The TCJA added a cap on the total deduction for state and local real estate, personal property, and income taxes of $10,000 for all filing statuses other than Married Filing Separately, which is limited to $5,000. The cap also would apply to general sales taxes if those were deducted instead of state and local income taxes.
Previously, these itemized deductions were unlimited.
Who is impacted?
The above expenses are itemized deductions, thus the cap only applies to non-business expenses. Any real and personal property taxes related to an income producing activity will continue to be deducted with that related activity, such as a sole proprietorship on Schedule C or a rental property on Schedule E.
What does this mean?
With the standard deduction increasing to $24,000 for Married Filing Joint filers, many will take the standard deduction as opposed to itemized deductions, and therefore will be unaffected by this $10,000 limitation. The cap will also create more standard deduction filers since filers with large amounts of state and local taxes that would have normally been in excess of the higher standard deduction would be substantially less when state and local tax deductions are limited to just $10,000.
Keep in mind that state and local real estate and personal property taxes related to your sole proprietorship or rental property are deducted on separate schedules and are not included in itemized deductions that are subject to this limitation.
This also means that C corporations will have an advantage over pass through entities such as partnerships and S corporations. This is because C corporations are able to deduct state and local income taxes when determining federal taxable income. However, owners of pass through entities will either no longer be able to deduct these taxes because they take the standard deduction, or their state and local income tax deduction will be limited due to the $10,000 cap.
What can you do?
It is difficult to soften the blow of this change. The TCJA even put a damper on some states’ hopes to include more deductions in 2017 when adding wording that stated any prepayments on 2018 income taxes in 2017 in order to avoid the $10,000 limitation would not be deductible until the year the tax paid relates to.
Some high income tax states such as California, Maryland and New York are exploring strategies to offset the new cap. California is considering allowing residents to make deductible contributions to entities such as public schools in lieu of paying state income taxes. However, it is unclear at this time if such strategies would actually achieve their intent.