Impacts of the Tax Cuts and Jobs Act of 2017 (AKA the GOP Tax Plan) on the Individual Tax Payer
The most popular question I have been getting lately from client's, friends and acquaintances at Holiday parties is, "What do I think of the new tax law." The first thing that comes to mind is how powerful a force popular media remains in entering items into the collective consciousness of its consumers.
In terms of the tax law, I'll admit that I was skeptical of it resulting in major changes for individuals upon first reading of the bills passed by the House and Senate. After digesting the details of the consolidated bill, I am more optimistic on the immediate impacts. In general, the final legislation followed the Senate’s version of the bill. Some of the House proposals were included. There were also a couple of positive surprises.
Make no mistake, the goal of this bill was to reduce the taxes that US businesses pay to make doing business here more competitive with the rest of the world. Reforms for individuals were made to bring about support from the public to make these changes. As such it is no great surprise that for individuals, this tax reform is less reformed than was promised. There will likely be no tax returns filed on an actual postcard…but maybe someone out there is willing to slap their social security number on a postcard. In fact, these changes may end up creating more opportunities for tax planning than the old rules once all the impacts are understood and tax software is updated so that new scenarios can be modeled.
Some of these changes were permeant, while many were not. With corporations being the primary beneficiaries, all Corporate tax law changes are permanent. The individuals as secondary beneficiaries will have most of their changes lapse after the 2025 tax year. The exceptions to this lapse are the new way individual tax brackets will be increased for inflation each year (the brackets will increase more slowly resulting in an incremental tax increase from the old system when compared year over year) and the repeal of the individual mandate for health insurance in 2019. These two items will be permanent.
Perhaps the most significant implication in this legislation that no one seems to be talking about is its potential to change the way Americans work. As the structures of the industrial revolution such as defined benefit pensions and the need for large capital-intensive work centers in many industries have broken down while technology simultaneously makes geographic location almost irrelevant for knowledge workers, many have predicted a shift from a New York "working for the man 9 to 5” based culture to a more Los Angeles "working for ourselves project based workforce." The 20% deduction for pass through entities will provide incentive for employees to look at moving toward performing their same duties, but as independent contractors and paying 20% lower income tax rates (if within the guidelines). This would be a welcome change that I believe would lead to significant improvements in quality of life for those who choose to recognize and embrace this change. More on that in future articles for now let's look at the specific changes in tax policy.
There are many articles out there at this point, but I have specifically oriented this to a person familiar with reviewing a personal income tax return so the impacts will flow in that order.
Treatment of Alimony Payments
Alimony payments resulting from alimony agreements entered into after 12/31/2018 (note the end of 2018) will no longer be deductible by the payor or income to the payee. When you think of the typical purpose of an alimony payment being to redistribute income from the higher earning party to the lower, this will likely result in a higher combined tax bill for the divorced couple as the payer is no longer allowed to write off alimony payments while the receiver claimed them as income in a typically lower tax bracket.
Basically any preferential treatment for moving expenses (be it income exclusion or expense deduction) will be eliminated with the exception of active duty military. Clearly the writers of the new tax law found no supporters of giving tax breaks to those who choose to move for the benefit of employment or employers willing to help them do so.
Capital Gains and Losses on Investments
The controversial rule that would have eliminated the flexibility for an individual to choose which shares of an investment to sell, and required all investors to sell their oldest (and likely most appreciated) shares first, did not make it into the final legislation.
This is good because we continue to have the ability to pick and choose specific share lots within an investment holding in order to control the size and timing of a gain or loss on the sale of an investment.
Sale of a Primary Residence
Despite agreement by both the House and the Senate to make excluding the gain on one's primary residence upon sale more difficult, none of the changes made it into the final bill, so the rules for capital gain exclusion when selling a primary residence remain the same.
This is a positive if you buy a house, it goes up in value and you must sell it for whatever reason prior to having lived in it for 5 years.
Deductions and Exemptions
Increasing the Standard Deduction
Under the current tax system, we have both a standard deduction for households that don't have sufficient expenses to itemize and an additional amount of income ($4,050 in 2017) for each person in the household that gets exempted from taxation. The latter is called the personal exemption.
With the goal of simplification, under both plans and going back as far as when tax reform started being discussed, the standard deduction and personal exemption will now be combined under a single increased standard deduction. Many are seeing the increased standard deduction as a huge bonus not understanding that it includes both the old deduction and the household’s personal exemptions. This is the centerpiece of this new bill in terms of the individual tax return and will result in the most significant impact for the average household.
The new Standard Deduction will be $12,000 for individuals and $24,000 for married couples. The “additional standard deduction” of $1,250 for a blind individual, or one over age 65 will be added to that amount.
As a result of this change it is expected as many as 90% of households will take the standard deduction and therefore will lose the tax benefit of things like charitable deductions.
Many of the itemized deductions expected to be eliminated somehow remain, but caps on individual deductions were implemented. However, with the increase in standard deduction, many fewer families are expected to reach the threshold where it makes sense for them to itemize so the reductions and caps will be irrelevant.
For those still itemizing, here are the specifics:
The two bills differed widely on the deductibility of medical expenses. The expectation was that medical expenses would no longer be deductible. In a stunning turn of events, not only do medical expenses remain deductible, but the deduction will actually be easier to take in 2017 and 2018 with the 10%-of-AGI threshold reduced to just the 7.5% of AGI previously enjoyed by the 65 and over crowd (or everyone prior to Obamacare).
Not only will it be easier to deduct medical expenses, but you read the above correctly in that this is one of the few changes that will be retroactive to the 2017 tax year. This was a nice surprise and will benefit a few of my clients this year.
State and Local Taxes
While the original proposals sought to eliminate the deduction of state and local income taxes on the federal income tax return, the final version of the bill will allow households the option to deduct the combination of their state and local income or sales and property taxes, but only up to a combined cap of $10,000 single or married filing jointly (there is no differentiation for filing status which makes this threshold punitive for married couples).
The bill was slick to incorporate a prohibition of prepaying 2018 income tax (NOT property tax) liabilities in the 2017 tax year to accelerate deductions into this year where they could still be taken advantage of. There is no such prohibition for paying 2017 tax liabilities early, such as Q4 estimated tax payments, so go ahead and get those in prior to 12/31/17 for a deduction on this year's taxes if you aren't subject to AMT.
Mortgage Interest Deduction
Ahh the mortgage interest deduction….. changes the real estate lobby decried as the end of private real estate ownership as we know it….. split the difference between the House and Senate bills and will not likely have impact on most people. The new cap on mortgage interest deductibility will be interest on the first $750,000 of acquisition (amounts borrowed to acquire, build, or substantially improve a primary residence).
This change is one that adds complexity in that it only applies to new mortgages taken out after December 15th of 2017. Existing mortgages retain interest deductibility up to the current $1,000,000 threshold so preparers with clients who itemize will have to be conscious of when that big mortgage was originated.
One part of this change that may have an impact on people is the elimination of the deduction of interest on home equity indebtedness not specifically related to the purchase or improvement of the real estate that secures it after 2017. Simply put, the interest on borrowed cash secured by real estate to payoff credit card debt etc. is no longer deductible.
Notably the original bills wanted to limit mortgage interest deductibility to just the primary residence, but that didn't make it either, so interest paid on a second home/vacation property will still be deductible if you are able to itemize.
Charitable Contributions Limits
Charitable contribution limits for cash (only) donations to public charities have been increased from 50% of AGI to 60% of AGI.
Contemporaneous written acknowledgement of such gifts over $250 is still required.
Sadly, there was no increase in rate for charitable mileage driven.
As expected from the original bills, going forward casualty losses will only be deductible in areas declared as disaster areas by the Federal Government (Katrina etc).
Misc 2% Itemized
The Senate bill won out as it relates to all Misc. itemized deductions subject to 2% as they will no longer be deductible.
This is bad news for employees with significant unreimbursed costs related to their employment and tax preparers and investment advisors who had clients that would still have been able to itemize under new rules.
Pease Limitation on Itemized Deductions
The Pease limitation, which reduced the amount of itemized deductions for taxpayers with high income, is no more.
This will effectively result in an additional cut to the marginal tax rate of high income earners still able to itemize deductions.
Qualified Business Income Deduction
As discussed, the provision in this bill that may have the most significant impact on the employment landscape in the coming years is the 20% QBI deduction for pass through entities.
There are some twists and turns here that limit the use of this deduction, but for the population that I work with, the most significant impact is that owners of partnerships, LLCs and S-Corporations with AGIs less than $157,500 for individuals and $315,000 for married couples (including both business and non-business income), will get a 20% reduction in income tax rate on their pass-through business income.
Effectively this means you will pay a 20% lower federal income tax rate as an independent contractor than a peer performing the exact same job as a W2 employee in a firm. Talk about an incentive to become a freelancer!
Calculating Tax Liability
Ordinary Income Brackets
Contrary to the simplification theme, 7 tax brackets remain. The 10 and 35% brackets remain the same. The other brackets are slightly increased in terms of income included in the bracket with the tax rate of each bracket being decreased by a few percentage points.
These changes are expected to result in a small reduction in marginal tax rate for most taxpayers, but nothing really to write home about.
Below is a terrific graphic put together by Michael Kitces and shared on his excellent blog on this subject https://www.kitces.com/blog/final-gop-tax-plan-summary-tcja-2017-individual-tax-brackets-pass-through-strategies/ that illustrates the changes.
Capital Gains Tax
Capital gains will continue with the same 0%, 15% and 20% preferential tax rates driven by the ordinary income tax bracket of the taxpayer.
However in a confusing twist, the tax brackets will be driven based on where the taxpayer would have fallen in the old, pre-reform, tax brackets. Yes…complication rather than simplification. Hopefully this will be rectified in a separate action.
Alternative Minimum Tax
One of the great promises of the new administration and features of the initial legislation was to do away with the dreaded Alternative Minimum Tax; the secondary tax system that runs in the background preventing high earners from taking a disproportionate level of deductions to their income.
Sadly, this was not accomplished in the final bill. However, the good news is that with the significant changes to itemized deductions and the widening of AMT exemption thresholds, this high-earner tax will catch far fewer in its trap than it does under the current rules.
While one of the new administrations original promises was to do away with the Obamacare instituted surtaxes, the additional .9% of payroll tax and 3.8% tax on net investment income will continue to apply with their current thresholds of $200,000 of AGI for individuals and $250,000 for married couples.
To add insult to injury, these thresholds will not be indexed for inflation. Unless repealed in future legislation the number of households impacted by this tax will increase as time goes on.
Individual Mandate (or Obamacare Penalty)
One of the great surprises of the final legislation was the repeal of the individual mandate to purchase health insurance that was signed into law with the Affordable Care Act. Unfortunately, the repeal of the mandate is one change that will not take place until 2019, so there will still be a penalty if you don't have health insurance in 2018.
While the popular media has relayed the impact of this change as skyrocketing premiums, several folks I know who work in the health insurance industry believe this will likely open the door for the return of more competitively priced individually underwritten plans to the market which will be a positive thing for generally healthy people. A better alternative than currently exists through the exchanges will need to be implemented for those with preexisting conditions between now and 2019.
Child Tax Credit
The expansion of the Child Tax Credit is designed to offset the loss of personal exemptions to larger households with children up to the age of 16. Under the new rules, the Child Tax Credit is expanded to $2,000 per child ($1,400 of which is refundable for households with negative tax liabilities).
More good news; the income phase-outs have also been dramatically increased to $200,000 for individuals and $400,000 for married couples, so more households will now be able to take advantage of the credits.
The new rules also include a new $500 (nonrefundable) credit for dependents other than qualifying children for college students and aging parents being cared for in the home.
The adoption credit was set to be eliminated (which was a ridiculous idea - yes let's take away the tax benefits of someone trying to adopt a child), but ultimately someone came to their senses and the adoption credit remains available.
Elderly and Dependent Care Credit
The elderly and dependent care credit remains unchanged.
PS: While not a credit, there was some conversation in the early stages that the new tax rules would do away with the Dependent Care FSA which allows families to pay $5,000 of childcare expenses with pre-tax income for two income households. Fortunately, that proposed change drew so much outrage, it didn't even make it into the initial bills that were passed so DFSAs are alive and well.
Kiddie Tax rates, taxes on unearned income for children under 18 or those in college up to age 23, have been made significantly more punitive by subjecting the child’s unearned income to the trust tax brackets – which have a top tax bracket of 37% on any income over $12,500 where as previously they would have just paid their parent's rate.
If your children have significant investments, this is something that demands attention as their tax liability will be negatively impacted.
While the goal was the complete repeal of the estate tax, that didn't happen. But the difference will be immaterial for most of the population as the estate tax exemption amount was increased to $11.2M for individuals, and $22.4M for couples. This means unless your estate is larger than the above thresholds, you will pay no taxes to pass your estate along to your beneficiaries when you die.
With the increase in estate tax exemption many believed there would need to be offsetting changes in the way inherited property was valued that would make accounting for future taxes on these items when sold by the inheritor incredibly complicated. The good news with the compromise is that there were no changes in basis rules, so inheritors will still receive items eligible for the step up (nonretirement assets etc) at their value on the date of the decedent's death. This will keep accounting for their sale straightforward so long as the assets are handled appropriately when leaving the estate of the decedent (appropriate valuation appraisal records etc).
The original plans had many of the tax benefits for education being consolidated into the American Opportunity Tax Credit. Ultimately the bill fell short on its goal of simplification in this regard.
They were able to make student loans discharged due to death or disability no longer taxable income which will be of benefit to those in such situations.
The most significant change in this area is that 529 plan distributions can now be used tax-free for public, private or religious elementary and secondary school expenses (specifically $10,000 per student per year) where as they were previously only allowed for use during the college years or for technical training after high school.
Likewise, while the original bills sought to repeal the exclusion of EE savings bond interest income if used for qualified education expenses (which made no sense), it appears the final bill actually expands the ability to exclude this income if used for qualified primary or secondary school expenses.
Student loan interest remains deductible up to the previous $2,500 annual limit. That was a big concern for many and will still be significant regardless of an individual's ability to itemize.
Just as in Newton's third law of motion and with most Government actions, every action will have an equal and opposite reaction. Many are not immediately known. As the IRS begins to draft procedures on how it will enforce the new tax law, it will likely take years to fully understand all of the impacts and strategies resulting from the changes contained in the 500-page bill. While the primary goal of simplifying the average individual's tax situation fell short, there was a significant victory in making US business more competitive with the rest of the world on a tax basis. Perhaps the real winners of this new law will be shareholders of US companies as stock prices continue to reflect the impact of these new lower tax rates and extra cash companies will have to put to work as a result.
For more reading on this subject, please check out the following articles used to develop this summary: