Several states have approved or are considering plans to let residents get around the cap on tax deductions. Treasury Secretary Steven Mnuchin on Thursday proposed a new rule to prevent it. (Evan Vucci/AP)

The Treasury Department moved Thursday to prevent states from allowing taxpayers to circumvent the GOP tax law's new cap on state and local tax deductions.

The law passed last fall limited the deduction taxpayers can take on their state and local taxes. Under the new law, taxpayers can take a deduction only on up to $10,000 in payments. Under the previous tax code, there was no cap on state and local tax deductions. The cap will increase tax bills in areas with high taxes, including Democratic-led states such as New York, California and Connecticut.

Several states have approved or are considering plans to let residents get around that cap, including by reclassifying the money they send to the government as charitable contributions instead of tax payments.

But the new rule proposed Thursday by Treasury Secretary Steven Mnuchin would undermine those state laws. The rule needs further federal review before being finalized.

“Congress limited the deduction for state and local taxes that predominantly benefited high-income earners to help pay for major tax cuts for American families,” Mnuchin said in a statement. “The proposed rule will uphold that limitation by preventing attempts to convert tax payments into charitable contributions.”

New York and New Jersey have enacted measures designed to let state residents get around the new limit. For instance, New York created a new “charitable” state fund that gives taxpayers an 85 percent tax credit in exchange for every dollar they pay into it. The intent was to make such donations deductible from one’s federal taxes, as opposed to state tax payments subject to the new cap.

But under the proposed rule from Treasury, taxpayers would only be allowed to claim federal deductions on the portion of their “charitable” donations that are not reimbursed with state tax credits.

The measure aims to curb proposed state workarounds but may also affect some of the long-standing tax credit programs that allow taxpayers to claim federal deductions on payments for schools and other public programs. The regulations would treat all types of charitable donations made in return for state tax credits the same, regardless of whether the recipient of the donation is a public entity or a private one.

“It’s a pretty sensible overhaul and improves the code to make sure only genuine charity is eligible for a charitable deduction,” said Carl Davis, a tax analyst at the Institute on Taxation and Economic Policy, a left-leaning think tank.

Steve Rosenthal, an analyst at the Tax Policy Center, opposed the cap on state and local tax deductions when passed by the GOP but said the Treasury Department rule appears to honor the intent of congressional lawmakers.

“Given that Congress decided to deny state and local tax deductions, the workaround would have defeated Congress’s intent,” Rosenthal said.

Democratic lawmakers have said their states need these workarounds to survive economically, arguing they are needed to protect middle-class residents from massive and sudden tax hikes. They have noted that, in 2017, millions of their state residents took the state and local tax deduction. (Some of these states are also suing the federal government over the law, arguing they were unconstitutionally targeted for living in states that tend to vote Democratic.)

On Thursday, New Jersey Gov. Phil Murphy (D) vowed to oppose Mnuchin’s proposed rule, arguing that the workaround will protect New Jersey taxpayers.

“We are prepared to fight back tooth and nail against any attempts by the IRS or the Trump administration to block localities from setting up charitable funds to help New Jersey taxpayers preserve their deductibility,” Murphy said in a statement. “We are closely examining all legal avenues against the federal government to protect New Jersey taxpayers from being unfairly targeted by the President.”

The tax provision (known as the “SALT deduction”) is more often used by wealthier people, who, by virtue of owning more and more expensive property and having higher incomes, tend to pay the most in state taxes. New York’s proposed workaround of the tax cap would give an additional $107,000 on average to the richest 1 percent of state residents, as opposed to an average $10 benefit for middle-income residents, according to ITEP.