What's Next for the State and Local Tax Deduction?

Taxpayers could see a change -- in either direction.

Dan Caplinger
Dan Caplinger
Mar 5, 2019 at 8:19AM
Investment Planning

Tax reform became a reality at the end of 2017, but taxpayers are only now starting to see the impact as they prepare their 2018 tax returns. A host of new provisions will affect the taxes that Americans pay this tax season, including new lower tax rates, a higher standard deduction, and significant changes to many deductions and credits.

One of the most hotly debated provisions of tax reform was the new limitation on itemized deductions for state and local taxes, often abbreviated as SALT. The new limit was especially painful in some key states, and that made many opponents argue toward restoring the deduction. However, a new group of policymakers believes that the SALT deduction should go away entirely, setting the stage for a new round of arguments on Capitol Hill and elsewhere.

Keyboard with the Return key in blue with the word Tax on it.

Image source: Getty Images.

The impact of tax reform

Under previous law, the deduction for state and local taxes allowed you to claim an unlimited amount of taxes you paid to state and local government entities. That included property taxes on real estate, as well as a choice between state income taxes a household paid and state sales taxes on the purchases that the taxpayer made over the course of the year. The only limit was that you weren't allowed to claim both state income tax and sales tax as deductible expenses.

That all changed with tax reform. The categories of permitted deductions remained the same, but the new tax law set a maximum deductible amount of $10,000. That left those in high-tax states facing big reductions in the amount they were allowed to itemize, in turn creating tax increases for many -- especially high-income earners in those high-tax states.

According to early assessments from the Treasury Department, about 11 million filers will have their state and local tax deductions reduced by the new SALT limitations. That has the same opponents who fought against the provision in the first place renewing their efforts, pointing to the unfairness of having their states singled out for punitive tax measures.

A new voice

However, on the other end of the spectrum, some lawmakers are arguing that tax reform didn't go far enough in curbing the SALT deduction. Instead, they believe that getting rid of the deduction entirely is the smarter policy choice.

There are several reasons for that stance. First, some believe that high-tax states need to reduce their rates in order to be economically competitive and keep residents from moving to tax-friendlier jurisdictions, and simply getting rid of the deduction entirely would stop what they see as a federal subsidy to states that heavily tax their residents.

In addition, given the other changes in tax reform, eliminating the SALT deduction would have the biggest impact on higher-income taxpayers. Standard deduction amounts have risen substantially, and so even if the SALT deduction were fully restored, not everyone who used to claim the deduction in the past would continue to do so now. By contrast, those with enough other itemized deductions to go above the much larger current standard deduction amount tend to have higher incomes. As a result, repealing the limit on SALT deductions could actually favor the wealthy more than the average taxpayer, while eliminating SALT deductions in full might arguably improve the tax code's level of progressivity.

Don't fret

Even with all this talk, there's no immediate likelihood of any changes in either direction for the SALT deduction. Even in 2017, lawmakers had a lot of trouble with the idea of completely killing the deduction. Despite the Republican majority in both the Senate and House when tax reform went through, many Republican lawmakers in high-tax states opposed any limitation on state and local tax deductions. The $10,000 limit was a compromise, and especially with Republicans having lost control of the House, any move to get rid of SALT deductions entirely is even less likely to become law.

Nevertheless, taxpayers should keep their eyes on Washington to see what further proposals come from Capitol Hill. With partisan fights likely, it'd take a monumental grand compromise for anything to get done -- but it's still better to be prepared for whatever might come next on the state and local tax front.