Call Your State Taxes a Donation to Avoid Federal Tax? Not So Fast

When the Tax Cuts and Job Act limited state and local tax deductions to $10,000, people with higher state and local taxes were understandably upset at losing their deductions. Some state governments listened to their voters and tried to give them a way around the cap — allowing them to donate to specified charitable funds rather than pay taxes. These charitable funds would then donate to things like parks and schools who would typically receive tax dollars.

In August, the IRS announced that this type of workaround was a loophole that it wouldn’t allow.

You Can’t Deduct the Amount of State Tax Credits

The new IRS regulation states that you can’t take a charitable deduction when you receive a state tax credit in return. Your deduction must be reduced by the amount of any credit.

For example, if your state gives a 50% credit for contributions to an eligible entity and you contribute $1,000, you can only claim a $500 charitable deduction on your federal tax return.

What’s This Rule Based On?

Federal tax law has long stated that you can’t take a charitable deduction for any value you receive in return. For example, if you buy an item valued at $100 at a charity auction for $150, you have to subtract the $100 from the $150 for a $50 charitable deduction.

A tax credit is a dollar-for-dollar credit. A $1 credit means you pay $1 less in taxes. Therefore, the IRS decided that receiving a tax credit in return for a charitable contribution gave you something of value and you should subtract the tax credit from your charitable deduction just like you would if you bought an item at a charity auction.

Exception: If your credit is 15% or less of your payment, you don’t have to subtract it from your charitable deduction under the de minimis exception.

What About State Tax Deductions?

Deductions are not affected by this rule. Deductions reduce your income rather than directly reducing your tax bill. They have also long been part of the state and federal tax code.

The IRS found that the long-standing precedent of allowing state and federal deductions plus the fact that they weren’t a dollar-for-dollar benefit meant they should continue to be allowed.

Will these new rules affect you? Will you even need to itemize after tax reform? Talk to us today to find out.

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