I.R.S. Warns States Not to Circumvent State and Local Tax Cap

I.R.S. Warns States Not to Circumvent State and Local Tax Cap

WASHINGTON — The Internal Revenue Service is preparing to crack down on states that try to circumvent a new limit on the state and local tax deduction, saying it will not allow workarounds aimed at helping individuals fully deduct those taxes.

The $10,000 cap, which was included in last year’s $1.5 trillion Republican tax overhaul, hit predominantly Democratic high-tax states hardest since it limits the amount of state and local sales, income and property taxes that taxpayers can deduct from their federal taxes. That has prompted a scramble among local lawmakers to find creative ways to allow constituents to continue to fully deduct those taxes and avoid a tax hit.

Some states, like New York, recently began allowing taxpayers to convert local property taxes into charitable contributions, which are fully deductible from federal taxes. Other states, like New Jersey and Connecticut, have been moving forward with similar plans to reclassify state taxes as charitable contributions. New York is also establishing a new system that allows taxpayers to convert their state income tax to a payroll tax, which companies would pay on their behalf and then deduct from their federal tax bill.

The Treasury Department on Wednesday warned that such workarounds are unlikely to pass I.R.S. muster.

“Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes,” the I.R.S. wrote in a notice released on Wednesday.

The notice is a precursor to a formal guidance from the I.R.S. that will need to go through a review process.

Last year, residents in may states tried to prepay their property 2018 taxes before the new law took effect, but the I.R.S. took action to limit that option.

Efforts to limit the state and local tax deduction, known as SALT, were controversial and prompted several Republicans lawmakers from high-tax states to vote against the tax bill. The $10,000 cap was imposed as a way to offset some of the cost of other individual and business tax cuts.

The Treasury Department and the I.R.S. are worried that the workarounds could further balloon the cost of the tax cuts, which are projected to add more than $1 trillion to the national debt over a decade.

Earlier this year, Steven Mnuchin, the Treasury secretary, scolded states that were looking for loopholes.

“I hope that the states are more focused on cutting their budgets and giving tax cuts to their people in their states than they are in trying to evade the law,” he said.

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