Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
Post Reply
boston10
Posts: 6
Joined: Sun Aug 21, 2016 9:44 am

Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by boston10 » Fri Dec 22, 2017 9:27 pm

Hi all,

I wanted to comment (and ask opinions) on the SALT deduction in the tax reform bill, and suggest a method of maximizing 2017 deductions if you believe your state/local taxes will exceed the SALT limit in 2018.

Starting in tax year 2018, we can only deduct up to $10,000 in combined property and income taxes. You may have heard that pre-paying your 2018 property taxes in 2017 to maximize your tax year 2017 deduction - this advice is widespread, so I'm not addressing it here. The focus of this post is on state and local income tax.

You may have heard that a provision in the bill prevents you from pre-paying 2018 taxes by making 2018 estimated tax payments in 2017 and deducting those payments on your 2017 return.

However, this limitation does not apply to state income taxes paid in 2017 for tax year 2017. Therefore, I believe we have two legal methods of maximizing the 2017 SALT deduction by maximizing state income tax paid in 2017 (and thus maximizing the 2017 deduction).

The first, and most obvious, would be to make a large Q4 2017 estimated tax payment to your state or local government by December 31st.

However, there are limitations to this - see page 151 of IRS Publication 17:
Estimated tax payments. You can deduct estimated tax payments you made during the year to a state or local government. However, you must have a reasonable basis for making the estimated tax payments. Any estimated state or local tax payments that aren’t made in good faith at the time of payment aren’t deductible.
So if you choose to do this, make sure it's reasonable and is done in good faith. Here's my plan, that I believe will lawfully minimize my income tax liability:

I am going to perform a basic calculation of my 2017 state income tax liability, document it (save the paper I use to make the estimate - this is important), do it contemporaneously (e.g., now, before making the payment), and make it relatively simple (roughly, take higher-end estimate of total income, subtract a conservative estimate of total 401k contributions and mortgage interest, then multiply by state income tax rate). Then I'm going to add a reasonable margin of safety, let's say 5%. Then I'll calculate the difference between that and the tax I've already paid, and make the 2017 ETP by December 31st.

By making a documented, good faith, but conservative/high-end payment of my estimated 2017 state income tax liability in 2017, I'm both maximizing my 2017 federal SALT deduction AND making sure I don't get hit with state underpayment penalties when I file. I believe it's a prudent approach.

The second method I'm about to suggest is one that I believe is beyond reproach and completely legal even if it results in you significantly overpaying your 2017 state income taxes.

If you have an additional paycheck coming in by December 31st, you can update your state's equivalent of the federal W-4 (in Massachusetts, this is Form M-4) with your employer to remove all exemptions. This could be huge if you have a big bonus check coming in.

Publication 17 addresses withheld state and local taxes thusly:
Withheld taxes. You can deduct state and local income taxes withheld from your salary in the year they are withheld. Your Form(s) W-2 will show these amounts. Forms W-2G, 1099-G, 1099-R, and 1099-MISC may also show state and local income taxes withheld.
As you can see, there is no "good faith" or "reasonable basis" provision for deducting withheld taxes. I believe eliminating all exemptions would be well within the realm of legality here, even if you were MFJ with four kids.

Massachusetts (and presumably other states with income tax withholding) allows you to specify on Form M-4 an "additional amount" to withhold from each paycheck. You could probably get into some trouble here if you had a $30,000 bonus coming and you filed an M4 with an additional $20,000 withholding.

Even without the "reasonableness/good-faith" provisions of Pub 17, you'd be sticking out like a sore thumb to the IRS, and they could probably make an argument for tax evasion of some kind under a more generic law. So I would not recommend going nuts with this. But I believe you could probably do a back-of-the envelope calculation that would estimate additional state tax liability, and have a reasonable basis to add $3000 in state withholding or something similar based on a $30,000 bonus. That could save you $1000+ in federal tax liability, depending on your bracket.


All of the above is based on my relatively educated understanding of how the tax system works. I have some experience with tax preparation but I am not a tax attorney. You should seek the advice of a professional before acting on something like this.

That said, any thoughts or advice on this strategy are welcome.

DrGoogle2017
Posts: 1322
Joined: Mon Aug 14, 2017 12:31 pm

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by DrGoogle2017 » Fri Dec 22, 2017 9:36 pm

I think your refund this year will be added back as income next year. So on average it’s not that advantage.

boston10
Posts: 6
Joined: Sun Aug 21, 2016 9:44 am

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by boston10 » Fri Dec 22, 2017 9:45 pm

DrGoogle2017 wrote:
Fri Dec 22, 2017 9:36 pm
I think your refund this year will be added back as income next year. So on average it’s not that advantage.
Normally? Yes.

But since they are putting a $10,000 cap on the SALT deduction starting in 2018, this may not be the case.

If you pay $15,000 in state and local taxes in 2018, and you receive a $5,000 state refund in April 2018 for your 2017 overpayment, on net you would have paid $10,000 in state and local taxes in 2017. So you would still be maxing out the deduction.

These calculations have always been done this way, on a cash basis. It's possible the IRS may attempt to interpret this differently, but in the absence of a statutory provision, I doubt their position would hold up in court.

NewtonsApple
Posts: 76
Joined: Thu Feb 24, 2011 10:07 am

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by NewtonsApple » Fri Dec 22, 2017 10:40 pm

So having a large refund effe
boston10 wrote:
Fri Dec 22, 2017 9:45 pm
If you pay $15,000 in state and local taxes in 2018, and you receive a $5,000 state refund in April 2018 for your 2017 overpayment, on net you would have paid $10,000 in state and local taxes in 2017. So you would still be maxing out the deduction.

These calculations have always been done this way, on a cash basis. It's possible the IRS may attempt to interpret this differently, but in the absence of a statutory provision, I doubt their position would hold up in court.
I'm not sure what is going on with your math, but this is what I get (assume $200k taxable prior to state tax deduction, $15 state taxes)
Extra 2017 withholding:
2017: Paid: $20,000 Deducted: $20,000 State Taxes: $15,000 Taxable Income: $180,0000
2018: Paid: $15,000 Deducted: $10,000 State taxes: $15,000 Taxable Income: $190,000+$5000 on 1099-g
Combined years taxable income: $375000

Normal 2017 withholding:
2017: Paid: $15,000 Deducted: $15,000 State Taxes: $15,000 Taxable Income: $185,0000
2018: Paid: $15,000 Deducted: $10,000 State taxes: $15,000 Taxable Income: $190,000+$0 on 1099-g
Combined years taxable income: $375000

Only difference is you shifted income from one year to the next, which MAY lead to lower taxes on that amount IF it ends up in a lower tax bracket. So say the $5000 extra in 2017 shifts to 2018 going from the 28% to %24 bracket, you saved $200.

I am actually doing some of what you are saying and changing my M-4 for my last paycheck, but that is to shift me from paying about 81% of my MA state tax due to 105%. If you are swinging the last paycheck to hit %200 of what you owe and that is a $10K+ over payment, you might need a pretty damn good excuse to explain that for a 4% gain.

I play all sorts of sign up bonus games, but those have almost zero downside. Similar games with the IRS better have bigger payouts than this approach because it seems like you would be lucky to clear enough to cover the first hour of talking to a lawyer about what you did.
Last edited by NewtonsApple on Fri Dec 22, 2017 11:14 pm, edited 1 time in total.

User avatar
whodidntante
Posts: 4036
Joined: Thu Jan 21, 2016 11:11 pm

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by whodidntante » Fri Dec 22, 2017 10:51 pm

I charged an estimated payment to my state on my rewards credit card. It was not a massive overpayment, but a slight one.

boston10
Posts: 6
Joined: Sun Aug 21, 2016 9:44 am

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by boston10 » Fri Dec 22, 2017 11:23 pm

NewtonsApple wrote:
Fri Dec 22, 2017 10:40 pm
So having a large refund effe
boston10 wrote:
Fri Dec 22, 2017 9:45 pm
If you pay $15,000 in state and local taxes in 2018, and you receive a $5,000 state refund in April 2018 for your 2017 overpayment, on net you would have paid $10,000 in state and local taxes in 2017. So you would still be maxing out the deduction.

These calculations have always been done this way, on a cash basis. It's possible the IRS may attempt to interpret this differently, but in the absence of a statutory provision, I doubt their position would hold up in court.
I'm not sure what is going on with your math, but this is what I get (assume $200k taxable prior to state tax deduction, $15 state taxes)
Extra 2017 withholding:
2017: Paid: $20,000 Deducted: $20,000 State Taxes: $15,000 Taxable Income: $180,0000
2018: Paid: $15,000 Deducted: $10,000 State taxes: $15,000 Taxable Income: $190,000+$5000 on 1099-g
Combined years taxable income: $375000

Normal 2017 withholding:
2017: Paid: $15,000 Deducted: $15,000 State Taxes: $15,000 Taxable Income: $185,0000
2018: Paid: $15,000 Deducted: $10,000 State taxes: $15,000 Taxable Income: $190,000+$0 on 1099-g
Combined years taxable income: $375000

Only difference is you shifted income from one year to the next, which MAY lead to lower taxes on that amount IF it ends up in a lower tax bracket. So say the $5000 extra in 2017 shifts to 2018 going from the 28% to %24 bracket, you saved $200.

I am actually doing some of what you are saying and changing my M-4 for my last paycheck, but that is to shift me from paying about 81% of my MA state tax due to 105%. If you are swinging the last paycheck to hit %200 of what you owe and that is a $10K+ over payment, you might need a pretty damn good excuse to explain that for a 4% gain.

I play all sorts of sign up bonus games, but those have almost zero downside. Similar games with the IRS better have bigger payouts than this approach because it seems like you would be lucky to clear enough to first hour of talking to a lawyer about what you did.
It looks like I might have been mixed up; this will be my first year itemizing so I was making assumptions.

I thought the amount of the state tax refund would end up on Schedule A as an offset to taxes paid. I was imagining line 5a to be a net amount - taxes paid minus refunds received in the tax year. Then, come TY 2018, the line stays basically the same but with a cap of 10k.

I see now that the refund actually literally goes into a line in the 1040 Income section, rather than just modifying the deduction. So your numbers are right. You learn something new every day ;)

Frisco Kid
Posts: 364
Joined: Sun Nov 16, 2014 6:18 pm
Location: San Francisco Peninsula

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by Frisco Kid » Sat Dec 23, 2017 7:40 am

Be careful with over payments as your refund is taxable for the following year making sure that amount doesn't bump you up a bracket.......

If I understand correctly for 2018 the challenge will be to hit your state tax withholding as close as possible to maximize remaining SALT deduction space. Assuming a person will exceed the $10K limit, every dollar you over withhold will cost you a dollar of deductible space?

Copernicus
Posts: 322
Joined: Thu May 16, 2013 4:38 pm

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by Copernicus » Sat Mar 03, 2018 2:03 pm

California resident
I expected to earn good income from self-employment during 2017, as I did in the previous three years, 2014 to 2016. Accordingly, I had calculated 2017 estimated tax payments for both Fed and State. I never picked up great income from self-employment. However, I continued to make the estimated payments throughout the years my work could have suddenly ramped up.
Alas, that never happened. Moreover, we made significant donations to our Donor Advised Fund in 2017.

Now, I am calculating huge 2017 tax refunds in the range of 30 k on Fed and 10 k on state!

- Does that mean my 2018 taxable income will include the fed and state refunds as taxable Fed income, or only the state refund will go into the fed taxable income?
- Does that expose me to risk of audit? -- although I do have a significant drop in the total income trend from the previous 3 years to 2017. I made those payments once every quarter, so not a sly move in response to tax law changes in December.
- What to manage in 2018 estimated payments, and otherwise 2018 tax planning?
- Should I see if I can apply 2017 overpayment to 2018 tax dues -I suppose that excess stays with the state tax board, and ---- if I am not receiving that amount as refund, will that reduce my taxable Fed and State amounts in 2018?

Thanks.

User avatar
House Blend
Posts: 4492
Joined: Fri May 04, 2007 1:02 pm

Re: Overpaying 2017 State Income Taxes to maximize 2017 federal SALT deduction

Post by House Blend » Sun Mar 04, 2018 7:51 am

Copernicus wrote:
Sat Mar 03, 2018 2:03 pm
Now, I am calculating huge 2017 tax refunds in the range of 30 k on Fed and 10 k on state!
Fed refunds are not taxable.

Since you mentioned a Donor Advised Fund, I assume you itemized deductions for 2017.

Assuming you claimed a deduction for state income taxes on your 2017 Schedule A, then yes, your CA tax refund will be reported as taxable income on your 2018 Form 1040.

(However, if your total itemized deductions were only, say, $9K more than the standard deduction, then you would only have to report $9K as income, rather than the full $10K.)

I would not worry about an audit. Stuff happens.

Certainly you can automatically apply any of your CA or Fed refunds to your 2018 CA or Fed taxes, respectively. (If you haven't filed your 2017 returns yet.) However, this won't change how much of your 2017 CA refund is Federally taxed in 2018.

Post Reply