Govt acts to stop high-tax states from skirting $10K cap

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The Trump administration has laid down rules aimed at preventing residents in high-tax states from avoiding a new cap on widely popular state and local tax deductions. The action under the new Republican tax law pits the government against high-tax, heavily Democratic states in an election-year showdown.

The Treasury Department's rules released Thursday target moves by states like New York, New Jersey and California — where residents could see substantial increases in their federal tax bills next spring because of the $10,000 cap on state and local deductions. The cap was put in as a compromise to eliminating the deductions completely, as part of the massive GOP tax package pushed by President Donald Trump and enacted late last year. Experts say the issue likely will have to be resolved by the federal courts.

But the new rules' "dollar-for-dollar" limit also applies to many other states that already have charitable funds offering tax breaks — and those programs too could be hurt by the rules. Those states include solidly Republican ones and others with relatively low taxes. In those programs, donors to schools, hospitals or land-conservation programs can get their state taxes reduced in return — plus a charitable deduction on their federal tax returns.

The limit means taxpayers only can deduct as a charitable contribution the portion of their donation for which they don't also get a state tax credit.

While the aim of the rules is to challenge the high-tax states' moves to skirt the cap, "these regulations sweep more broadly than that," said Daniel Rosen, a tax lawyer at Baker McKenzie who formerly was an IRS official.

A few programs may be protected because of an exception to the rules' "dollar-for-dollar" requirement, he said.

Steven Rosenthal, a senior fellow at the nonpartisan Urban-Brookings Tax Policy Center, said he was surprised by the broad reach of the rules, affecting both high-tax states' "workaround" efforts and existing programs in Republican states to fund private-school tuition.

He also noted the prompt effective-date of the rules, Aug. 27 — which could spur a wave of donations to current programs before the deductions are limited. "I think this is going to cause an unbelievable opening of the pipeline," Rosenthal said.

Four high-tax states — Connecticut, Maryland, New Jersey and New York — already have sued the federal government over the deduction cap, asserting it's aimed at hurting a group of Democratic states and tramples on their constitutional budget-making authority.

A dozen high-tax states have taken or are considering measures to get around the cap. Most of the workarounds take advantage of federal deductions for charitable contributions — which aren't capped — in place of the old deductions for paying state and local income taxes. So people's state and local taxes exceeding $10,000, which can't be deducted, are turned into deductible charitable donations.

"The Republican tax law is an affront to middle-class Connecticut families and a massive giveaway to the wealthiest individuals and largest corporations, and the (rules) issued by the Trump administration today only make it worse," Connecticut Gov. Dannel Malloy, a Democrat, said in a statement Thursday.

Treasury said it expects that only about 1 percent of all U.S. taxpayers would see a reduction of their tax credits for donations to private-school voucher funds. Several states — Alabama, Arizona, Georgia, Montana and South Carolina — allow taxpayers who donate to private-school funds to get a 100 percent credit against their state taxes, according to data compiled by the Institute on Taxation and Economic Policy.

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HOW DO THE LIMITS WORK UNDER THE NEW RULES?

Dollar-for-dollar: When a taxpayer receives a benefit in return for donating to charity, the taxpayer should only be able to deduct the net value of the donation as a charitable contribution, Treasury says.

An example: You donate $1,000 to a charity in a state that offers a 70 percent tax credit, so $700 in this case. You would only be able to claim a $300 charitable deduction on your federal return.

There is an exception. If the state tax credits don't exceed 15 percent of the amount donated, so up to a $150 state tax credit on a $1,000 donation, the taxpayer could claim the full amount as a charitable deduction.

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WHY IS THIS IMPORTANT?

Taxpayers could have less incentive to donate without getting a deduction or if the deduction is reduced.

All states rely on property and income taxes to fund an array of services such as education, health care and public safety. Advocates for restoring the full state and local deductions say the reduced property tax deduction brings a decrease in the value of taxpayers' homes, possibly spurring residents of high-tax states to move elsewhere and crimping funding for local programs.

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WHAT'S HAPPENING IN THE HIGH-TAX STATES?

Measures designed to work around the $10,000 cap have been adopted in Connecticut, New Jersey, New York and Oregon, and introduced or explored publicly by officials in California, Illinois, Maryland, Nebraska, Rhode Island, Virginia, Washington and the District of Columbia.

New York Gov. Andrew Cuomo, a Democrat, on Thursday called the new rules "politically motivated" and threatened to sue the federal government over them. New Jersey's Gov. Phil Murphy said the state also is weighing its options for legal action, while California State Sen. Kevin de Leon said he expects the state to sue. Murphy and de Leon also are Democrats.

In some key "blue" states:

—Connecticut has a new law establishing a state charitable fund; donors can get tax credits in exchange for giving.

—In New Jersey, where high local property taxes are the major issue, the state is allowing local schools and governments to use the charitable workaround. But so far, no towns have notified authorities that they've set up funds to receive contributions — because state regulators haven't issued the necessary rules, experts say.

—New York is offering three options: One like Connecticut's, one like New Jersey's and another to let employers pay payroll taxes for employees, who would receive credits to cancel out the income taxes they would have paid otherwise.

—In Maryland, about 500,000 residents — over 18 percent of state taxpayers — will together lose $6.5 billion in state and local deductions, according to state estimates.

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Mulvihill reported from Cherry Hill, New Jersey. Associated Press writer Michael Catalini in Trenton, New Jersey, contributed to this report.