Final Regulations Issued on Charitable Contributions in Exchange for State and Local Tax Credits

On June 3, 2019, the IRS issued final regulations under IRC Sec. 170 on state and local charitable tax credit programs.

Recent Limitation to State and Local Tax Deduction

Prior to the enactment of the Tax Cuts and Jobs Act (the “TCJA”), taxpayers were allowed a deduction for state, local, and foreign taxes paid. Under the TCJA, the Schedule A deduction for foreign taxes was eliminated (not to be confused with the foreign tax credit) and the deduction for state and local taxes was limited to $10,000 per year ($5,000 per year for married taxpayers filing separately).

State Tax Credit Programs

As a workaround, many states with real estate taxes often in excess of the $10,000 limit have set up tax credit programs. Under these programs, a taxpayer makes a contribution of cash or property (“contribution”) to an IRC Sec. 170(c) organization, thus qualifying for a charitable contribution deduction. In exchange for the contribution, the taxpayer receives a credit on his property taxes. For example, if a program provided a dollar-for-dollar credit for the contribution, a taxpayer with assessed property taxes of $17,000 would make a $7,000 charitable contribution to his state’s credit program. He would be entitled to a $7,000 charitable contribution deduction under IRC Sec. 170(a)(1). In exchange for the donation, the taxpayer receives a property tax credit, thus bringing his paid state and local taxes down to $10,000. In this scenario, the taxpayer is not affected by the TCJA’s limitation on the state and local tax deduction.

New Regulations

The new regulations, generally effective for contributions after August 27, 2018, disallow a taxpayer’s action to circumvent the TCJA’s state and local tax deduction limitation. Under the regulations, the charitable contribution deduction is reduced by any state or local tax credit which the taxpayer receives or expects to receive in exchange for the contribution. There are two exceptions:

1. Where the credit received is 15% or less of the value of the taxpayer’s contribution, the charitable contribution deduction is not reduced.
2. To the extent that the taxpayer receives a state or local deduction (as opposed to credit) that does not exceed the value of the contribution, the charitable contribution deduction is not reduced. However, if a taxpayer receives a state or local tax deduction that exceeds the value of the contribution, the taxpayer’s charitable contribution deduction is reduced.

Safe Harbor

On June 11, 2019, the IRS issued Notice 2019-12, which creates a safe harbor for individual taxpayers.

The safe harbor applies to individual taxpayers who made contributions to state tax credit programs after August 27, 2018 and who itemize deductions. Under the safe harbor, the portion of the charitable contribution deduction that is disallowed under the new regulations will be allowed as a payment of state and local taxes. The state and local tax deduction of $10,000 will then be applied. If the taxpayer lives in a state that allows a carryforward of unused state and local tax deductions, the unused payment of taxes may be used in future years.

For most taxpayers, this will not be a large benefit. In our above example, where the taxpayer made a $7,000 charitable contribution for an equal state property tax credit, the full $7,000 would be disallowed under the new regulations. However, under the safe harbor, the $7,000 would be treated as a state tax payment (though, because this $7,000 is in excess of the $10,000 state and local tax deduction limitation, it will not be deductible). Thus, the taxpayer is in the same position he would have been in but for the charitable contribution.

In other situations, a taxpayer may find a benefit. For example, assume a taxpayer makes a $7,000 charitable contribution for an equal state property tax credit. Under state law, this credit may be carried forward for three taxable years. The full $7,000 is disallowed and treated as a state tax payment under the safe harbor. In year 1, the taxpayer’s state tax liability is $5,000. Therefore, the taxpayer treats $5,000 as a payment of state tax. In year 2, the taxpayer’s state tax liability is in excess of $2,000. Therefore, the full remaining $2,000 credit is treated as a payment of state tax. If the taxpayer’s total state and local tax payments in each of year 1 and year 2 is below $10,000, the full amount of the credit is deductible.

The IRS issued final regulations under IRC Sec. 170 on state and local charitable tax credit programs. Prior to the enactment of the Tax Cuts and Jobs Act (the “TCJA”), taxpayers were allowed a deduction for state, local, and foreign taxes paid. The deduction for foreign taxes was eliminated and the deduction for state and local taxes was limited to $10,000 per year ($5,000 per year for married taxpayers filing separately). As a workaround, many states with real estate taxes often in excess of the $10,000 limit have set up tax credit programs.