The IRS has finalized regulations that limit federal charitable contribution deductions if a state tax credit is received in return. If the regulations stand, taxpayers will no longer be able to circumvent the $10,000 federal limit on state and local tax (SALT) deductions by contributing to special state tax credit programs. Despite receiving almost 8,000 comments pleading for exceptions, the final rules fail to exempt state tax credit programs that were in effect before the enactment of the Tax Cuts and Job Act from the offset rule. That means conservation easement donations and private school scholarship programs will bring fewer tax benefits in the future. Three states, New Jersey, New York, and Connecticut, are suing the IRS to block the new regulations, but the success of that effort is uncertain.
The final regulations largely adopt the provisions of the proposed regulations issued in August 2018 (See earlier coverage). Here are the basics:
- Federal Deduction Offset. Federal charitable deductions must be reduced by the amount of state tax credits claimed for the same contribution.
- State Deductions Permitted. Taxpayers do not have to offset state tax deductions, only state credits. However, taxpayers must reduce their charitable contribution deductions if a taxpayer receives state or local tax deductions in excess of the taxpayer’s donation or in excess of the fair market value of the property transferred by the taxpayer.
- De Minimis Exception. No federal offset is required if the state or local tax credit does not exceed 15% of the taxpayer’s payment or 15% of the fair market value of the property transferred by the taxpayer.
- Credits May Have to be Estimated. The rules apply to state credits received or expected to be received. This means the taxpayer who has not yet received the state credit still has to reduce the federal deduction by the maximum state credit allowable or estimated value of the future credit.
- Estates and Trusts. The offset rules also apply to charitable contribution deductions made by an estate or trust.
- Effective Date. The regulations are effective August 12, 2019, and apply to amounts paid or property transferred after August 27, 2018. Note that the effective date relates to when the proposed regulations were issued.
Examples: The regulations offer the following examples of how the offset rules work.
Example 1. Basic Offset
A, an individual, makes a payment of $1,000 to X, a qualified nonprofit entity. In exchange for the payment, A receives or expects to receive a state tax credit of 70% of the amount of A’s donation. A’s federal charitable deduction must be reduced by $700 (0.70 × $1,000), the state tax benefit for the donation. Thus, A’s federal deduction for the $1,000 payment to X may not exceed $300.
Example 2. De Minimis Exception
B, an individual, transfers a painting to Y, a qualified nonprofit entity. At the time of the transfer, the painting has a fair market value of $100,000. In exchange for the painting, B receives a state tax credit of 10% of the fair market value of the painting. B is not required to offset the federal charitable deduction by the amount of the state credit received because the state tax benefit does not exceed 15% of the fair market value of the property transferred to Y.
Example 3. State Tax Deduction
C, an individual, makes a payment of $1,000 to Z, a qualified nonprofit entity. In exchange for the payment, under state law, C is entitled to receive a state tax deduction equal to the amount paid by C to Z. C’s federal charitable contribution deduction is not required to be reduced by the amount of C’s state tax deduction.
New Safe Harbor
Along with the final regulations, the IRS also published Notice 2019-12, providing a safe harbor that allows an individual who itemizes deductions to treat payments that are disallowed as charitable contribution deductions as deductible state taxes. Eligible taxpayers can use the safe harbor to determine their state and local tax (SALT) deduction on their tax-year 2018 federal return. Those who have already filed may be able to claim a greater SALT deduction by filing an amended return if they have not already claimed the $10,000 maximum SALT deduction. The safe harbor only applies to taxpayers who do not otherwise exceed the $10,000 SALT limitation.
Example 1. In year 1, Taxpayer A makes a payment of $500 to a qualified nonprofit entity and, in return, gets a dollar-for-dollar state income tax credit. Prior to taking the credit, A’s state income tax liability for year 1 was $500 or more; A applies the $500 credit to A’s year 1 state income tax liability. A can treat the $500 payment as a deductible state tax payment for federal purposes. To determine A’s deduction amount, A must apply the SALT limit under the federal rules.
Example 2. In year 1, Taxpayer C makes a payment of $7,000 to a qualified nonprofit entity. In return for the payment, C receives a local real property tax credit equal to 25% of the payment amount, or $1,750. Before applying for the credit, C’s real property tax liability was $3,500. C applies the $1,750 credit to C’s real property tax liability. For year 1, C treats $1,750 as a payment of local real property tax, deductible on C’s federal return, subject to the $10,000 SALT limitation.
Even with the new restrictions on federal tax deductions, there are exceptions and safe harbors and other ways for taxpayers to maximize their combined federal and state deductions. Consult with your Frazier & Deeter tax advisor for planning opportunities that may be available to you going forward.