How to Avoid Salt Cap With Pass-Through Equity
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The SALT cap changed deductions for millions of taxpayers, along with the passing of the Tax Cuts and Jobs Act, increasing the standard deduction. As a result, the standard deduction increases each year, making it harder for individuals to take advantage of such deductions, such as the SALT deduction.
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What Is SALT Cap?
SALT stands for state and local tax deductions and applies to taxpayers who itemize deductions on their tax returns. Certain taxpayers can deduct the state and local taxes paid on their federal income taxes. However, the Tax Cuts and Jobs Act put a $10,000 cap on the deduction.
The cap applies to property taxes and state or sales taxes paid.
Salt Cap Pros and Cons
The SALT cap mainly affects people in high-tax states, such as California and New York. It doesn't affect most taxpayers in other parts of the country because their property taxes don't exceed the $10,000 cap.
The increase in the standard deduction offset the SALT deduction cap in most states, allowing most taxpayers to take the standard deduction and not worry about itemizing.
However, the SALT cap may negatively affect population numbers in states where property taxes are higher. With many more people working remotely today, most people can live just about anywhere but will likely steer clear of the higher-taxed states because there isn't a federal tax break.
Example of SALT Cap
Here's a quick example of how the SALT cap works.
You're filing your 2022 taxes and find that your itemized deductions exceed the standard deduction of $25,900 for married couples filing jointly. In addition, you have $9,000 in property taxes and $6,000 in state income taxes to deduct.
Since the total taxes exceed the $10,000 cap, you can only deduct $10,000 instead of the $15,000 you paid. If you're in the 24% tax bracket, that's $2,400 in savings.
Before the SALT cap, you would have saved $3,600 in taxes.
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Brief History of SALT Deduction
Before the Tax Cuts and Jobs Act, taxpayers could deduct all state and local taxes paid, including real estate taxes and personal property taxes. However, there wasn't a limit on the deduction, and the standard deduction was much lower, so more taxpayers itemized deductions versus taking the standard deduction because itemized deductions were worth more.
Changes to the SALT Tax Deduction
The changes to SALT deductions took effect in tax years 2018 through 2025, and most affect those who don't have enough deductions to avoid the standard deduction. If you have more deductions than the standard, which in 2023 is $27,700 for married filing jointly taxpayers and $13,850 for single-filers, you can itemize your deduction but can't deduct more than $10,000 in SALT.
Defining Pass-Through Equity
Taxpayers in high-tax states are at a disadvantage with the SALT cap, but states wanted to help their residents (and keep them in their state), so they came up with the pass-through entity tax.
The PTET applies to partnerships, LLCs, and S-corporations. The PTET allows businesses to be taxed based on business income. The amount is comparable to the income taxes individuals would pay.
Pass-Through Equity Pros and Cons
The pass-through equity workaround helps some taxpayers but not all. For example, while it's beneficial for the taxpayers who can have the business cover their personal taxes by giving the business more deductions, those who don't itemize their personal taxes won't benefit. So it's not a workaround feasible or beneficial for everyone.
How Are SALT Cap and Pass-Through Equity Related?
The SALT cap prompted many states to offer the pass-through equity workaround. The pass-through entity is meant to help business owners get as many deductions as possible, working around the $10,000 SALT cap limit.
How To Avoid SALT Cap with Pass-Through Equity
Certain business owners can avoid the SALT cap by having the business bear a higher burden. This means the money distributed to owners is lower, so they pay lower taxes and receive a personal income tax credit for the PTET. This credit is a reduction in the effective federal tax rate.
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SALT Cap Adjustment Options to Reduce Revenue Losses
Any SALT cap adjustments so far create revenue losses, but four suggestions have been brought to the table to avoid loss of revenues, including:
- Increase the SALT cap - Increasing the SALT cap to $15,000 for single filers and $30,000 for married filing jointly couples eliminates the 'marriage penalty' currently embedded in the SALT cap.
- Repeal SALT cap for households with income lower than $400,000 - This change makes the SALT cap only applicable to households with over $400,000 in income.
- Use the $10,000 cap OR deduct SALT over 8% of your income - This option allows taxpayers to limit their deduction to $10,000 or only deduct any SALT over 8% of their adjusted gross income.
How Progressive Offsets for SALT Sacrifices Future Opportunity
Any money used to offset the SALT cap would sacrifice national priorities. Most importantly, it would take money from the support for low and middle-income families. Because the TCJA primarily helped high-income households, working households felt it the most and would pay the highest price with progressive offsets.
The upper class would benefit from repealing the SALT cap the most, namely those making $1 million or more, who would get 50% of the benefit, and 70% would go to households making $500,000 or more.
The middle class would hurt the most, as a majority wouldn't see any tax reductions with the repeal of the SALT cap.
The Overall Impact of the SALT Deduction Cap
Overall the SALT cap increases taxpayers' state and local tax liabilities and reduces the amount the federal government must contribute. However, the states with the most changes are those with higher income earners and higher state taxes. As a result, most people believe it is a handout to the rich and hurts the middle class and poor.
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Will Salt Dedications Be Capped or Uncapped?
The SALT deduction is temporary and set to end in 2025. There have been proposals to eliminate and raise it, but none have been successful.
How Does SALT Deduction Work?
The SALT deduction allows taxpayers who itemize deductions to deduct up to $10,000 in state and local taxes. This includes property taxes, state income taxes, and sales taxes.
Which State and Local Taxes Can Have Deductions?
Taxpayers can deduct property taxes, sales tax, and state income tax, but only up to $10,000 if you itemize your deductions on your federal income tax returns.
How Much Can Be Deducted From State and Local Taxes?
Taxpayers can deduct up to $10,000 in state and local taxes paid on their federal tax returns.
Is There an Alternative or SALT Cap Workaround?
The only SALT cap workaround is the pass-through entities tactic. However, this applies only to business owners with pass-through income who can carry the tax burden in their business and pass down the lesser income to taxpayers who then pay fewer taxes.
The Bottom Line on How to Avoid SALT Cap with Pass-Through Equity
Understanding the SALT cap deduction and how to get around it is key for business owners. Unfortunately, at least through 2025, it will affect your tax returns, but there is a workaround if you're a business owner.