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How high-tax states might dodge the new tax law

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New Jersey’s governor-elect joined a chorus of leaders in Democratic states who are proposing workarounds for their residents to avoid new caps on state and local tax deductions — even as a top Trump administration official suggested the federal government might act to limit such strategies.

Phil Murphy, a Democrat who will be sworn in as New Jersey’s governor on Jan. 16, said Friday he’s working on a plan that would effectively convert property taxes into charitable gifts.

Murphy joins New York Governor Andrew Cuomo and California Senate President Pro Tem Kevin de León, who have also said they’re considering ways to shield their constituents from a new $10,000 federal cap on state and local tax deductions.

Murphy’s announcement came just hours after White House economic adviser Gary Cohn said the Trump administration may try to block any potential avoidance strategies by high-tax states.

“I understand what they’re trying to do for their cities and their states and their taxpayers,” said Cohn, director of the National Economic Council, during a Bloomberg Television interview. “We at the federal government still have to collect revenue.”

The state actions and Cohn’s response suggest a looming showdown or the beginning of a cat-and-mouse game between state and federal policy makers, experts said.

Before the Republican Congress’s tax overhaul took effect Jan. 1, most filers could deduct state and local taxes from their federal returns, a benefit that applied to property, income and other levies. But the new law that President Donald Trump signed last month caps the so-called SALT deduction at $10,000, a change that could cost residents of high-tax states billions of dollars.

A precursor to tension between the federal government and states first emerged at the end of December over the prepayment of state and local property taxes. Some officials in states including New York and New Jersey encouraged homeowners to prepay their 2018 property taxes before the end of 2017 so that they could claim those deductions under the previous tax code — without the $10,000 cap.

But the IRS issued guidance that would effectively limit or kill the prepayment benefit for millions, saying the taxes in question would have to have been assessed by local tax authorities in 2017 to qualify for deductibility on 2017 returns. Many jurisdictions hadn’t yet done such assessments for 2018 property taxes — putting prepayments in question and stirring anger and confusion across the country.
Overall, the tax cuts that Congress approved last month are estimated to reduce federal revenue by more than $1 trillion over the next decade, after accounting for macroeconomic effects, according to the Joint Committee on Taxation, Congress’s official scorekeeper. If states devise workarounds for the $10,000 cap on state and local tax deductions, the revenue shortfall could grow.

The new limit hits California and New York hardest, due to their high state taxes and large populations. Connecticut, New Jersey and the District of Columbia round out the top five jurisdictions where individuals claimed the largest average SALT deductions.

“We want to pursue this aggressively,” said Murphy, who was joined during a news conference by Rep. Josh Gottheimer, a New Jersey Democrat, and other officials. In addition to the charitable-giving strategy, he said he’s exploring changes to the state income-tax system — and a potential lawsuit.

“If there’s even a sliver of hope to challenge constitutionality of this, we will” file suit, he said.

Murphy’s charitable-giving plan builds off of a nascent movement among states to provide full and partial tax credits in return for donations that fund tuition vouchers for private and religious schools. A 2011 memo from the Internal Revenue Service seemed to signal the agency’s approval of taxpayers claiming federal deductions on those gifts.

Murphy said there’s precedent for the charity approach — but the IRS memo shouldn’t be considered as such, said Andy Grewal, a professor at the University of Iowa College of Law.

“If somehow this did succeed, Congress could just pass a one sentence statute,” said Grewal. “It’s too good to be true.”

On Jan. 4, California’s de León introduced a bill offering a dollar-for-dollar tax credit to state taxpayers who make donations to an entity called the California Excellence Fund — a proposal that, like Murphy’s, would seek to use the federal deduction for charitable gifts to shield residents from the cap on the SALT deduction.

The day before, New York’s Cuomo likened the federal tax reform law to “economic civil war” in a speech and promised a number of strategies to counter the SALT cap — including suing the federal government and expanding opportunities to use deductible charitable gifts to fund government operations.

Cuomo also said he’s developing a plan to shift the state from a personal income tax to a system of payroll taxes levied on employers, who’d still be allowed to deduct such levies on their federal taxes by law. Tax officials in Cali are considering a similar idea, according to The Connecticut Mirror.

Replacing state income taxes with payroll taxes would be a complicated process — requiring employers to adjust wages and potentially create a system of tax credits. It would also offer greater economic benefits than would the charitable-giving strategy, since a shift to payroll taxes would also apply to taxpayers who don’t itemize, according to David Kamin, a New York University School of Law professor.

Proposals from New York and California are “interesting, but unlikely to succeed for both legal and practical reasons,” Jared Walczak, a senior policy analyst at the conservative-leaning Tax Foundation, said in a report Friday.

“If states are genuinely concerned about the effects of their tax codes absent an uncapped state and local tax deduction, they should consider revisiting their tax rates rather than devising increasingly convoluted and legally suspect workarounds,” Walczak wrote.

Bloomberg News