Don’t worry, they’re not doing a cooking podcast. In this episode, Tax Directors Candace Varner and Ben Hake discuss a different kind of SALT – State and Local Tax. The SALT deduction was capped at $10,000 in 2018, and many high-tax states have since introduced their own workarounds. Recently, the Build Back Better Act proposed a significant increase to the deduction, but taxpayers who can’t take advantage of it this year may be left feeling salty.
Wishing happy holidays (including Festivus) to all our listeners!
Hear more about the Build Back Better Act tax proposals: https://creativeplanning.com/podcast/tax-legislation-proposal-changes-life-comes-at-you-fast/
Read more about the California SALT workaround: https://creativeplanning.com/insights/california-latest-state-to-add-state-tax-workaround/
Learn more about Festivus: https://youtu.be/HX55AzGku5Y?t=34
The Standard Deduction podcast is hosted by Tax Directors Candace Varner and Ben Hake. This podcast is a thoughtful, informed discussion about ideas, trends and developments in taxes related to personal wealth management.
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Candace Varner: Hello, and welcome to The Standard Deduction. I’m Candace Varner.
Ben Hake: And I’m Ben Hake.
Candace: And today we want to talk to you about state and local taxes, also known as SALT.
Ben: I think we can almost say we’re going to add a pinch of “SALT” to the holiday season.
Candace: Wow. We could, Ben. There’s so many good puns with this particular topic. It was really designed for us specifically and our style of talking. Okay. So the SALT deduction, you’re hearing it in the news a lot right now. That’s what I’m getting asked about it all the time. So remember SALT is state and local tax. It’s currently part of the proposals in the Build Back Better Act, that some of this might be changing. And so that’s why you’re seeing it in the news a lot. State and local tax includes a group — all different types of taxes that are paid to a state or local government. So a lot of people consider this, you’ll think of the state income tax. That’s probably one of the biggest ones that you’re paying, but it also includes real estate taxes that are paid, personal property taxes (usually on cars and boats), sales taxes on large purchases, but also the income tax. So anything that’s basically not the check is payable to the IRS, but other taxes you’re paying, that all falls into this lovely group of SALT taxes.
Ben: And part of the reason this is coming up is because as part of the tax reform that took place in 2018 is that deduction is now being capped at $10,000; and a lot of the media, and when the news covers this, they kind of describe it as a coastal issue. So they always bring up New York, New Jersey, California, places that have really high income taxes. But we also hear about it from a lot of our clients who live in states with no income tax at all. So we’ve got clients down in Texas who have extremely high real estate tax bills, and this is something that’s impacted them, even though, again, they’re not what most people think of when they think of the states with high SALT rates.
Candace: Right. So even though the income tax piece is a big part of it, there’s a lot of things that go into this category. But for the state income tax piece specifically, it’s really only a federal tax issue because the income tax paid to states is not deductible on your state return. That would make it circular and even worse for us wonderful CPAs. So because it’s only a federal tax deduction, the states have had a lot of incentive to try to find a workaround since this law changed with the Tax Cuts and Jobs Act that was effective in 2018. And since then, a lot of the states that have high taxes have been trying to find a way to work around this and help people continue to benefit from the deduction at the federal level while working with this $10,000 cap. So Ben, how have they done that?
Ben: So, the real groundbreaking pioneer in this space is the state of Connecticut. And they came up with a strategy where instead of charging — and this is always going to apply to flow-through entities. So if you’ve got a corporation, like you work for Amazon or Microsoft, that wouldn’t work here. But if you have a flow-through or a small business, what ends up happening is instead of charging your state level tax — let’s say you would owe $10,000 on $100,000 — instead of charging that on your individual return, they’re going to charge your business for that. And so now we’re deducting that outside of that SALT limit. But most people are like, “Well, I don’t want to pay $10,000 at the entity and $10,000 at my individual return. I’m getting double taxed.” So the states say, “Hey, we’re going to give you a credit.”
Now, Connecticut’s is a percentage of what you pay in, but a lot of these states are making it dollar for dollar. So if you pay $10,000 at the entity level, you’ll get a credit at $10,000 on your individual return. So Connecticut does that and everyone – it’s a little bit of a waiting game. The IRS hadn’t at the time announced if they’d left that fly, if they were going to try and fight that in court. And so, in late 2020, they introduced a revenue ruling that basically said, “Hey, we’re going to acquiesce, we’re not going to fight it. Do it if you’d like.” And the other states said, “Heck yeah, we’ll do that!”
So, 2021 rolls around and we’ve probably got about 15 other states who have done it, including every state we’ve mentioned earlier. So with new Jersey’s, New York’s, California’s, and they work with a very similar approach — which is you proactively elect into this new tax regime, you pay your tax at the entity level, and subsequently get a credit at the individual return, which has incentivized a lot of clients to try and pay their 2021 state liabilities before the end of the calendar year in order to get that deduction, which is likely well in excess of $10,000, and to benefit from that on the federal return.
Candace: Okay. Whoa, that’s a lot. I think this would be a good time to revisit the words deduction and credit. A lot of our listeners are confused by that, which is totally normal. A lot of clients I talk to are confused by that. Deduction means we’re going to take it — we’re going to say, okay, you made $50,000 in revenue, and deduction means we’re going to reduce that amount by those expenses. Then that net number is multiplied by a tax rate. So a deduction is not dollar for dollar. A credit is dollar for dollar.
So that’s an important distinction in the description you were giving of, say, California’s way of getting around this in that you get the deduction on the business return, which gives you a credit on your individual return. Side note, shout out to one very special listener who has told me that he would prefer that we refer to it as a reduction, as opposed to a deduction, because that would help him understand the difference better. And, I really like his style, but I don’t think I can get the whole industry to change. So I might stick with deduction, but I see where you’re coming from. So we’ve got all these different workarounds now, but as you said, this is only for business income, correct? So I can’t do anything since I’m just earning wages on a W-2?
Ben: Correct. It’s a very specific set of income, or kind of how you earn your income, that would benefit from this. So if you’re somebody who has large investment income, interest dividends, capital gains from a brokerage account, these workarounds don’t assist or provide a mechanism to pay those taxes and deduct them. And similarly, individuals who are earning a W-2 or earnings of that nature are also unable to participate in these. So, it’s really focused on small business, and even large business owners, but for those other segments where you’re either a W-2 employee or retired possibly and have brokerage income or IRA distributions, neither of those would be able to benefit from it.
Candace: So another classic tax thing, where it depends on your specific set of facts, how you earn the income, and what state you live in, because each state that has made this, it’s not that they all copied what Connecticut did. They each made their own way of doing it. So whether or not it applies to you will depend greatly on where your business is.
Candace: So if we step back to what you were saying earlier about what it used to look like before 2018 tax law change, I guess it passed in 2017, but it was effective in 2018. Before that $10,000 cap, you used to be able to deduct an unlimited amount. So, if I sold my business and I happened to pay $1 million to California, that entire $1 million was deductible for federal purposes. Now we saw a lot of clients in the income ranges of $200,000 to $500,000 not get the benefit of this deduction because of alternative minimum tax (AMT).
So think of AMT as an alternate universe where totally different rules apply. And we’re just going to recalculate your tax under entirely different set of rules. It’s fun. We didn’t have enough fun doing the tax the first time. So we’re going to do it again. And under that system, none of this has ever been deductible. None of the state and local taxes that we’ve talked about at all have ever been deductible.
So, in the olden days, in 2017 and before, you got that deduction for federal taxes, but then if you ended up in AMT, you really got no benefit. So yes, you deducted it, but it didn’t lower the actual tax you paid to the IRS. So it caused a lot of confusion as to when you should pay it and the timing and all of that kind of stuff. And since that’s been gone, now we’re capped $10,000, it’s made it a little simpler I think for a lot of people in this category, if you’re not those small business owners. But now it’s back on the table, something that might change. So what’s this latest bill say they might do to it, Ben?
Ben: So, in the past couple of weeks, the House has passed the Build Back Better Act. And one of the provisions that has been included in that, but wasn’t included in the original kind of design from the Senate, was increasing that state and local cap from $10,000 all the way up to $80,000. So if that were to pass, that would be an incentive for — if you’ve got real estate taxes that you pay twice a year, you might want to pull that second payment in to increase the deduction you’re able to claim on your 2021 return, assuming that between those property taxes and your state income taxes, you’d still be under that $80,000 threshold.
Candace: Seems like a pretty big jump from $10,000 to $80,000.
Ben: It is. I can’t say I know the rhyme or the reason as to how they came up with that.
Candace: Still much lower than unlimited, but a significant jump for, again, a certain subset of clients. So that is everything on state and local tax. As the Senate takes up the House version of the Build Back Better Act this might change, the dollar amount might change, who knows. And the latest I’ve heard is that some people don’t think this is even going to get done before the end of the year. They’re going to push it into early 2022. So, as always, stay tuned. For now, we wish all of our listeners a happy holiday season — including happy Festivus, if you celebrate.
Ben: And we will be back next year with more exciting tax updates and topics. Thank you.
Candace: Thank you.
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