The most comprehensive tax law change in decades, commonly known as the Tax Cuts and Jobs Act, was signed into law on December 22, 2017. Although the corporate tax cut provisions were a highly publicized aspect of the bill, the numerous and dramatic changes to individual income tax rules will change the landscape for most taxpayers, beginning with the 2018 tax year. For some, the estate tax changes will have a material impact as well. However, as widespread as these changes are, almost all are set to last only seven years, through 2025, unless Congress acts to extend or revamp the laws before then.
Key individual income tax changes fall into a few major categories, some that appear to be beneficial and some that rescind beloved exemptions and deductions. Because of the give-and-take nature of the sweeping changes, it’s hard to tell how they may affect your taxes without actually running the numbers. As a general rule though, it appears many taxpayers may be pleasantly surprised with their new tax situation, despite the loss of some major tax deductions.
Here are highlights of the changes for individual income taxes:
- Tax rates: The seven tax rate brackets were tweaked a few percentage points downward, while taxable income allowed within each of the decreased brackets became more generous. However, the computation of taxable income for the new brackets varies significantly from previous law, precluding a direct comparison of old to new at this level.
- Personal exemptions: Generally, taxpayers were allowed a deduction from income of $4,050 in 2017 for each taxpayer and each of their dependents. These exemptions are suspended under the new law.
- Itemized deductions: Most itemized deductions are either eliminated or curtailed under the new tax regime. Some common deductions and their fate under the new law are:
- Charitable contributions – increased deduction of up to 60% of adjusted gross income (AGI). However, this will not matter if the new standard deduction is higher than combined itemized deductions.
- Medical expenses – generally easier to qualify for deduction as the 10% of AGI floor threshold is decreased to 7.5%. But again, this will not matter if the new standard deduction is higher than combined itemized deductions.
- Miscellaneous itemized deductions – previously subject to floor of 2% of AGI (including tax preparation fees and investment advisor fees) – deduction eliminated.
- Mortgage interest on principal residence – limited to interest on $750,000 of acquisition loans for purchases after December 15, 2017.
- Mortgage interest on home equity loans – deduction eliminated after 2017 for new and pre-existing credit lines. However, interest paid on funds used for business purposes remains deductible.
- State and local taxes, including income and real property taxes – limited to a combined $10,000 deduction each year. (Note that taxpayers subject to alternative minimum tax under the old rules did not benefit from these deductions anyway.) Key exception: Real property taxes and sales taxes paid in carrying on a trade or business remain fully deductible.
- Standard deduction: Many taxpayers who itemized their deductions under the old rules will find that the new standard deduction will provide a larger tax benefit than itemizing their allowable deductions remaining under the new laws. For example, the 2017 standard deduction of $12,700 for married taxpayers filing a joint return almost doubles in 2018 to $24,000. If this amount is more than their new itemized deduction total, the $24,000 standard deduction would provide the greater benefit.
Whether the standard or itemized deductions will be more beneficial will depend on each taxpayer’s particular mix of limited or eliminated itemized deductions discussed above, and whether they were previously in alternative minimum tax (AMT), or continue to be in AMT, or not.
- Alternative minimum tax (AMT): Alas, AMT for individuals was not repealed, as both the House and Senate committees had proposed, but was retained at the last minute, with slightly adjusted terms. As a refresher, AMT is an alternative tax computation all taxpayers must make, in addition to the standard tax computation, which includes, disallows, or adjusts different items of income and deductions for the AMT calculation. Taxpayers pay the higher of the two taxes, i.e. either under the standard or the alternative computation.
The new law slightly increases the amount of income exempted from alternative minimum tax, e.g. to $109,400 for married taxpayers from $86,200. It also increases significantly the phase-out threshold for retaining this exemption, e.g. from $164,100 for married taxpayers to $1 million – in other words, more taxpayers will be able to utilize the AMT income exemption.
Because many of the now eliminated itemized deductions were not deductible for AMT purposes under the old laws anyway, many taxpayers may not see a change in AMT taxable income, but may now be able to fully utilize the AMT income exemption. At the same time, taxpayers who itemized under the old laws may see their regular taxable income increase with the disallowance of itemized deductions under the new law, but that higher income base may now be subject to lower tax rates.
Whether these AMT changes, combined with the changes to itemized deductions and tax rates, will ultimately result in overall higher or lower tax liabilities for specific taxpayers depends on their particular mix and levels of income and deductions. Again, the best estimate of the impact of the new laws for a specific taxpayer would be gained by running the numbers.
The final version of the new law created a 20% deduction of income from qualified business entities for individual taxpayers. In other words, an individual taxpayer could potentially reduce by 20% (and therefore receive tax-free) taxable income received from:
- sole proprietorships reported on Schedule C
- rental activities reported on Schedule E
- S corporation K-1s
- partnership K-1s
This treatment does not include any capital gain income from these activities, and may not apply to specified service trades or businesses, depending on the taxable income of the individual taxpayer.
Full details of this new tax break is beyond the scope of this article, but has the potential for significant tax savings for many taxpayers.
Estate and Gift Taxes
The new law increases the federal estate and gift tax unified credit exclusion amount to $10 million per taxpayer. Adjusted for inflation, this amount is presumed to be $11.2 million per taxpayer in 2018. The increased exemptions are effective for decedents dying and gifts made after 2017 and before 2026, when the new law is set to expire. This provides a window of opportunity to reduce potentially taxable estates through additional gifting through 2025, and for more estates of decedents who die during this window to avoid estate tax.
Virtually all taxpayers will be impacted by the Tax Cuts and Jobs Act in some way, and each should consider how their own tax situation will change, including potential planning opportunities. As always, we are here to help as needed. Please don’t hesitate to contact your Abbott, Stringham & Lynch tax advisor with any questions you have.
For a more in depth discussion listen to our latest podcast as Chris Madrid and Julie Malekhedayat from our Family Wealth and Individual Tax Planning Group go into further detail and conversation regarding individual taxes under the new tax reform act.