New IRS Rules Undercut NJ’s Effort to Get Around SALT Cap

John Reitmeyer | June 13, 2019 | Budget
New regulations will prolong uncertainty for New Jersey homeowners and local governments; state Attorney General threatens lawsuit

Credit: Twenty20
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New regulations by the Internal Revenue Service significantly undercut — at least for now — a New Jersey law that was enacted last year to help residents get around the capping of the long-cherished SALT deduction for state and local taxes.

The action taken by the IRS this week drew immediate condemnation from Gov. Phil Murphy and other elected officials who backed the law, and it will likely trigger another a lawsuit involving New Jersey Attorney General Gurbir Grewal and the federal government.

Grewal previously threatened to sue the IRS if it moved to undermine the state’s so-called workaround law, which gave local governments a way to reclassify most property-tax payments as charitable contributions after the federal SALT deduction was capped at $10,000. In a statement posted on social media in response to the latest IRS action, Grewal said, “I remain as committed as ever to challenging the IRS in court.”

New Jersey Attorney General Gurbir Grewal
For New Jersey homeowners who have been hit hard by the recent cap on the SALT deduction, the new IRS regulations will prolong an uncertain regulatory atmosphere that thus far has kept local governments from implementing the new workaround law. The cap was set in place as part of the 2017 federal tax-code overhaul engineered by President Donald Trump and fellow Republicans who, at that time, controlled the Congress.

Several analyses have shown that many New Jersey residents enjoyed some tax relief as a result the changes. But many others saw a hefty tax increase, largely due to the $10,000 cap on the SALT deduction, which had previously been unlimited.

But there’s also some good news for small-business owners as the regulations won’t impact another proposed SALT workaround that’s currently before state lawmakers.

The Trump changes

Among the many changes included in the major federal tax-code overhaul enacted by Trump in 2017 was a lowering of individual income-tax rates, an expansion of the standard deduction and a significant cutting of the federal tax burden for corporations and those with large estates. But rules related to several federal tax exemptions and deductions were also changed as a way to help pay for the tax cuts.

Several analyses have shown that many New Jersey residents enjoyed some tax relief as a result the changes. But many others saw a hefty tax increase, largely due to the $10,000 cap on the SALT deduction, which had previously been unlimited.

To help New Jersey homeowners cope with the new limit, Murphy, a first-term Democrat, worked with lawmakers last year to pass a law that shifted the classification of local taxpayer contributions that fund things like K-12 schools and municipal law enforcement from property taxes to charitable contributions. The 2018 law attempted to take advantage of the full federal deduction that is still allowed for charitable contributions by also giving municipalities, counties and school boards the power to offer property-tax credits worth up 90 percent of a contribution to those who donate to a civic fund in their respective communities.

The IRS put up an initial roadblock to that strategy last August when the agency published a new set of regulations for tax deductions that said the value of any associated state or local tax credit generally must be deducted from a charitable contribution when reporting it on federal taxes. Tax credits do not have to be deducted if they are worth no more than 15 percent of a contribution, according to the regulations, which were then finalized by the IRS this week.

“Under the final regulations, a taxpayer making payments to an entity eligible to receive tax-deductible contributions must reduce the federal charitable contribution deduction by the amount of any state or local tax credit that the taxpayer receives or expects to receive in return,” the IRS said. As an example, the IRS said if a taxpayer made a $1,000 contribution and received a tax credit worth 70 percent, they could only deduct the remaining $300 from their taxes. But the state workaround law sought to allow tax credits worth up to 90 percent of a contribution to be provided while still allowing for the contribution itself to be fully deductible.

Another lawsuit?

Last year, Grewal threatened to sue the IRS over its approach to New Jersey’s new workaround law. His office and several other state attorneys general already are involved in an ongoing lawsuit against the federal government that is seeking to overturn the capping of the SALT deduction at $10,000. Oral arguments in that case are pending.

“I was proud to lead a coalition of Attorneys General opposing the IRS’s proposal, and I remain as committed as ever to challenging the IRS in court for going through with its harmful and illegal approach,” Grewal said this week in response to the latest IRS regulations.

Murphy also spoke out forcefully against the new regulations in a statement that suggested they wouldn’t stand as the final word on the issue.

“We will continue to fight alongside our Congressional delegation and sister states to restore our residents’ full SALT deductions,” Murphy said.

While it remains to be seen whether a new lawsuit will be filed against the IRS, no local government in New Jersey has stepped forward amid the uncertain regulatory environment to create one of the civic funds that’s authorized under the 2018 state law, according to the state Department of Community Affairs.

Wait and see

“While a lot of local officials were supportive of the overall concept, they took a wait-and-see attitude based on the anticipated guidance and rulings from the federal Treasury and the IRS,” said Michael Cerra, assistant executive director of the New Jersey State League of Municipalities.

“I think that dampened the willingness to take the initiative,” he said.

State Sen. Joseph Pennacchio (R-Morris) suggested the IRS’s new regulations vindicate the position that he and many other Republicans took as the workaround law moved through the Legislature last year.

“If we really want to cut property taxes, then we need to pass the fiscal reforms necessary to get our State budget back on track — and stop trying to circumvent the federal government,” Pennacchio said.

Meanwhile, the IRS regulations shouldn’t put a crimp in the bipartisan effort to establish a SALT-cap workaround for small businesses in New Jersey by reclassifying the tax payments made by so-called “pass-through” entities. Legislation that has already sailed through the Senate and is pending in the Assembly would establish a new “business-entity tax” in New Jersey for members of partnerships, limited-liability corporations and S corporations since the state and local taxes paid by such businesses are still fully deductible from federal taxes.

The annual savings for small-business owners and other pass-through entities could be as high as $800 million.