WASHINGTON — The Treasury Department moved on Thursday to block high-tax states from circumventing new federal limits on state and local tax deductions, escalating a dispute with Democratic governors.
A proposed Treasury Department rule, which is certain to face legal challenges from several states, would limit the type of charitable contributions that Americans are allowed to deduct on their federal taxes. The rule would effectively exclude donations that are rewarded with state tax credits, such as charitable contributions made to certain private or charter schools and universities, land donated for conservation purposes and donations to housing assistance programs.
It is expected to affect only a small slice of the population, according to Treasury estimates, though it will likely be concentrated among high earners in high-tax states, like New York and California. The regulations would affect taxpayers who currently deduct more than $10,000 in state and local taxes, a group that officials put at about 5 percent of the population.
In proposing the rule, the Treasury Department is looking to block efforts by New York and other states to circumvent a provision of the new Republican tax law that set a $10,000-a-year cap on deductions for state and local taxes. The cap helped Republicans keep the estimated cost of the tax law, which centers on a sharp reduction in the corporate tax rate, under $1.5 trillion, to comply with a budget procedure that allowed the bill to pass without the support of any Democrats.
But the cap angered lawmakers in several states, and they moved quickly to find ways to circumvent the limits. New York and New Jersey passed laws that set up charitable funds for state services, such as schools, and award state tax credits based on donations to those funds. The idea was to create a roundabout way of funding state services which preserves a higher federal tax deduction for residents — because the charitable deduction, unlike the state and local tax deduction, remains uncapped.
The Treasury rule would render those credits effectively useless for taxpayers. They would still be paying the same amount to the state, but receive no additional tax deduction from the federal government for their trouble.
Under the proposal, someone who makes a $10,000 charitable contribution to the state and receives an $8,500 tax credit can deduct only $1,500 from federal taxes — the difference between the value of the credit and the contribution. Previously, Americans were allowed to deduct the entire value of a charitable contribution linked to a state tax credit.
The rule does not apply to state tax deductions, only to credits, and it does not affect taxpayers who receive a credit worth 15 percent or less of the amount they donate — a loophole that could exempt landowners who donate large tracts for conservation purposes.
The proposal is aimed primarily at high-tax states like New York that are trying to jury-rig a way around the cap. In New York, according to Internal Revenue Service data, more than a third of taxpayers took the state and local tax break in 2015, deducting more than $20,000 on average from their federal taxes. In Alabama, just over a quarter of taxpayers took the deduction, and claimed less than $6,000 on average.
More than 90 percent of households earning at least $200,000 in 2015 took the state and local deduction, writing off $269 billion in taxes. Those households accounted for less than 5 percent of all filers in 2015, but took nearly 50 percent of the total deduction that year.
Jim Tankersley reported from Washington and Ben Casselman from New York.