Hi, thank you for tuning in to today’s Emerald GEM, which stands for Get Educated in Minutes. I’m Tom Kelley, director of income tax planning for Wilmington Trust’s Emerald Family Office and Advisory and your host for today’s podcast. In today’s GEM I’m going to answer the question: How, with greater understanding, do I optimize my use of state and local tax deductions, otherwise known as the SALT deduction?
Let’s begin with some background on federal income tax deductions related to taxes paid to states and their localities. First, individuals and families evaluate whether they will take the standard deduction or decide to itemize their deductions. The standard deduction is an amount allowed each year based on income tax filing status. For example, for tax year 2021, this amount was $12,550 for single filers and $25,100 for those married filing jointly. Each year, this amount is indexed for inflation. Individuals and families may determine that it may be more advantageous to deduct their combined itemized deductions. These itemized deductions include items such as state and local taxes, mortgage interest, allowable medical deductions, charitable contributions, etc.
Prior to the legislative passage of what is known as the Tax Cuts and Jobs Act, individuals and households that itemized federal deductions could deduct state and local taxes without any dollar limitations or limits. Following the Act’s passage, an individual’s aggregate deduction was limited to $10,000 ($5,000 in the case of a married individual filing a separate return) during any calendar year. This means that your state and local income taxes, real property taxes, personal property taxes, and general sales taxes cannot exceed this $10,000 deduction threshold. This dollar limit is not permanent and will end in 2025. Presumably, without any additional legislation, the deduction for these taxes would be without dollar limitations again beginning as of January 1, 2026.
As a result of the legislative changes, a lot of clients who live in states with high state and local taxes, such as New York, New Jersey, and California, end up with a higher tax bill because they can no longer make their full SALT deduction. So today, I’d like to share three strategies that may help to mitigate this:
- Timing of your income and deductions
- Timing of when you pay state and local taxes
- Activities within a pass-through entity
First, timing of your income and deduction: Timing is everything and I, as a taxpayer, may have no control over the timing of my real property taxes. But depending on my earnings, investments, and business activities, I may be able to influence the timing of my income realization by offsetting income with losses or deductions or credits to align income tax planning optimally. For example, let’s say an individual determines that a current year will have less than usual income. This individual typically itemizes deductions for federal income tax purposes and is not subject to the alternative minimum tax. This individual determines that next year he or she may have more than usual income—perhaps from anticipated capital gains on investment holdings. Additionally, this person, working with an advisor, finds that the taxes we have been describing will not aggregately meet the $10,000 limitation this year. However, combined taxes next year are projected to exceed the $10,000 limitation. It may then be opportunistic to incur income in the current year rather than the next year. Therefore, it’s always important to consult with your advisor on proactive tax planning so that you can benefit from optimized total federal deductions over the current and next tax year. And as Goldilocks would say, this SALT deduction strategy is “just right.”
Second, timing of when you pay state and local taxes: Often, individuals and households who pay estimated income tax payments throughout the year compute whether it is better to pay their fourth quarterly state and local income taxes before the close of the current tax year even in states that may allow such payments to be made as of January 15 of the following year. Again, the analysis includes whether a particular tax year may not reach the $10,000 deduction limitation; thus, timing the payment may potentially ensure maximizing federal deductions.
Third, the use of pass-through entities: This one applies mainly to those individuals who are partner owners in partnership entities or limited liability companies that are treated as partnerships for federal tax purposes, and shareholder owners of a type of corporation known as an S corporation. Generally, S corporations do not pay income tax at the entity level. Rather, the corporation is a pass-through. That is, all the income, gains/losses, deductions, and credits are reported by the shareholder owners.
In 2020 the department of the Treasury and the Internal Revenue Service issued a Notice Communication regarding how certain state and local income taxes paid by these entities may be fully deductible against what it calls non-separately stated income. Most commonly, this includes trade or business income.
Generally, although income taxes are not imposed on partnerships or S corporations, a state may require the entity to withhold state and local income taxes for certain types of income incurred by the entity. The state may wish for the tax to be collected from the entity rather than have the owners separately remit the tax. Interestingly, states may allow entities, electively, to pay state and local income taxes on certain types of income attributable to the owners. Why might state or local income taxes paid by a partnership or S corporation be advantageous to the taxpayer? The previously referenced IRS Notice provides that state and local income taxes paid by an entity, whether mandatory or electively, on certain types of income are not subject to the current $10,000 state and local income tax deduction limit. That is, the entity will subtract the full amount of state and local income taxes remitted from the reported federal income. That may be beneficial because then the $10,000 federal income tax deduction limitation on the individual taxpayer’s level may not apply. In effect, the taxpayer may now benefit from the full SALT deduction, or at least more than what was available under the $10,000 limit regime. It’s important to note that this entity strategy is available for states that have laws that permit an election for entities to pay the SALT tax, or states that otherwise impose mandatory SALT tax withholding at the entity level. As examples, New York and New Jersey are two states that do allow for entity level deductions. Therefore, if you are a partner or shareholder of a pass-through entity, it may be valuable to consult with your tax advisor about whether this potential type of tax savings activity is available.
While many may still be feeling the pain of the reduction of the SALT deduction, there are potential ways to mitigate this by carefully looking at your timing—whether it’s the timing of your income and deductions; the timing of your state and local taxes; or, in some cases, using entities if you have the trade or business income.
One last note is that currently in legislative discussion, specifically in the contemplated Build Back Better Act, there may be provisions to increase the annual deduction limitation up to $80,000 for certain tax filers. At the time of this recording, this type of legislation has not been passed, but we want you to be aware that changes may occur, and it is important to monitor future possible tax law changes.
Thanks again for joining us today. Please contact your Wilmington Trust advisor if you have any questions about how to maximize opportunities to deduct state and local taxes to reduce potential federal income taxes. We would be glad to help you. See you next time!