How Tax Reform Affects the State and Local Tax (SALT) Deduction
In analyzing filings for prior years, the IRS documented that nearly a third of all taxpayers have itemized deductions. Of those who do, nearly all of them take the state and local tax (SALT) deduction.
Prior to the Tax Cuts and Jobs Act (TCJA), passed in December 2017, taxpayers were allowed an itemized deduction for the following taxes held for personal use without limitation:
- State, local and foreign real property taxes.
- State and local personal property taxes.
- State, local and foreign income.
- War profits and excess profits taxes.
In addition, taxpayers could elect to deduct state and local general sales taxes in lieu of state and local income taxes. Of the taxes described above, the primary component that drives the deduction is typically the real property taxes.
The TCJA limits the state and local tax deduction to $10,000 ($5,000 if married filing separately). This deduction limitation is applied to the combined state/local income taxes or general sales taxes, real estate taxes, and personal property taxes. The limitation does not apply to foreign income taxes and other taxes.
Impact of the SALT Limitation
Who will the SALT limitation impact the most? According to a 2016 report from the Tax Policy Center, “Taxpayers with incomes over $100,000 would have the largest tax increases both in dollars and as a percentage of income.” Filers with incomes over $500,000 would be greatly affected, but their loss in deductions would also be offset by the decrease of the top income tax rate from 39.6 percent to 37 percent.
As part of the TCJA, the standard deduction nearly doubled to $12,000 for single filers, $18,000 for head of household, and $24,000 for married filing jointly or qualifying widow(er). As a result, many taxpayers who itemized deductions in prior years may now claim the standard deduction; therefore, they would not be impacted by the SALT limitation.
Schedule A Example
Illustration 1 is an example of Schedule A showing the new format to handle the TCJA’s changes. On this new version of Schedule A, the state and local taxes are first summed up on line 5d, and then limited on line 5e.
Implications: The mechanics of the limitation are straightforward on Schedule A. However, there are downstream effects on other tax forms that are complex:
Form 1116, Foreign Tax Credit. Real estate taxes for a taxpayer’s home carry from Schedule A to the foreign tax credit on Form 1116, line 3a. If state and local taxes were limited on Schedule A, what amount of real estate taxes are carried to Form 1116? As of this writing, there is not specific instruction on this, except to limit the aggregated state and local taxes to $10,000 ($5,000 if married filing jointly).
Form 8829, Expenses for Business Use of Your Home. There are several new rules on 2018 tax returns for how to report real estate taxes on business use of home:
- If the taxpayer is claiming the standard deduction, all real estate taxes on Form 8829 must be allocated as excess real estate taxes.
- If the combined state and local income taxes, real estate taxes, and personal property taxes do not exceed the Schedule A limit, then real estate taxes are reported for business use of home the same as they were in prior years. Real estate taxes paid on the home used for business are entered in full as indirect expenses. The business portion will be claimed on Form 8829, while the personal portion will automatically carry to Schedule A.
- If the combined state and local income taxes, real estate taxes, and personal property taxes exceed the Schedule A limit, the Line 11 worksheet in Form 8829 instructions must be used to determine how to enter real estate taxes for the business use of home. In this scenario, the computed amount of real estate taxes from the Line 11 worksheet are entered as direct expenses, either as real estate taxes or excess real estate taxes. The remaining amount of real estate taxes not entered on the business use of home must be entered in the itemized deduction input screen.
Form 8960, Net Investment Income Tax – Individuals, Estate and Trusts. This form calculates an additional tax for individuals who have a modified adjusted gross income that is greater than the threshold amount of $250,000 for married filing jointly and qualifying widow(er), $125,000 for married filing separately, and $200,000 for single and head of household.
If the taxpayer itemizes deductions on Schedule A, the program will automatically carry real estate taxes on property held for investment, and state/local/foreign income tax as investment expenses on Form 8960, Part II. In the situation where the Schedule A SALT limit applies, the application will limit the amounts that carry to Form 8960 to a maximum of $10,000 ($5,000 if married filing separately).
A Note About States
Many states require the state return to follow the method used for federal. For example, if the taxpayer claims the standard deduction on the federal return, many states require the taxpayer to also claim the standard deduction on the state return. For these states, it may be advantageous to claim the lower itemized deductions for federal if it is higher than the state standard deduction.
States with a low standard deduction amount that are most likely to fit this scenario are the District of Columbia, Georgia, North Carolina, Oklahoma, Oregon and Kansas. As a tax preparer, it may be good to first document the overall tax liability for federal and all states attached with the standard deduction, then force itemized deductions to compute the overall tax liability for federal and all states attached. Bottom line: Use the method that will give the best scenario for the client.