“Repeal of the State and Local Tax Deduction?”
As mentioned in last week’s edition of “Tax Reform Now,” President Trump’s “Unified Framework for Fixing Our Broken Tax Code” would eliminate most itemized deductions. Although the home mortgage interest and charitable contribution deductions would be retained, this framework would eliminate the widely used state and local tax deduction (“SALT deduction”). The Trump administration believes the revenue generated from eliminating the SALT deduction would help defray the costs of other proposed tax cuts in the framework. Proponents of eliminating the SALT deduction argue that taxpayers living in states that impose less state and local taxes currently subsidize taxpayers living in states that impose more state and local taxes. Merely talking about eliminating the SALT deduction has triggered backlash from both political parties. As a result, the SALT deduction may be used as a potential bargaining chip in ongoing discussions between Republicans and Democrats.
The SALT deduction can be taken by a taxpayer who itemizes their deductions. The SALT deduction allows a taxpayer to deduct property taxes along with state and local income taxes or sales taxes. Due to the availability of this deduction, some states and local governments have imposed more onerous taxes on taxpayers. Wealthy taxpayers living in states that impose more state and local taxes, such as California and New York, can utilize the SALT deduction to reduce their federal income tax bill by the amount paid to their state and local governments. This deduction is typically one of the largest itemized deductions taken by taxpayers. By eliminating the SALT deduction, wealthy taxpayers living in states that impose more state and local taxes would pay more taxes. Less affluent taxpayers living in these states are likely to switch from itemizing their deductions to utilizing the larger standard deduction offered in Trump’s framework. If the SALT deduction is repealed, states and local governments may feel pressure from their constituents to lower state and local taxes.
The states that would be most affected by the elimination of the SALT deduction are traditionally “blue” states. However, Republican politicians from California, New York, New Jersey, and Illinois have spoken out against eliminating the SALT deduction. These politicians do not want their constituents to pay more taxes. They are also apprehensive about not being reelected, which could result in the Republicans losing control over the House of Representatives in 2018. Their resistance has produced immediate results. During this past week, the Trump administration mentioned that eliminating the SALT deduction is a position up for negotiation.
The fate of the SALT deduction may decide whether President Trump has enough clout to enact his proposed tax framework. If the SALT deduction is not completely eliminated, the Trump administration must find other revenue streams to defray their proposed tax cuts. “Tax Reform Now” will provide updates about this contentious deduction when more information is disseminated.
And what happens to basis?
Under the current tax regime, taxpayers receive a step-up in basis when they inherit property. For example, imagine that you inherit a painting today that your mother purchased for $2 million. Now, that painting is worth $20 million. Upon your mother’s death, you receive a step-up in basis to the current fair market value: $20 million. That is, you receive the painting with a basis of $20 million. You avoid recognizing any gain that accrued during the time your mother owned it ($18 million) when you ultimately sell the property. This has been the law for some time.
However, in his campaign, President Trump proposed eliminating the basis step-up for assets exceeding $10 million. At this point, it is not clear whether the proposed framework supports (with respect to the above scenario) (1) an income tax recognition event at death, whereby your mother’s estate would recognize $18 million of gain at her death; or (2) a carry-over of the basis, whereby you would receive the painting with a basis of $2 million (the basis in which your mother had) and when you chose to sell the painting, would recognize whatever the gain is at that time (at its sale price). Clause (1) proposes a deemed recognition event at death for assets exceeding $10 million – this has never been seen before in our tax law. A forced recognition event, as described in clause (1) above would be problematic if the decedent did not have sufficient liquid assets to pay the tax. If that is the case, it will be crucial for individuals who have assets in their estate that have appreciated greatly, along with individuals who have few liquid assets, to plan in advance for more liquidity. A typical planning tool would be to purchase a life insurance policy in an amount sufficient to pay such taxes, whether income or estate (or to continue holding an existing life insurance policy).
Where do we go from here?
A bill regarding tax reform is expected to be introduced in early November. Before the bill can be written, a 2018 budget resolution must be adopted in order for the tax-writing committees to know the financial parameters of the bill. If the House and Senate fail to adopt a budget resolution that is filibuster proof, there will likely be no significant tax reform this year. Additionally, Republican House members have already shown dissidence with the elimination of the state and local tax deduction. A split Republican Party will make it more difficult for any tax legislation to be passed.
We hope this update has been helpful. As always, please let us know if you have any questions.