State Tax Credits: Navigating the New IRS Rules to Find Tax Savings

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As we wrote at the end of last year in “State Tax Credits Are Becoming Less Valuable,” in order to shut down a state workaround of federal law, the IRS decided to rule that state tax credits count as “receiving a benefit” when it comes to charitable gifts. Back then, they decided that the new IRS ruling would take effect on gifts made after August 27, 2018, even though the rules were not yet finalized.

This June, however, the IRS came out with their final ruling on how charitable gifts to receive state tax credits will be handled. Those rules are summarized as follows:

What are the new rules?

1. You must reduce your federal itemized charitable deduction by the amount of tax credits you receive in return.

Many charitable state tax credits offer a percentage of your gift back as state tax credits. For example in Virginia, both the Neighborhood Assistance Program (NAP) and the Education Improvement Scholarships offers a state tax credit for 65% of your total charitable contribution.

This means that NAP or education scholarship charitable gifts would only be 35% deductible on your Schedule A Itemized Deductions. The remaining 65% goes to your benefit of having received state tax credits.

The exception? If the tax credits received are 15% or less than the amount transferred, then you can deduct the full amount of your gift on your Schedule A Itemized Deductions.

They also clarify that receiving a dollar-for-dollar state tax deduction for your charitable gift does not reduce your federal deduction at all. So, your charitable giving can be deducted on both your state’s Schedule A itemized deductions and your federal Schedule A itemized deductions to the fullest extent that you are allowed to deduct it on both.

2. You may count your charitable state tax credits towards your federal State and Local Tax (SALT) deduction.

Although you are still limited by the SALT deduction cap, state or local tax paid by tax credit from charitable contributions excluded from your charitable deduction may be counted as state or local taxes for your federal itemized deductions.

The IRS Notice that makes this rule clarifies that any state tax credit carry forward that is used for your state tax burden in subsequent taxable years may also be counted as SALT for your federal itemized deductions in the same tax years.

How does this change the tax benefit of this giving strategy?

In 2013, we wrote the article “How to Make Money Paying Virginia Income Tax.” In it, we demonstrated how, if you were going to give to the charity anyway, you could make money by donating to a Virginia Neighborhood Assistance Program (NAP) for state tax credits.

Here is how that old math worked out:

Let’s assume Mr. Biz has shares of highly appreciated stock worth $100,000. … Instead of selling the stock and paying the capital gains tax, Mr. Biz gives the stock directly to charity. By transferring the stock to a NAP, he avoids paying any federal capital gains tax. He can take a deduction of $100,000 against his income, saving him $39,600 on his federal income taxes and $5,750 on his Virginia state taxes. But his tax savings don’t stop there. He receives a $65,000 tax credit from the NAP. In all, Mr. Biz receives a total of $110,350 in tax savings.

In this old example, the $110,350 of tax savings comes from $39,600 in less federal tax, $5,750 in less state tax, and $65,000 in state tax paid. If he has just given to charity without receiving the state tax credits, then he would have only had $45,350 in tax savings due to the less tax owed from the deductions. Thus, the advantage of acquiring state tax credits over merely doing a charitable gift for Mr. Biz used to be $65,000 ($110,350 – $45,350) or the value of the state tax credits.

Now, both the rules regarding state tax credits and the federal income brackets have changed. The top income bracket is now 37% and state tax credits reduce your charitable deduction. Here is how the math works out now under these new rules (changes in bold):

Let’s assume Mr. Biz donates his shares of highly appreciated stock worth $100,000 to a charity in exchange for NAP credits.

Mr. Biz receives a $65,000 tax credit from the NAP. He can take a deduction of his gift minus the tax credit received which is $35,000. This saves him 37% or $12,950 on his federal income taxes and 5.75% or $2,013 on his Virginia state taxes.

This is a total tax savings of $79,963. It comes from $12,950 in less federal tax, $2,013 in less state tax, and $65,000 in state tax paid.

If he has just given to charity without receiving the state tax credits, then he could have taken a charitable deduction for the full gift of $100,000. This would have saved him 37% or $37,000 on his federal income and 5.75% or $5,750 on his state taxes. This totals to $42,750 in tax savings.

Thus, the advantage of acquiring state tax credits over merely doing a charitable gift for Mr. Biz is $37,213 ($79,963 – $42,750).

As you can see from this example, giving charitable gifts to get state tax credits is still a valuable tax saving strategy. Even though the value of the strategy over normal charitable giving has been reduced by 42.75% or so, charitable giving for tax credits still can generate considerable savings.

The math to calculate the savings can be found in a simple formula:

Tax Credit Giving Savings = (Total Gift – Tax Credits Acquired) * (Federal Rate + State Rate) + Tax Credits Acquired

Standard Giving Savings =  Total Gift * (Federal Rate + State Rate)

Additional Tax Savings = Tax Credit Giving Savings – Standard Giving Savings

Using this formulas, here is the tax savings of 65%-tax-credit gifts over a standard charitable deduction for the various income brackets:

Federal Income Bracket State Income Bracket Savings from
Full Itemized Deduction
Savings from
65% Tax Credits
Additional Tax Savings of
Tax Credits Over Full Deduction
37% 5.75% 42.75% 79.96% 37.21%
35% 5.75% 40.75% 79.26% 38.51%
32% 5.75% 37.75% 78.21% 40.46%
24% 5.75% 29.75% 75.41% 45.66%
22% 5.75% 27.75% 74.71% 46.96%
12% 5.75% 17.75% 71.21% 53.46%
10% 5.75% 15.75% 70.51% 54.76%

From this you can see that the additional benefit of state tax credit charitable giving over regular charitable giving is actually regressive. Even though charitable giving in general is more beneficial to those in the higher brackets, there is more additional benefit for those who are in the lower federal income brackets to make the switch to acquiring state tax credits. This is because state tax credits reduce your final tax bill by 100% whereas a deduction only reduces your tax bill by your top marginal rate. Because the top marginal rate of the lower bracket is by the definition lower, this means that the additional savings from switching to state tax credits is higher.

Also, for those who are taking the standard deduction anyways, state tax credits are an obvious choice. Even though these gifts are not fully tax deductible on your federal return, because you take the standard deduction whether they are deducted on the federal return does not make a difference. At the state level though, your charitable giving can then supplement or pay for your state tax bill, saving you money. For those taking the standard deduction 100% of the gift is tax savings over not acquiring state tax credits.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine