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Economic Insights

The dreaded cap on the deduction for state and local taxes (SALT) takes effect in the 2018 tax year and has some high earners fretting about the impact.

 

In Brief:

  • The Tax Cuts and Jobs Act of 2017 (Tax Act) has severely limited the state and local tax (SALT) deduction, especially for taxpayers in states where they’re likely to need the deduction the most.
  • The average SALT deduction taken in New York State was more than $21,000 in a recent tax year.
  • Many people won’t be able to use the newly reduced SALT deduction because the standardized deduction is now greater than their itemized deductions.

 

Since 1913, the deduction for state and local taxes, also known as the SALT deduction, has allowed taxpayers of high-tax states to deduct state and local tax payments (primarily income and property taxes) on their federal tax returns. For taxpayers who itemize their deductions, this arrangement has been quite advantageous.

So What Has Changed?
SALT was one of the Internal Revenue Service (IRS) itemized deductions that actually survived the contentious tax reform process in Congress—but just barely. As it emerged from the Tax Cuts and Jobs Act of 2017 (the Tax Act), SALT has a $10,000 cap. (There was no cap prior to this.) What’s interesting is that the cap is the same whether you’re single or married and filing jointly. (If you’re married and filing separately, the cap is $5,000.)

Considering the fact that the average SALT deduction taken in New York State was more than $21,000 in a recent tax year, that’s a cut of more than half of the deduction the average New York taxpayer has been able to claim historically, according to IRS data.

That’s Not All the Tax Act Did
Keep in mind that the SALT deduction is an itemized deduction, meaning that to use it you have to itemize deductions on your tax return. Here’s why it matters. The Tax Act nearly doubled the standard deduction to $12,000 for single filers, $18,000 for heads of households, and $24,000 for married couples filing joint returns. Because the standardized deduction is higher, many people won’t be able to itemize and use the newly reduced SALT deduction, even if they would otherwise qualify for it.

Let’s say you’re a married couple who files a joint tax return. You live in a high tax state and you paid property taxes of $12,000 and state income tax of $18,000 in 2018. Because of the reduced SALT deduction, even though you paid $30,000 in state and local taxes, only $10,000 of the amount is deductible.

However, your standard deduction is now $24,000 so that means that your itemized deductions need to be more than this amount for itemizing to be worthwhile. In other words, unless you have another $14,000 in other itemized deductions, such as mortgage interest and charitable contributions, you won’t be able to use your SALT deduction at all. Plus the Tax Act eliminated a variety of formerly itemizable deductions, which will make justifying itemizing even tougher for many people.

In fact, only about 5% of taxpayers are expected to itemize deductions starting in 2018. In recent years, about 30% of all tax returns contained itemized deductions. That means five out of six people who usually itemize deductions will no longer be able to.

Who Will Miss the SALT Deduction the Most?
Filers with incomes over $500,000 are greatly affected, but their loss in deductions could also be offset by the decrease of the top federal income tax rate (from 39.6% to 37%), the doubling of the estate tax exemption, changes to the alternative minimum tax (AMT), and the elimination of the itemized deduction phase-out.

A Few Positives
On the plus side, it may be easier for many taxpayers to complete their income tax returns. When deductions are itemized, there can be an additional three to four pages of tax forms that need to be filed. By just taking the standard deduction, the filing is briefer and simpler. Another positive is that there may be some planning opportunities around the timing of charitable contributions. In addition, the IRS is offering some penalty relief for taxpayers who may not have withheld enough in 2018.

The Bottom Line
Yes, state and local income and property taxes are still deductible in 2018 and beyond. However, the Tax Act has severely limited the deduction, especially for taxpayers in states where they’re likely to need the deduction the most. When you consider this fact, combined with the higher standard deduction that make itemizing not worthwhile for most people, it’s fair to say that only a small percentage of taxpayers will be able to deduct their state and local income and property taxes in 2018.

Since these matters can get complex, it’s useful to have guidance through tax season from an expert.

 

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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