Plus steps to take now
The impact of new tax legislation will vary by Taxpayer depending on your particular situation. Generally, tax rates have been lowered but many itemized deductions have been significantly limited or eliminated. The standard deduction has been increased significantly so many Taxpayers will no longer need to itemize deductions. Personal exemption deductions will be eliminated. Child tax credits will be enhanced. Businesses operating as S Corporations, LLC’s, partnerships and sole proprietors will receive a tax break if certain qualifications are met. In effect, 20% of the net income from qualifying small businesses may be tax free. Alternative minimum tax (AMT) has not been repealed but the threshold for triggering AMT has been enhanced. Minimum tax credit carryovers resulting from prior exercise of ISO’s will be easier to utilize starting in 2018. Estate taxes have not been repealed but a married couple will not incur estate taxes unless the value of their estate exceeds $22.4 million. Following are highlights of the tax rule changes.
Tax rates
The top marginal tax rate has been reduced from 39.6% to 37%. There will be 7 tax brackets starting at 10% up to 37%. Most people will see their effective tax rates go down by about 2% to 3%. Long term capital gain rates have not changed (primarily 15% to 23.8%). The C corporation tax rate has been reduced to 21%.
Expanded standard deduction
Starting in 2018, the standard deduction increases from $6350 to $12,000 for single taxpayers and from $12,000 to $24,000 for joint returns. Fewer people will need to itemize deductions in the future because the new standard deduction will exceed the allowable itemized deductions.
Personal exemption deductions
Commencing in 2018, personal exemption deduction ($4050 per person) for taxpayers and their dependents will be eliminated. However, the expansion of the child tax credit may make up for the lost personal exemptions for larger families.
Child tax credit
The child tax credit increases from $1000 to $2000 per qualifying child under age 17. Many higher income taxpayers were not eligible for the child tax credit under existing law. The new law significantly increases the income phase out amounts from $75,000 to $200,000 for single and from $110,000 to $400,000 for joint returns. Many more taxpayers will now be entitled to take child tax credits. The new rules also provide a $500 credit for dependents over age 17 including children in college or dependent parents. These are credits and not deductions so they reduce your tax liability dollar for dollar. Credits are always better than deductions.
State income tax and property tax deduction
Beginning in 2018, deductions of state and local income tax and property tax are limited to $10,000. This is a combined limit so the total of state income tax and property tax is subject to this limit.
Mortgage interest limit
The deduction for mortgage interest will be limited to $750,000 of principal. The previous limit was $1,100,000 of principal. However, there is a grandfather clause based on the amount of principal (up to $1,000,000) existing on December 15, 2017. You are also allowed to refinance your grandfathered amount in the future without losing the higher limit.
Home equity line
Under existing law, a taxpayer could borrow up to $100,000 on a home equity line and deduct the interest even if the loan proceeds were not used to make home improvements. This provision has been eliminated and interest deductions will only be available if the loan proceeds were used to make home improvements.
Medical expenses
The threshold for deducting medical expense has been improved and this provision is retroactive to 2017. You can now deduct medical expenses to the extent they exceed 7.5% of adjusted gross income. In recent years, the threshold was 10%.
Other miscellaneous itemized deductions
Deductions for unreimbursed employee expense, tax preparation fees, and investment advisory fees have been eliminated.
Alternative minimum tax (AMT)
The AMT exemption amounts and phaseouts have been enhanced. In computing AMT, the state income tax and property tax deductions are added back to income and often resulted in large amounts of AMT. With the new limit of $10,000 on state income tax and property tax deductions, the large amounts of AMT related to these deductions will no longer exist. An exercise of incentive stock options (ISO’s) will continue to trigger AMT. With the AMT exemption amounts expanded, more ISO’s can be exercised before triggering AMT. Additionally, you are allowed minimum tax credits to recoup the AMT resulting from exercise of ISO’s. Under the new law, it will be easier to use your minimum tax credits in future years. If you currently have minimum tax credit carryovers from prior years, you will likely be able to use these credits faster.
Tax break for small businesses
A new 20% deduction on “Qualifed Business Income (QBI)” can be taken on your individual return if you receive pass through income from an S Corporation, LLC, or Partnership. This deduction will also apply to sole proprietors. In effect, 20% of your qualified business income can be tax free. However, this tax benefit comes with many restrictions. If the taxable income on your individual return (before the QBI deduction) is less than $157,500 (Single) or $315,000 (Married filing Joint), you will be eligible to take the full 20% deduction. If your taxable income exceeds this amount, you will be subject to restrictions or limitations on this deduction. For specified service businesses, this deduction is not allowable if your taxable income exceeds certain amounts. The specified service businesses include the fields of health, law, accounting, actuarial services, performing arts, consulting, athletics, and financial services. Engineers and architects are exempt from this restriction. If your business is not a specified service business, the deduction will be limited to 50% of your allocable share of wages paid by the business to all employees, including S Corporation owners salaries. You have the choice of using an alternative limit based on your allocable share of 25% of W2 wages plus 2.5% of your share of the cost of depreciable property used in the business. There will be significant tax planning opportunities in navigating through these rules. Defining the specific nature of the services you provide will be important, particularly for high tech professionals. In certain situations, software engineers will be entitled to this deduction while consultants will be ineligible. Some businesses will be able to optimize the deduction by operating as an S corp and paying the owner a salary. Some individual’s may benefit by operating as an independent contractor as opposed to being an employee of their client. But there are IRS guidelines which must be met to qualify as an independent contractor. Some businesses may consider switching to C corporation status to take advantage of the 21% tax rate. But C corporation dividends are also taxed when cash is distributed to the owners making the 2 levels of tax exceed the tax rates on pass through income in most cases.
Section 529 plans
The new tax law permits tax free distributions to be used for grades K through 12 up to $10,000 per student per year. There is no limit to the amount you can withdraw for college tuition and expenses. Previously, only Coverdell education savings accounts could be used to fund K through 12. You should consult with your financial planner to see which type of education savings accounts are best for you.
Alimony
Under existing law, alimony payments are deductible to the individual paying the alimony but the recipient must report the alimony as income. For divorce agreements entered into after December 31, 2018, alimony is no longer deductible to the payer nor is it included as income to the recipient. Existing divorce agreements can be modified to adopt this tax treatment beginning in 2019.
Moving expenses
Beginning in 2018, moving expenses are no longer deductible except for active duty military personnel. Also, employers can no longer pay for moving expenses for employees on a tax free basis.
BONUS: Steps to take now
If you are not subject to AMT in 2017, then you should prepay the balance of your current property tax bill which is due in 2018. The IRS has stated that you can deduct property taxes paid before December 31, 2017 only if the tax was assessed in 2017. You can also pay your forth quarter estimated state income tax payment and pay any expected state tax to be owed with your 2017 tax return by December 31, 2017. Prepaying your 2018 state income tax is specifically precluded from being deductible in 2017. If you are a business owner, defer as much income as possible to 2018 and pay all possible business expenses before year end. Wait until 2018 to exercise NQSO’s or do same day sales of stock options since lower rates will apply to most people in 2018. If you expect to take the increased standard deduction in 2018, then consider making extra charitable contributions in 2017. You can make contributions to a donor advised fund in 2017 which can be disbursed to your chosen charity in future years.