A Shot Across California’s Bow
By Michael Repka, ESQ | CEO & General Counsel
(LL.M.—Taxation, NYU School of Law)
Since the earliest hints at the substance of President Trump’s new tax proposal, there has been one element that has remained consistent—the elimination of the deduction for state and local taxes. A cynical observer may note that this significant change to US tax policy would disproportionately hit states that have traditionally voted Democratic. In fact, of the top eight states in terms of maximum personal income tax levied, all but Iowa voted for Ms. Clinton in the most recent presidential election.
While it is clear that this proposal will be very tough on California, which has the highest personal state income tax rate by a significant margin, the extent of the impact is somewhat challenging to determine. The main reason is because state and local taxes are considered “Preference Items” under the Alternative Minimum Tax (AMT) regime. This means that AMT taxpayers have had some or all of their state tax deduction eliminated anyway. Therefore, the true impact of the elimination of the state tax will vary dramatically from person to person.
The AMT applies when the taxpayer’s deductions are considered too high relative to the taxpayer’s income. Many high-wage earners who derive most of their income from standard sources, such as a traditional salary, may not have enough deductions to trigger the AMT, which means they get to take advantage of all of their deductions. Therefore, this loss of one of the most significant deductions for many people in this situation could be devastating. On the other hand, taxpayers with a large number of deductions and very sophisticated tax returns may find that they already had the state and local tax deduction eliminated as a result of AMT, and therefore, the loss of the deduction would be insignificant. Additionally, these taxpayers would benefit tremendously from the elimination of the AMT.
Painting with a very broad brush, it appears that Silicon Valley’s working wealthy—that is, taxpayers making $400,000-$1,500,000 as a married couple filing jointly, with income from relatively traditional sources, such as W-2 wages—will likely see a significant tax increase, whereas the very wealthy, or those that derive their income from other sources, are likely to see a significant tax decrease.
Irrespective of the actual impact of the loss of the state tax deduction, it is likely that Silicon Valley real estate prices will be negatively impacted by the elimination of the state tax deduction. There are two reasons for this. First, companies will have an incentive to locate more of their high-paid executives outside of the state to the extent that is otherwise economically feasible. This will drive down demand, especially for higher-priced homes. Second, any elimination of deductions that are directly related to homeownership are likely to have a negative impact on buyers’ psyches, even if the actual impact is blunted by other factors. Under the new tax legislation, taxpayers would lose some of the benefits long associated with homeownership—specifically, the deductions for property taxes and interest on mortgages. To the extent that buyers receive a reduction in these types of deductions, they also will feel less compelled to own property. Naturally, states with higher property values and higher taxes, such as California, will be disproportionately hit.
It is imperative that all taxpayers seriously consider the actual impact under their personal circumstances before making any decisions related to real estate. For some taxpayers, the net effect of these changes will be positive, while for others, the effect will be negative. This is true irrespective of which income tax bracket you may fall into.
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