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Navigating SALT Deduction Changes and Passthrough Entity Strategies for Maximum Benefit
The State and Local Tax (SALT) deduction allows taxpayers to deduct either their state and local income taxes or their state and local sales taxes, in addition to property taxes, on their federal income tax returns when they itemize deductions. This deduction has long been a staple in the tax code, designed primarily to mitigate double taxation on the same income.
The Pre-OBBBA Era
Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, there was no cap on the SALT deduction. Taxpayers could deduct all state and local taxes paid on their federal returns when itemizing. This deduction was especially beneficial for taxpayers in high-tax states such as New York, California, and Illinois.
However, with the implementation of the TCJA, significant changes were made. The SALT deduction was capped at $10,000 for both single filers and married couples filing jointly and $5,000 for married individuals filing separately. This cap substantially affected taxpayers in high-tax states, where state and local taxes often exceed the federal cap.
The Impact of OBBBA
Recently, with the enactment of the "One Big Beautiful Bill Act" (OBBBA), the cap on the SALT deduction has been amended with a more generous limit. Beginning in 2025, the SALT deduction cap increases to $40,000, with an annual 1% increase until it peaks in 2029. After 2029, however, without further Congressional action, the cap is set to return to $10,000.
SALT DEDUCTION CAP | |
Year | Salt Cap |
2024 | $10,000 |
2025 | $40,000 |
2026 | $40,400 |
2027 | $40,804 |
2028 | $41,212 |
2029 | $41,624 |
2030 and subsequent years | $10,000 |
½ those amounts for married couples filing separate
This legislative change was made in response to complaints from the high-tax states’ Congresspeople. By enabling a higher cap, more taxpayers from high-tax states can potentially benefit, specifically those who itemize deductions on their federal returns.
Limitations for High-Income Taxpayers
The OBBBA introduces limitations for higher-income taxpayers, who are now subject to a phase-out of the SALT deduction based on their modified adjusted gross income (MAGI). The allowable deduction starts to decrease when MAGI exceeds specified thresholds.
For instance, in 2025, taxpayers with a MAGI exceeding $500,000 will experience a reduction in their deductible amount by 30% of the excess income above the threshold, limiting the full benefit of the enhanced SALT cap. If a taxpayer's MAGI is $600,000 or more, the deduction is limited to $10,000, making the increase irrelevant for them. This approach seeks to offer relief while balancing the tax system's overall fairness for high-income taxpayers. The MAGI thresholds also change for each year as illustrated in the table.
SALT DEDUCTION REDUCTION | ||
Year | MAGI Phase Out Threshold | MAGI - Reduced to $10,000 |
2025 | $500,000 | $600,000 |
2026 | $505,000 | $606,333 |
2027 | $510,050 | $612,730 |
2028 | $515,150 | $619,190 |
2029 | $520,302 | $625,719 |
Examples Illustrating the Limitations
To illustrate, consider two example scenarios:
Example #1 (2027): A taxpayer with a $523,000 MAGI would start with an allowable SALT deduction of $40,804 (from the table shown previously). However, since $523,000 exceeds the $510,050 MAGI threshold, there’s a deduction reduction of $3,885, resulting in a maximum SALT deduction of $36,919.
Example #2 (Maximum Reduction in 2027): A taxpayer with a MAGI of $615,000 starts with the same allowable deduction of $40,804. But since the taxpayer’s MAGI is over $612,730 the SALT limit is reduced to $10,000 (the minimum).
Passthrough Entity Workarounds
In response to the federal cap on SALT deductions, several states have enacted legislation to create passthrough entity tax (PTET) mechanisms as a workaround. These mechanisms allow businesses structured as S corporations or partnerships to pay state taxes at the entity level rather than pushing these taxes onto individual shareholders or partners. By doing this, the entity takes the deduction for state taxes paid at the federal level, effectively bypassing the individual SALT cap. The individual owners then receive a corresponding state tax credit. This workaround has gained traction as a strategy to mitigate the impact of the SALT cap on high-income taxpayers involved in businesses and facing substantial state tax obligations. These state initiatives maintain compliance with IRS regulations while offering a viable tax planning opportunity to capitalize on entity-level deductions, a critical consideration in high-tax jurisdictions for taxpayers looking to maximize their tax efficiency amidst federal limitations.
Conclusion
The landscape of SALT deductions has evolved significantly, influenced by legislative changes and taxpayer strategies. The OBBBA has sought to provide some relief from the TCJA's stringent $10,000 cap, albeit temporarily and with limitations for higher-income taxpayers. However, the introduction and adoption of passthrough entity tax (PTET) workarounds illustrate a proactive response from states to help taxpayers mitigate federal constraints. These workarounds offer a strategic avenue for businesses to optimize their tax liabilities through entity-level deductions, highlighting a dynamic intersection of state ingenuity and taxpayer adaptability. While these measures provide temporary relief and opportunities, taxpayers must remain vigilant and proactive in managing their tax strategies, considering both current provisions and potential future changes to maintain tax efficiency.
Please contact this office if your SALT deduction is being reduced because of your MAGI to see if your state has a PTET workaround that will benefit you.
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Rose Tax & Financial
Cedar Crest, New Mexico 87008
Sat: 10:00am to 2:00pm
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