Don't Mess With Taxes

As expected, states whose residents will take a major federal tax hit under the new $10,000 limit on deductions of state and local tax (SALT) payments have headed to court.

Connecticut, Maryland, New York and New Jersey on Tuesday (July 17) afternoon filed a lawsuit in federal court in New York seeking to invalidate the Tax Cuts and Jobs Act's (TCJA) changes to a long-standing federal tax deduction.

In this latest semi-reform of the tax code, Congress essentially gutted the value of this itemized tax deduction for, in most cases, the millions in state income and local real property payments that filers in high tax states claim on Schedule A each year.

The ability to claim "all or a significant portion of state and local taxes," notes the lawsuit, has been available "since the enactment of the first federal income tax in 1861."

Now, say the states, the new tax law's 10 grand cap "effectively eviscerates the SALT deduction, overturning more than 150 years of precedent by drastically curtailing the deduction's scope."

Costly for taxpayers: The limit on the deduction will primarily affect states that have a relatively high personal income tax rate and/or expensive real estate that produces sizable annual property tax bills.

This situation tends to apply to the four plaintiffs in the lawsuit, as well as California, which is not a party to the legal action. Those states also tend to usually lean Democratic, or blue in the popular color-coded political vernacular.

The political implication was noted by New York's Democratic Gov. Andrew Cuomo after the lawsuit was filed.

"The so-called SALT provision was un-American," Cuomo told reporters. "What you did was you divided the states. You penalized the Democratic states."

However, the SALT limit also could cause tax deduction problems in even reliably red states, like Texas, or those that vacillate depending the election choices, like Florida.

I've lived in both (currently now back in my native Lone Star State), as well as in Maryland. And while Texas and Florida have no state income tax, they both have some very wealthy areas (as does the Old Line State) with very expensive housing.

Trust me, those residents, regardless of which way they lean politically, are not happy with losing a portion — and a big portion in some cases — of their property tax deduction.

Costly for states, too: The states are seeking, in legalese, declarative and injunctive relief from the new tax law. Basically, they want the court to say the law shouldn't apply and that the federal government should stop enforcing it.

That, of course, would definitely help their affected tax paying and deducting residents.

But the states also want the law changed because, they argue, it infringes on their rights.

Here's how, according to the filing:

As the drafters of the Sixteenth Amendment [which constitutionally codified the federal income tax] and every subsequent Congress have understood, the SALT deduction is essential to prevent the federal tax power from interfering with the States' sovereign authority to make their own choices about whether and how much to invest in their own residents, businesses, infrastructure, and more — authority that is guaranteed by the Tenth Amendment and foundational principles of federalism. The new cap disregards Congress's hitherto unbroken respect for the States' distinct and inviolable role in our federalist scheme. And, as many members of Congress transparently admitted, it deliberately seeks to compel certain States to reduce their public spending. This Court should invalidate this unconstitutional assault on the States' sovereign choices.

State tax victory unlikely: While the states' lawsuit has been expected, its chances of succeeding are slim.

Congress has added, axed and tweaked tax laws since the get-go.

Early last year, as tax reform talks were ramping up, there was talk that the state and local tax deduction might be eliminated, not just capped.

In an analysis back then of what that might mean, the Tax Policy Center, a nonpartisan Washington, D.C., tax think tank, noted prior changes to this long-standing law:

• Since the inception of the federal income tax in 1913, all state and local taxes not directly tied to a benefit were deductible against federal taxable income.
• In 1964, deductible taxes were limited to state and local property (real and personal property), income, general sales, and motor fuels taxes.
• Congress eliminated the deduction for taxes on motor fuels in 1978 and the deduction for general sales tax as part of the historic Tax Reform Act of 1986, the last major Internal Revenue Code shakeup before 2017's effort.
• The sales tax deduction was temporarily reinstated (as part of extenders legislation) in 2004. That let taxpayers deduct either income taxes or sales taxes, but not both. Congress made the provision permanent in 2015.

None of these actions has prompted states to cry foul, at least not as loudly. Of course, these prior SALT changes weren't as drastic as the TCJA move.

Congress taxing authority likely to stand: Still, few will argue that Congress doesn't have the power to make tax law, even tax law that harms individual filers or hampers the operations of the states in which they live.

"Congress can do almost what it wants on who pays, what's deductible and what's exempt from the income tax," Joseph Bishop-Henchman, an attorney and executive vice president of the Tax Foundation, another D.C.-based tax policy organization, told CNBC. "The main limit is that it has to be geographically uniform, the law has to apply everywhere in the United States, which this law does."

The attorneys general of Connecticut, Maryland, New York and New Jersey think differently.

We'll eventually see who's right.

In the meantime, the suit's plaintiffs can at least tell their residents that they're trying to reclaim their deduction.

Legal details: Named as defendants in Civil Action No. 18-cv-6427 are U.S. Treasury Secretary Steven T. Mnuchin, Acting Internal Revenue Service Commissioner David J. Kautter, the Treasury Department, the IRS and the United States of America.

The states argue that the $10,000 SALT cap violates:

1. States' rights that are protected under the 10th Amendment,
2. Federal power to tax incomes under the 16th Amendment and
3. Article I, Section 8, which covers Congress' power to tax.

The Tax Foundation's Bishop-Henchman details why he and his group believe the states' constitutional challenges will fail.

Then there's the workaround issue: Plus, before this lawsuit makes it very far down the judicial road, states also will have to deal with IRS regulations that are expected to end some SALT deduction workarounds.

In these cases, states create special charitable trusts to which taxpayers can make contributions in lieu of state and local income taxes and property taxes. New York and New Jersey already have taken this step.

The IRS is expected to say such arrangements are not allowed when it comes to SALT deductions under the TCJA.

That decision also could spark additional legal action.

You also might find these items of interest:

• Tax reform's $10K property tax deduction is worthless
• Lawmakers continue fight against SALT deduction limits
• Property tax appeals likely in wake of new federal deduction limit on state and local taxes