabama, Montana and South Carolina – that allow 100% of certain donations to count as tax credits. 

Investors seeking to minimize the uncertainty around their 2018 tax bill --- and to limit the amount they pay Uncle Sam – would be well advised to explore opportunities to turn taxable income into non-taxable income. Among the options are a variety of IRA accounts (many with income limitations); 401 (k) retirement accounts offered by an employer; 529 accounts that can be used to pay for higher education and, of course, municipal bond funds.

Of these, only muni bond funds are available to all investors.

The battle over the SALT deduction is just beginning and may create all types of confusion about what’s deductible in 2018.  What’s clear is that the net investment income generated by municipal bonds and muni bond funds remains exempt from federal income taxes and, where applicable, state and local income taxes, too. 

As our long-time investors know by now, we see muni bond funds as the right way to invest when the IRS says “not so fast” to other deductions.