States Help Taxpayers Game the System

Bryan Strike

 MS, MTx, CFA, CFP®, CPA, PFS, CIPM

 June 29, 2018

The Tax Cuts and Jobs Act of 2017 have altered the traditional tax saving advice.  Many are going to see their taxes reduced but lose precious itemized deductions at the same time.  One of the more contentious additions to the law is the limitation on State And Local Tax (SALT) deduction.

The Basics

Historically, if a taxpayer paid state and local taxes—including income, sales, real estate, and property taxes—these amounts could be deducted on Schedule A as an itemized deduction without limit.  This deduction amount, in addition to mortgage and investment interest, charitable donations, medical expenses, and miscellaneous deduction must add up to more than the taxpayer’s standard deduction to actually receive a tax benefit.

Example: Stan, a 53-year-old single taxpayer, has income of $150,000 in wage income.  He pays $8,300 in state income taxes, $4,000 in real estate taxes, $200 in ad valorem taxes on his car (tag taxes), $7,000 in mortgage interest, and $5,000 in charitable donations for a total itemized deduction of $24,500.  His standard deduction for 2017 was $6,350, so he will clearly use itemized deductions.

Too Much SALT

Now (beginning in 2018), the SALT deduction is limited to $10,000 for all filing statuses except married filing separately, who get $5,000.  This creates a new challenge for taxpayers since the standard deduction has also increased to $12,000 for single and $24,000 for those married filing jointly.

Example: If we look at Stan’s situation (from above), his itemized deduction is going to be reduced because of the SALT limitation.  His SALT deduction was $12,500 but is now limited to $10,000, a loss of $2,500!

State Government’s Response

The easiest way to help a state’s taxpayers get around the new limitation is to convert state income taxes to charitable deductions.  But how?  Several states, Georgia included, have utilized various programs in the past where taxpayers can make charitable donations to certain causes that the state government would otherwise have to fund.  The taxpayer is given a state income tax credit for the donation and a federal charitable deduction to boot! 

My last article on the Georgia Student Scholarship Organization (GaSSO) is just that type of program.  You can read more about it here.  Now there is another option!

Qualified Rural Hospital Organization Credit

This program has been of little interest in the past because it lacked the same tax benefits available with the GaSSO.  The qualified rural hospital (QRH) rules are similar to the GaSSO except the donation limits are higher, taxpayers donate funds to a QRH rather than a school, and (most importantly) the state only credited taxpayers at 70%.  This means, for a $100 donation, taxpayers get a $70 credit, leaving $300 on the table.

Example: Donna and Jim, a married couple filing jointly, donated $5,000 (the maximum) to a QRH in 2017.  They are in the 30% federal and 6% state income tax brackets.  Here’s the breakdown of the tax consequences:

  • Federal tax: Charitable donation of $5,000 instead of a state income tax deduction of $5,000.  Since both deductions are unlimited for 2017, there is not a net benefit here. 
  • State tax: Donna and Jim receive a credit against state income tax of $3,500, that is 70% of the $5,000 donation.  They will also have to increase state income tax by $300, that is $5,000 * 6% if the federal charitable deduction was taken.
  • In net, the donation could cost the couple $1,800.  This is the unrealized credit of $1,500 plus the $300 in additional state income taxes.

The program was updated in March to increase the crediting rate to 90% and the donation limits to $10,000 for married couples filing jointly or $5,000 for single individuals.  Currently, there is a proposal to increase the crediting rate to 100%!  Let’s look at how the current law (90% crediting) works in 2018.

Example: Donna and Jim, from above, decide to contribute to a QRH again in 2018.  This time they donate the new maximum of $10,000 and maintain their federal and state income tax brackets of 30% and 6%, respectively.

  • Federal tax: The federal tax benefit depends on whether the taxpayer itemizes their deductions and whether they are limited on their SALT deductions.  If the taxpayer is limited on their SALT deductions and able to itemize, the federal tax benefit is $3,000, which is $10,000 * 30%.  If not, there is no federal tax benefit.
  • State tax: Just like in 2017, Donna and Jim get a state tax credit, but this time it is $9,000 ($10,000 * 90%).  They also have to add back the federal tax deduction (if taken) of $10,000, which increases state taxes by $600 ($10,000 * 6%).
  • In net, the donation could benefit the couple by $1,400! 

The Return

Without getting too personal, my wife and I will be limited on the SALT deduction but because of our charitable giving, we will still itemize our deductions in 2018.  Therefore, we should actually “earn” $1,400 for our $10,000 donation.  Should the state move forward with the 100% crediting rate, we would “earn” $2,400.  That’s a 24% return on investment!  But honestly, I’ll be happy with a 14% return.

The Ointment is Not Without Flies

Unfortunately, the federal government is aware of this strategy.  States are pushing these programs hard because of the tax advantages, which cost the states nothing.  In fact, the IRS has specifically put states on notice that they are not pleased with this work around strategy.  Notice 2018-54 has indicated that regulations on the treatment of these “donations” are forthcoming.

The federal government cannot take away the credit from the state perspective, but they can alter the treatment of the donation for federal tax purposes.  My guess is for federal tax purposes any donation with state credits assigned to it will be nondeductible donations on Schedule A.  This means the federal tax benefit goes away, taking with it the anticipated return on investment.  Taxpayers would be better off just paying their taxes to the state, getting no federal deduction, and a 100% credit against their state income tax liabilities.

Conclusion

The QRH programs update has considerably increased the appeal, however, like everything in finance, it isn’t for everyone.  Below is a simple flowchart to determine whether the you should even consider the program.

If you are not limited by the SALT deduction, you will not gain any federal tax benefit from the QRH program.  Likewise, if you simply use the standard deduction (and estimates are that 90%+ will), you will not gain any federal tax benefit from the program.  As such, in these situations your cost will exceed any benefits.  However, if you are maxed out on SALT deductions and do itemize your deduction, this program has potential to offer monetary and philanthropic benefits!

There is some hope that this strategy will persist since the state of Georgia has had these programs in place for several years already; they aren’t new.  The anticipated downside is that they will get swept into the same pile with all the new programs and have their federal tax benefits removed regardless.  Personally, I do the GaSSO program every year and did the $10,000 donation this year to a QRH.  Even if it costs me a little, I figure it is money well spent in areas needing the cash.

If you have any questions about this or any other planning issues, please feel free to reach out to your advisor.

 

Bryan Strike, MS, MTx, CFP®, CPA, PFS, CIPM is a Senior Financial Advisor at Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at bstrike@scottkays.com.

This report and Mr. Strikes’ comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance.

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