Since the original passage of the income tax in 1913, taxpayers have been permitted to deduct unlimited state and local taxes (SALT), which included sales tax, state income tax, and property taxes. Before the Tax Cuts and Job Act (TCJA) went into effect, homeowners in higher-taxed states were able to deduct state income taxes and property taxes, which reduced their tax burden up to 25%. Deductions for SALT have previously been unlimited, which helped to alleviate tax burdens for many property owners and residents of high-tax states or states with a higher cost of living.

The new tax act caps the SALT deduction at $10,000, causing significant frustration for many residents of these high-tax states. The revision reduces the allowed deduction to $10,000 per year, per return. Due to the $10,000 limitation, the TCJA has effectively limited the subsidy to those living in higher-tax states. Understanding how this heavy burden effects clients is imperative for advisors.

Adding insult to injury, the SALT limitation disproportionately impacts married couples, particularly those who file jointly. This is because the cap remains at $10,000 per return and not per individual. And those who are married filing separately must split the allowed deduction between them at $5,000 per individual.

This could be a significant financial encumbrance to couples. Having said that, the tax act does provide relief to families in the form of lower and expanded tax brackets, as well a generous child tax credit for families with AGI up to $400,000. So, as with all aspects of the TCJA, every client’s situation is different and must be reviewed.

Location matters more than ever

Seven states account for more than half of the value of the SALT deductions: New Jersey, New York, Connecticut, Maryland, Massachusetts, Illinois, and California. Of the 50, these “blue” states charge the highest property taxes and SALT deductions taken by residents there are typically highest as a percentage of income. According to the New York Times, New Jersey has the highest property tax rate in the nation, coming in at 2.40% in 2018, while Connecticut is in the top five, at 2.02%. In comparison, Hawaii has the lowest at 0.27%, followed by Alabama at 0.43%, and Louisiana at 0.51%.

Although governors of these affected states feel personally targeted by this tax hit, their fight to defeat this newly imposed limitation will be an uphill battle. There has been some talk of other workarounds such as a “payroll tax strategy” and an “unincorporated business tax strategy” however, these strategies are likely to be unsuccessful. The legalities behind these strategies are uncertain and should not be relied upon to reverse the situation.

Indeed, these attempts will be challenged by the IRS, which has released a notice 2018-54 stating “despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposed.”

5 ways to combat the new SALT restrictions

Given these unwelcome new tax restraints, clients from these states are turning to their financial advisors for guidance and strategies. Here are five workarounds that may help.

1. Bunching works!

If  clients can’t take the full SALT deduction, they should consider strategically using their other potential deductions, including incorporating the reliable method of bunching, which has a renewed usefulness under the new tax regimen. This method lumps together two years of charitable (and other) deductions into one single tax year. Clients can take the standard deduction one year and itemize the following year, in an effort to make up for some of the lost itemized deductions.

Utilizing this option, clients could prepay their mortgage, pay elective medical expenses, pay real estate taxes and then fund their charitable contributions all in one year, and then take the standard deduction the next year. By purposefully planning the timing of client’s charitable contributions, they can receive a greater tax benefit for the same dollar amount of contributions, as demonstrated in the table below.

2. Open a donor-advised fund

DAF funds help clients make multiple years’ worth of charitable gifts in one tax year while distributing the gifts at a later time. Clients receive an immediate tax deduction when they open and fund the account, despite the gifts being allocated at a later date. That’s a win and can be used to offset the loss of SALT deductions!

3. Qualified charitable distributions

QCDs are a great option for those age 70½ and over. If a client is an owner of an IRA (or beneficiary) over age 70½, a qualified charitable distribution up to $100,000 could be another beneficial way to offset the loss of SALT deductions and to reduce taxable income. The QCD satisfies the required minimum distribution and lowers taxable income. This makes sense for clients who are in a higher tax bracket. Clients could even benefit further if their spouse is also eligible to use their IRA for the QCD.

Although a tax deduction for the contribution is not permitted, the transferred amount from the IRA to the charity is excluded from taxable income, which is most beneficial, particularly as a way to avoid Medicare premium surcharges, among other things.

4. Relocating or downsizing

Discuss residency preferences and possible relocation for clients who work remotely, as well as those who can relocate if they are nearing retirement. Some blue-state residents are considering relocation to more tax-friendly states such as Florida, Arizona, South Carolina, and Delaware. Yet relocating won’t always solve the issue, since states with lower property taxes will often have higher taxes or costs in another area. For instance, in Florida, homeowner’s insurance costs considerably more, decreasing the benefit received from the lower SALT taxes.

Another option is simply downsizing. A smaller home can help clients reduce their personal costs significantly, reducing their property taxes, mortgage payments, and lowering utilities and maintenance expenses. And there are no hitches to this strategy, while relocation—or partial relocation—may create quite a bit of turmoil.

Relocation must be genuine

If clients are curious about relocation, make sure they understand that they can’t dodge the issue just by buying a vacation home in Florida, staying there for a month, and claiming it is their primary residence. Relocators will need to show that they have genuinely and fully moved their lives to the new state. State-appointed auditors will go to great lengths to disprove claims of a new home, especially if that new home is conveniently located in a state with low or no income taxes. For instance, Bloomberg has reported that New York’s Department of Taxation and Finance is very invested in keeping their wealthy clients paying taxes in New York. And the state will go to extreme lengths to determine if a taxpayer has truly moved their main residence, or is just trying to dupe the state for the tax savings.

Auditors will test New York residents looking for an out by using a domicile test based on five factors: (1) other residences owned, (2) where the taxpayer spends most of their time, (3) where their treasured items are kept, (4) where business is conducted, and (5) the location of the taxpayer’s family.

New York residents will also need to meet the “183-day rule” if they plan on moving but keeping a residence in New York state. They must prove that they haven’t spent more than 183 days per year in New York, and any day where there is no proof can be counted as a day in-state. Even entering the state’s boundaries for one hour can make the day count as an in-state day.

And auditors are willing to go after taxpayers by issuing subpoenas for credit card statements, using phone records to track the taxpayer’s location, and even confirming where they go for doctor’s appointments. So, although a relocation might help some clients, keep in mind that they need to legitimately be ready and willing to make the move.

5.  Charitable Donation of a Conservation Easement

A conservation easement is a land-preservation agreement between a landowner and a qualified land protection organization. The conservation easement is recorded on the property’s deed, which provides for permanent preservation of the property through a development restriction.

To qualify for the tax deduction, the conservation easement must be exclusively for conservation purposes, which include

• preservation of the land areas for outdoor recreation by or for the education of the general public;
• protection of a relatively natural habitat of fish, wildlife, or plants or a similar ecosystem;
• preservation of open space (including farmland and forest land) where the preservation is for the scenic enjoyment of the general public or pursuant to governmental conservation policy and will yield a significant public benefit; or
• preservation of a historically important land area or a certified historic structure.

The conservation easement terms can include reservation of certain rights, provided they don’t impair the conservation purposes. These can include recreation, hunting, timbering, and traditional agricultural uses.

The conservation easement charitable deduction can be up to 50 percent of your adjusted gross income, and you can carry forward any unused amounts for up to 15 years.

You generally have three ways to get your conservation easement charitable deduction:

• You own a parcel of land and donate the development rights to that land to a qualified organization.
• You live in a historic district and donate the rights to alter the building façade to a qualified organization.
• You invest in a real estate partnership that acquires land and donates the development rights to that land to a qualified organization.

For the real estate partnership strategy, you don’t need the land or the building; you simply need the cash to invest. It works like this:

1. You invest cash in a partnership.
2. The partnership buys property.
3. The partnership donates the property’s development rights.
4. The partnership passes the conservation easement charitable deduction to the partners on their Schedule K-1s.

Many reputable firms and conservation organizations facilitate these real estate partnerships so that investors can use their cash to both

• help preserve open space and
• gain a tax benefit from doing so.

Compliance Issues

The IRS recently made the use of a real estate partnership to facilitate a conservation easement charitable deduction a listed transaction in certain circumstances. This requires

• filing of Form 8886, Reportable Transaction Disclosure Statement, with the tax return; and
• full disclosure of the transaction details on the tax return.

You’re probably concerned that there’s something wrong with this strategy because the IRS appears to be targeting it.

Don’t worry—the strategy is sound if properly administered. Certain promoters were not acting properly causing increased IRS scrutiny of sponsors, which I welcome.

For more information about conservation easement donations, click here and watch the video on the Resources page.