State Practitioners Mulling Impact of Capped State Tax Break

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By Ryan Prete

Congressional Republicans’ compromise agreement on the federal deduction for taxes paid to state and local governments hasn’t resolved potential complications at the state and local level, according to several leading state and local tax practitioners.

A House-Senate conference committee of tax negotiators agreed last week that taxpayers would be allowed to deduct up to $10,000 of state and local taxes paid—property taxes and either income taxes or sales taxes. The versions of the bills approved by the House and Senate preserved only the individual deduction for state and local property taxes—capped at $10,000—but not for income or sales taxes (SALT deduction).

With both the House and Senate primed to vote on the final tax reform bill (H.R. 1) as early as Dec. 19, the home stretch for tax overhaul has tax professionals analyzing the potential hit on states.

Jeff Friedman, a tax partner at Eversheds Sutherland (US) LLP, told Bloomberg Tax Dec. 18 that because tax levels vary by states, the consequences won’t be uniform.

“One thing that is clear is that those states that rely more heavily on personal income taxes will have more to lose,” Friedman said. “The impact will not be immediate, as it will take time for taxpayers to adjust to the limitation. But, in the longer run, it is possible that individuals will consider changing states of residence because of the heavier overall tax burden they will feel by losing the ability to fully deduct state and local taxes.”

Friedman said that relocation could be more popular in regions of the country where high income tax states share a border with a state without personal income taxes—and political consequences and state compromises are expected.

High-Tax States

Supporters of the deduction, many from high-tax states such as California, New York, and New Jersey, have objected to repealing or restricting the write-off because they argue it could affect everything from home prices to education budgets. And supporters of the tax break argue that residents of their states will be less likely to support attempts to raise revenue if they can’t deduct the taxes on their federal returns.

Personal taxes are poised to rise for 13 percent of New Yorkers and 11 percent of California and New Jersey residents, according to a Dec. 16 analysis by the Institute on Taxation and Economic Policy. And scratching the SALT deduction hasn’t sat well with some House Republicans from those states.

Rep. Peter King (R-N.Y.) told Bloomberg Tax Dec. 14 that he would vote “no” on the bill and that he wanted the SALT deduction cap raised to $20,000.

However, congressional lawmakers are still working through the conference committee’s changes and assessing the potential state-side impact.

“I don’t understand all the changes yet,” Rep. Darrell Issa (R-Calif.) told Bloomberg Tax Dec. 18, adding that he will be briefed on the changes.

“Californians need tax relief now more than ever, especially as the tax factory in our State Capitol continues looking for ever increasing ways to take more of our hard-earned paychecks,” Issa had said in a Dec. 16 news release. “Yet I still fear that, even in the revised proposal, many in my area could face higher taxes under this plan.”

‘Greater Tax Neutrality’

However, not all tax practitioners view dumping the SALT deduction as problematic.

“The state and local tax deduction represents a transfer from low-income, low-tax states to high-income, high-tax states, and subsidizes state and local government in high-income areas. Ideally, the deduction would be repealed outright, but capping it represents a step in the direction of greater tax neutrality,” Jared Walczak, a senior policy analyst at the Tax Foundation, told Bloomberg Tax Dec. 18.

Walczak said that most taxpayers pay far less than $10,000 in state and local taxes, and that the vast majority of those taxpayers would take the standard deduction.

“Several ingenious proposals were advanced to allow taxpayers to take the greatest possible advantage of the more limited state and local tax deduction, but these generally centered around states artificially boosting property tax liability with income tax offsets to allow taxpayers to take advantage of a property tax-only deduction,” Walczak said. “These are no longer relevant now that income taxes may be claimed as well. Other tax planning advice involved pre-paying in 2017 to take advantage of current law treatment of the state and local tax deduction, but the conference report expressly disallows this strategy.”

Open Audits

Leah Robinson, partner and State and Local Tax Group lead at Mayer Brown LLP, told Bloomberg Tax that by limiting the SALT deduction, properties in high tax states would become less attractive and cost-of-living would increase in states with high income taxes.

Taxpayers may also need to consider open audits, Robinson said.

“One thought is that anyone who has an open audit for pre-2018 should think about prepaying any possible settlement amount now,” Robinson said in an email Dec. 18. “This is different than preparing 2018+ liabilities—those won’t be deductible come 2018. But prepaying currently disputed pre-2018 liabilities before year-end may help.”

Time Will Tell

While the SALT deduction won’t have a direct fiscal impact on states, it will make state and local taxes more expensive to many taxpayers, especially higher-earners in states with higher tax levels, according to Joe Crosby, a principal with MultiState Associates.

“This may, for example, make it more difficult for states to raise marginal income tax rates on high earners. Given the complexity of the federal reform, though, it will be some time before the full effects are known, and, on balance, how significant is the impact on state and local governments,” Crosby told Bloomberg Tax Dec. 18.

With assistance from Kaustuv Basu in Washington.

To contact the reporter on this story: Ryan Prete in Washington at rprete@bloombergtax.com

To contact the editor responsible for this story: Cheryl Saenz at csaenz@bloombergtax.com

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