Wealthy Americans living in blue states are scrambling to find tax loopholes that will help them get around one of the most controversial (and for some, infuriating) provisions in President Trump’s tax plan: The capping of the so-called SALT deduction. Enter real-estate planner Jonathan Blattmachr, who this week made the mistake of explaining to a Bloomberg reporter about a plan he’s devised for his clients who are trying to get out of paying the additional taxes on their summer homes in the Hamptons or Cape Cod. According to the Bloomberg story, Blattmachr is planning on transferring the interest in his two New York residences – one in Garden City and one in Southampton – into LLCs, which he will then divide up into five separate trusts that will be based in Alaska. He can then use the trusts to take the maximum $10,000 deduction five separate times. In this way, he can deduct $50,000 in mortgage taxes from his federal tax bill instead of $10,000.
“This is an under-the-radar thing and it’s novel,” said Blattmachr. (Or at least it was under-the-radar until you went blabbing to the media). The trusts that Blattmachr and other savvy estate planners are using to take advantage of this loophole are called non-grantor trusts. While trusts are typically used by the wealthiest Americans to preserve their wealth as it’s handed down from generation to generation, the tax law is giving the merely wealthy an incentive to explore setting up these trusts to pay taxes at rates found in low-tax red states. The trusts can help property owners avoid paying an additional $100,000 in taxes across their properties.
However, the plan isn’t practical for everybody, and even those who can reap the benefits over the long term must take an up-front risk because they must pay the maintenance costs for the trusts – which can be as high as $20,000 – up front. If the IRS ever issues guidance invalidating the loophole, there’s no way to recover those costs.
Setting up dozens of non-grantor trusts for those with six-figure plus property taxes can be impractical and burdensome. Plus, those whose taxes are under six figures feel the new cap most acutely, according to Steffi Hafen, a tax and estate planning lawyer at Snell & Wilmer in Orange County, California. Those clients often have monthly mortgage payments that eat up a big chunk of their take-home pay, Hafen said.
More than 10 percent of taxpayers in New Jersey will see a tax hike under the new law – the highest percentage in the U.S. – followed by Maryland and the District of Columbia at 9.4 percent, 8.6 percent in California and 8.3 percent in New York, according to an analysis earlier this year by the Tax Policy Center. Those who’ll pay more are mostly being affected by the state and local tax deduction limit.
Mark Germain, founder of Beacon Wealth Management in Hackensack, New Jersey, said the strategy is “absolutely viable,” adding that he has about a dozen clients who want to create non-grantor trusts.
Building and administering the trusts could cost about $20,000, according to Brad Dillon, a senior wealth planner at Brown Brothers Harriman. But those expenses would be justified after a few years, said Scott Testa, a lawyer who leads the estates and trusts tax practice at Friedman LLP in East Hanover, New Jersey.
Already, it’s unclear just how much longer individuals will be able to take advantage of the loophole. As Bloomberg explains, an existing provision in the US tax code could easily be revived to prohibit Americans from using trusts to avoid paying SALT taxes. Though it would take effort on the IRS’s part.
Still, the Internal Revenue Service could issue guidance that would prevent taxpayers from using the trusts to get around the SALT cap. An existing provision says that multiple non-grantor trusts with identical beneficiaries and identical grantors – and whose primary purpose is to avoid taxes – can potentially be considered a single entity, with just one $10,000 SALT deduction. But the measure has never been bolstered by regulations, leaving it vague.
That IRS provision could potentially derail the whole strategy, Dillon said. But compared to the other workarounds that have been proposed by high-tax states, the non-grantor trust “is the only one that’s come out of the fray that seems like a viable structure,” Dillon said.
Furthermore, people with large mortgages might have difficulty convincing their lender to allow them to transfer ownership over to an LLC.
The strategy isn’t for everybody: People with large mortgages on their homes might not be able to win approval from the bank to transfer ownership to an LLC. Also taxpayers with a primary residence in Florida, which like Alaska doesn’t have an income tax, can’t take advantage of the scheme because of complex rules surrounding the state’s homestead exemption.
But for those who are curious, here’s an in-depth explanation of how the process works:
Here’s how it works: First, you set up an LLC in a no-tax state such as Alaska or Delaware. Then, you transfer fractions of that LLC into multiple non-grantor trusts, which are trusts that are treated as independent taxpayers (unlike grantor trusts, where the person who creates them are generally taxed on the trust income). Each trust can take a deduction up to $10,000 for state and local taxes.
If a spouse is designated as the beneficiary, another “adverse” party – meaning someone who may want the money also — has to approve any distributions.
Keep in mind that you no longer control or can benefit from anything placed in the trust. And you have to put investment assets in the trust that will generate enough income to balance out the $10,000 deduction. One option would be a vacation home that generates rental income, according to Steve Akers, chair of the estate planning committee at Bessemer Trust. Marketable securities could also work.
Some caveats: If the home placed in the non-grantor trust is sold, the trust recognizes the gains on the sale and has to pay taxes on it – and it won’t be able to take advantage of a special home sale exclusion that’s available under a separate tax rule. For those with New York residences, putting the home in the LLC or the trust could potentially trigger the state’s 1 percent mansion tax, which is levied on sales of homes of at least $1 million.
As we pointed out earlier this year (citing research from BAML), the Northeast and West coast – traditionally liberal bastions and, according to some, explicitly targeted by the Trump administration – generally have higher average amounts and will feel most of the pain. The chart below shows a heat map for average amount claimed under SALT deductions, with redder states farther above $10k and greener states below.
For those who are still getting up to speed on the new tax law, Goldman offered this guide earlier in the year to the most important provisions. Of course, estate planners aren’t the only ones searching for loopholes. Several blue-state governors have threatened “economic civil war” on Washington by devising loopholes for their residents that will allow them to take advantage of a “charitable” fund being set up by certain states that will essentially allow them to convert some of their taxes into charitable contributions that can still be deducted from their federal tax bill. However, the IRS has already warned states not to try and circumvent the SALT deduction caps. The retaliation has sent state lawmakers scrambling for an alternate solution. As next year’s tax deadline draws closer, expect the conflict between blue states and the federal government to intensify.