The state and local taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. (SALT) deduction represents a major transfer to high-income earners, but its interactions with the alternative minimum tax (AMT) and the Pease limitation are complex, and a source of considerable confusion in understanding the implications of the House Tax Cuts and Jobs Act on taxpayer liability. We’ve received many questions about who is paying the SALT deduction now, and how this would change if the provisions of the House Tax Cuts and Jobs Act were enacted, so it may help to walk through each component.
The alternative minimum tax is essentially a separate, simplified tax code running alongside the regular tax code, with a much larger exemption amount, but far fewer tax preferences. Taxpayers must calculate their liability under both the regular tax code and the AMT, paying whichever results in greater liability. The most significant ways the AMT diverges from the standard income tax code are as follows:
- The first $55,400 of income ($86,200 for joint filers) is exempted, though the exemption is reduced by one dollar for every four dollars above $123,100 ($164,100 for joint filers)
- There are only two rates: 26 percent for the first $191,500 of income above the exemption, and 28 percent on all income above that
- There is no standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. or personal exemption
- The state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. is disallowed
- The mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. is limited to first and second residences
- Certain other deductions are either capped or disallowed, including medical expenses (capped) and miscellaneous itemized deductions (disallowed)
The Pease limitation, meanwhile, reduces the value of a taxpayer’s itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. s by 3 percent for every dollar of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. above a certain threshold, currently $266,700 for single filers and $320,000 for joint filers. This reduction continues until the Pease limitation has phased out 80 percent of the value of itemized deductions.
This can be confusing, so let’s look at an example. A joint filing couple has an AGI of $500,000, which is $180,000 above the Pease threshold. Three percent of $180,000 is $5,400, meaning that their itemized deductions are reduced by $5,400. The couple’s top marginal rate is 39.6 percent, so their tax liability goes up by $2,138.40.
The Pease limitation, therefore, can have the effect of limiting the value of the state and local tax deduction. If a taxpayer is subject to the alternative minimum tax, on the other hand, she loses it outright. The two never go together. If the taxpayer’s liability under the regular code (which includes the Pease limitation) is less than AMT liability, then she remits that amount. If AMT liability exceeds regular liability, she loses the state and local deduction outright and the Pease limitation is irrelevant.
The House Tax Cuts and Jobs Act eliminates the state and local income and sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. deductions, retaining the property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. deduction subject to a $10,000 cap. At the same time, however, it repeals the AMT and Pease limitation. The interactions here have generated considerable confusion, as it can appear that certain taxpayers would “lose” the state and local tax deduction when, in fact, they cannot claim it under current law due to the AMT, or can only claim a portion of it due to the Pease limitation.
Here’s a simplified example of how AMT calculations and Pease deductions work, using three wealthy single filers. These are not necessarily representative of the types of taxpayers who typically face these limitations, but it may help explain how AMT and Pease work:
| Taxable Income | |||
|---|---|---|---|
| $200,000 | $250,000 | $300,000 | |
|
Pre-Pease Regular Liability |
$40,008 | $53,133 | $66,932 |
|
Pease Deduction Limitation |
n/a | n/a | $999 |
|
Regular Liability |
$40,008 | $53,133 | $67,261 |
|
AMT Liability |
$38,390 | $53,941 | $68,991 |
Our first filer, while wealthy, owes more under a regular income tax calculation than he does under the AMT schedule, where he gains the benefit of the majority of the high AMT deduction. He pays what he owes under the regular income tax calculation. Our second filer, though, has income sufficiently above the AMT exemption threshold as to owe more under the AMT calculation once the nonexempt income is exposed to the AMT’s higher rates and the loss of the state and local tax deduction. She pays the AMT, and gains nothing from the SALT deduction. And our final filer is above the Pease threshold, losing $999 in deductions, though this turns out to be unimportant because, even after taking Pease into account, he owes more under the AMT.
Only about 5 percent of all taxpayers are subject to the AMT, nearly all of them high earners. Few households with less than $200,000 in income are subject to the AMT, with those earning between $200,000 and $500,000 most likely to incur AMT liability. These taxpayers are already unable to claim the state and local tax deduction, a fact that is important to bear in mind when considering the implications of limiting the state and local tax deduction.
The House Tax Cuts and Jobs Act would repeal the state and local income and sales tax deductions, while capping the property tax deduction at $10,000. Many taxpayers who currently itemize (and take the SALT deduction) would benefit from taking the higher standard deduction instead, and even some of those who still elect to itemize may come out ahead due to the new rate schedule. Some analyses have assumed that those with uniquely high state tax burdens would be set back substantially by this provision of the Tax Cuts and Jobs Act. But many of these taxpayers are already unable to take the SALT deduction due to the AMT, or only claim a portion of it due to the Pease limitation. For taxpayers denied the SALT deduction currently, replacing the overall deduction with a capped property tax deduction, paired with the repeal of the AMT and the Pease limitation, actually represents a modest benefit, not a loss.
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