Describe the nuances of state and local tax (SALT) deductions, including the federal limitation on the deduction amount and its impact on different income earners.

The state and local tax (SALT) deduction allows taxpayers to deduct certain taxes they've paid to state and local governments on their federal income tax returns. These taxes primarily include state and local income taxes, property taxes, and sales taxes. Before the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers could deduct the full amount of these taxes without any limitation, provided they itemized their deductions instead of taking the standard deduction. However, the TCJA introduced a significant change by placing a federal limitation on the amount of SALT that can be deducted. This has had a substantial impact, particularly on taxpayers in states with high state and local tax burdens.

The most crucial nuance of the SALT deduction is the federal limitation set by the TCJA. This law imposed a limit of $10,000 per household per year for the total combined deduction of state and local taxes. This limit applies whether you are single, married filing jointly, head of household, or another filing status, and includes the combined total of state and local property taxes, income taxes, or sales taxes. This limit is not adjusted for inflation so it remains the same year after year.

To understand the implications, let’s consider an example: If a married couple residing in New Jersey has paid $12,000 in state income taxes, and $8,000 in property taxes in a given year, the total SALT they paid would be $20,000. However, due to the federal limitation, they can only deduct $10,000 from their federal tax returns. This means they cannot deduct the full amount of their state and local taxes, so their taxable income will be higher. Now let’s consider a single taxpayer residing in a state with low taxes. This taxpayer has paid $2,000 in state income taxes and $2,000 in property taxes. Their total SALT is only $4,000 and they can deduct it all because it falls under the $10,000 limit.

This limitation on the SALT deduction has disproportionately impacted high-income earners, particularly those residing in states with higher income tax and property tax rates, such as New York, New Jersey, California, and Illinois. Before the TCJA, high-income earners in those states often claimed a substantial amount in state and local taxes, significantly reducing their federal tax liability. Now, with the $10,000 limit, those same taxpayers cannot deduct their full SALT burden, leading to a larger federal tax liability. In effect, taxpayers in high-tax states are subsidizing taxpayers in low-tax states.

For lower-income earners in high-tax states, the impact is not always as substantial, but still significant. While their tax burden might be lower overall, they also face a disadvantage because they often cannot deduct all of their state and local taxes. They're unable to offset as much of their tax burden through federal tax deductions as they previously did before the TCJA. Conversely, middle and lower income earners in low-tax states might not be as impacted. They may not even approach the $10,000 limit on SALT so it remains mostly unchanged. The limit particularly impacts itemizers; if they take the standard deduction the SALT limitation is irrelevant to them.

The option to deduct state and local sales taxes instead of state and local income taxes may be beneficial to taxpayers residing in states with no income tax or lower income tax rates, but with higher sales taxes. However, it’s not possible to deduct both state income taxes and sales taxes, and you can only choose which of these two to deduct alongside your property taxes. In most instances, it is advantageous to deduct state income taxes if the amount is higher than sales taxes. The IRS has a sales tax calculator that can be used to determine if choosing sales taxes might be beneficial.

Another nuance is that the SALT limit is not always tied to an individual’s ability to deduct, but is related to where the tax payer is located. If a taxpayer resides in a high-tax state, then they are penalized by the cap on the SALT deduction, even if their income is not extremely high, because their expenses may exceed that limit. This contrasts with the federal tax system that was intended to allow tax burdens to be offset through deductions. The SALT cap effectively punishes taxpayers residing in higher tax states.

In summary, the federal limitation on the SALT deduction significantly impacts the tax liability of different income earners, particularly those in high-tax states. High-income earners are disproportionately affected, as they often have high state and local tax burdens that now exceed the $10,000 cap. Low-income earners are also impacted, because while their SALT burden may be lower, they are still limited in the amount of the deduction, so they will still pay higher federal taxes. The $10,000 cap and the rules surrounding state income tax deductions, sales tax deductions, and property tax deductions, must be carefully analyzed to understand how to maximize tax savings.