By, Justin Arnold, AIF®
So, we have a new tax code. It may not have received an invitation, but a new tax code came for the holidays. The final reconciled version of the legislative text for the new tax bill, entitled The Tax Cuts and Jobs Act of 2017, was released on Friday, December 15, along with Conference Committee notes that support it.
The Tax Cuts and Jobs Act of 2017 results in substantial changes. Yet, the tax code and the implications for financial planning opportunities remain as complicated as ever. I hope to help you better understand the potential impacts of the new tax legislation on your situation, and give you actionable ideas to consider before the ball drops on 2017. But first, what is in this tax legislation anyway?
The Basic Provisions of The Tax Cut and Jobs Act of 2017
Individual Tax Rates
- Relative to 2017, the new TCJA should reduce marginal rates for most.
The brackets will continue to be adjusted for inflation after 2018 and will use a measure called chained-CPI or C-CPI-U, which many consider more accurate than previous benchmarks.
The Standard Deductions
- The standard deduction will increase to $12,000 for individuals and $24,000 for married couples filing jointly.
- If you are over 65, blind or disabled, you can tack on $1,300 to your standard or $1,600 for unmarried taxpayers.
- The standard deduction amount will also increase by a measure of inflation known as C-CPI-U, for taxable years starting in 2018.
Capital Gains Tax Rates
- Capital gains taxes will continue at 0%, 15%, or 20% based on taxable income. But the thresholds have changed.
Corporate Tax Rates
- The corporate tax rate drops from 35% to 21%.
The Taxation of Pass-Through Entities
- The new tax bill allows for a 20% deduction of qualified business income or QBI from income.
- The QBI deduction does not apply to "specified service" businesses -- as the bill draws (apparently random) lines around industries, favoring some sectors of the economy over others.
- Essentially, this means qualifying pass-through entities will be taxed on only 80% of their income; which has the impact of reducing the top rate from 37% to 29.6%.
Disfavored vs. Favored Service Categories
- For these disfavored businesses, the deduction is limited to $157,500 for a single or $315,000 for married couples, with the deduction phasing out over the next $100k.
Under IRC Section 1202(e)(3)(A) below are a few of the "Named" disfavored industries:
- Financial Services
- In the case of “favored business” like real estate, the deduction would apply without limit.
So, starting in 2018, business owners and partners with taxable income over $157,500 (single filer) in certain industries cannot claim the pass-through deduction, as I currently understand it.
Why? Who the hell knows. And, it's now the law.
I’ve always said it would be good for healthcare to have fewer doctors.
The Alternative Minimum Tax (AMT)
- AMT exposure will impact very few people moving forward and the Minimum Tax Credit carryover changes will be significant for anyone currently paying under AMT.
The Estate Tax & Trusts
- The Estate Tax Exemption is increased to $11,200,000 for individuals and $22,400,000 for married couples.
- Tax brackets for estates and trusts have been compressed from 5 to 4 with a bottom rate of 10% and a top rate of 37%. All but the wealthiest among us will need to worry about the Estate Tax.
A New Cap on State Tax Deductions or "SALT"
- The new tax bill limits the deduction on state and local income and property taxes or "SALT" to $10,000, for both to individuals and married couples filing jointly starting in 2018.
- The limit is the same for both single and married filers.
- For high-income investors who live in high-tax states, the new cap on SALT deductions may create a much more significant tax burden.
Some SALTy Stats:
- Nationwide, 4.1 million Americans pay more than $10,000 in property taxes alone, according to ATTOM Data Solutions.
- More than 95% of itemizers claimed the deduction in 2014, according to the Tax Foundation.
- About 90% of the benefits go to taxpayers with income higher than $100,000, according to the Tax Foundation.
Deductibility of Housing Debt
- Deductibility of mortgage interest has decreased to $750,000 for all mortgages taken out after December 15th, 2017.
- Any existing mortgages will retain their deductibility of interest on the first $1,000,000.
Home Equity Lines of Credit
- Interest on home equity loans or lines of credit -- including cash outs from a traditional mortgage -- is no longer deductible if it is not used to acquire, build, or substantially improve the primary residence.
- The loss of deductibility applies to new and existing home equity loans.
Vacation Property Debt
- The new law preserves the deduction of mortgage debt used to acquire a second home.
Length of Ownership for a Primary Residence
- Homeowners owners will continue only to need to live in their primary residence twenty-four months in a sixty-month period to be eligible for tax exclusion up to $250,000 if filing single and up to $500,000 if married filing jointly.
- Investment property owners can continue using 1031 tax-deferred exchanges.
- Property owners will still have the ability to convert a residence into a rental property or convert a rental property into a home and qualify for tax benefits.
- The new tax law continues current depreciation rules for real estate.
- Public charitable contribution limits expanded from 50% to 60% of adjusted gross income.
Child Tax Credit
- The Child Tax Credit expands from $1,000 per qualifying child to $2,000.
- Additionally, the income thresholds for the credit are increased from $75,000 to $200,000 for individuals and $110,000 to $400,000 for married couples filing jointly.
529 College Savings Plans
- These tax-free distributions can now be used for private elementary and secondary school expenses up to $10,000 per student each year.
Miscellaneous Itemized Deductions
- Items which have been subject to deductibility only above 2% of your AGI will no longer be allowed.
- Financial planning icon Michael Kitces' noted that if expenses can be properly attributable to business expenses, then the deductions could remain.
Medical Expense Deductions
- Medical expense deductions are reduced to 7.5% of adjusted gross income (AGI) retroactively for 2017 as well as for 2018 but revert to 10% of AGI in 2019.
Depreciation of Business Assets
- The new tax bill allows businesses to immediately deduct 100% of the cost of eligible property in the year it is placed into service, through 2022.
A Few Planning Opportunities to Explore in the New Code
Has a tax paper ever gone viral before? This one has.
The new paper, The Games They Will Play, provides insight from more than 13 tax scholars, practitioners and analysts into the new law and the "games" that will be explored. At least in part, due to the increased complexity of the tax code as it relates to pass-through entities.
Corporations as Tax Shelters
- The paper predicts that C-Corps will now be used to shelter income against the top ordinary income rate of 37%. For a C-Corp, the rate is now a flat 21% beginning in 2018.
- The tax rate difference of 21% vs. 37% is too high for taxpayers to ignore, whereas before, the rates were close enough where any “tax arbitrage” wasn’t worth the effort.
- And, according to the paper, the bill has no protections to prevent this.
For example, a large law firm, organized as a partnership, might obtain much less benefit from the pass-through deduction and face the top ordinary income tax rate of 37%. But, under new TCJA provisions, law firms may reorganize as corporations, or choose to have their business taxed as a corporation; permitted under "check the box" taxation rules for some firms.
As described in the earlier reporting from the authors of the paper, there may be little downside to this planning opportunity. If you change your mind, you can simply convert your C-Corp to an S-Corp (that’s taxed as a pass-through).
Pass-Through Reindeer Games -- “I, Inc.”
- The paper predicts that you will now be able to shield labor income from tax by setting up a corporation and having your income accrue in the form of corporate profit.
- Income that would have been taxed at the high individual rates will instead be taxed at the lower corporate rate as people look to exploit planning opportunities.
The new bill grants a 20% deduction for certain qualified business income, which in effect reduces the top rate from 37% to 29.6%. This is good news if you can quit and be rehired as an independent contractor or become a partner.
“Bunching” Charitable Donations
In the New York Times article How to Write Off Donations Under the New Tax Plan: Considering "Bunching" author Ann Carrns describes a strategy of pooling or “bunching” charitable gifting into years plan to exceed the (now much higher) standard deduction.
- For example, instead of giving $2,000 each year, consider bunching multiple years together and giving $10,000 (or five years of donations) in one year.
But, what about nonprofit budgets?
I'm concerned about charitable giving with the increased standard deduction. Very few will itemize moving forward and that impact on future giving is worrying.
This is where the Donor Advised Fund or DAF may play a role.
What is a Donor Advised Fund (DAF)
- With a Donor Advised Fund or DAF for short, you can bunch several years of donations into one, but not distribute the funds to your preferred nonprofit all at once.
- Additionally, the money can be invested and expected to grow over the long-term, possibly increasing your total lifetime gifting and potentially leaving a gifting legacy for years to come.
It works like this:
- Open a Donor Advised Fund.
- Contribute during a tax year you plan on itemizing.
- You direct the fund's administrator on how the fund pays gifts each year to your preferred nonprofits.
For tax planning, you've made a large donation in a single tax year but you can still level your gifts to nonprofits over time. For more information on donor advised funds, please see Further Reading at the end.
Donate Appreciated Stock
- One of the key benefits of the DAF is the ability to gift appreciated stock with long-term gains for the full value of the securities.
- If you donate low basis stock, you may be able to deduct the full market value of the stock; maximizing a charitable gift deduction and not realizing a taxable gain.
Move to a Lower Tax State
Well, not before the year is over. But, if you’re struggling to save, entering retirement, or just want to pay less in taxes, it might make sense to take a look around and see how local and state taxes compare.
Tax Moves Before the Ball Drops
If you’re one of the 44 million (about a third of all tax filers) that will itemize for 2017, it makes sense to spend a few hours before the end of the year on tax planning. As the year comes to a quick close, you may benefit from taking time to consider a few of these last-minute ideas.
Pay Any Taxes You Can
- By prepaying next years property taxes now, homeowners are hoping to take the deduction in 2017 before the cap comes into effect.
- In New York, Gov. Cuomo signed an order that suspended a New York state law that may have blocked some residents from prepaying taxes.
- Gov. Cuomo is expecting the new tax plan to cost New Yorkers more than $14 billion.
Should I Prepay Taxes? Current analysis suggests that it makes sense to try. The problem you may find is that your county won’t accept the payment. Check with your county to see whether you can prepay online.
Pay Business Expenses and Defer Income
- Defer any income until next year if your tax rate is going down.
- Also, if you're no longer going to be itemizing and pay dues, professional fees, or buy supplies for your job that you may typically deduct, consider buying before the end of the year, if you plan on itemizing in 2017.
Tax Loss Harvesting
- Tax loss harvesting is the practice of selling off assets at a loss and using the "losses" to offset capital gains and reduce your tax bill.
- Capital gains can be offset dollar for dollar with capital losses.
Tax loss harvesting can reduce year-end taxes. But, make sure you’re taking transaction costs into account.
Donate to Charity
Year-end is a great time to look at your charitable giving. If your income taxes will be higher in 2017, and you may not itemize next year, you may want to get all the tax benefits you can by increasing your donations to nonprofits in 2017.
What about Donor Advised Funds? It may be too late to get a new fund open and funded, as the deadline for donating is Dec. 31. But, if you’re interested in trying; Fidelity and Vanguard have two of the most popular options, with the former receiving more than 4 billion in donations in 2016.
I have a feeling the phone is ringing.
In short, this bill is a mess.
- Higher income law partners, doctors, and other professionals will likely be able to engage in strategies to access the special rates.
- Tax consultants will exploit the confusing rules and it may prove difficult, if not impossible, for the IRS to police the lines between creativity and “not-legal”, according to tax experts.
- A new massive gap between corporate and personal income will inspire taxpayers to use corporations as tax shelters for earned income (21% vs. 37% is big).
- Some may decide to form a business and be hired as a company, to take advantage of the 20% deduction on qualifying business income.
- Some may change their “official” profession (just slightly) to take advantage of the random lines that are now drawn around industries; with some professions being favored for no discernable or logical reason.
- Four items to consider before year end:
- Pay Taxes
- Defer Income and Pay Expenses
- Donate to Charity
- Tax-Loss Harvest
The Tax Cuts and Jobs Act of 2017 legislation introduce sweeping changes to the U.S. tax code and the above synopsis is in no way a comprehensive explanation of the new tax bill. It will take time to understand the full scope of the new tax environment and all of the planning opportunities it creates.
But, isn't the new tax code simpler? In my opinion, not at all.
Yes, many people will no longer need to itemize, but for others, there will be significant planning opportunities in this newly crafted law and it will take years of clarifications, IRS publications/rulings, and probably a lawsuit or two to crystallize the new tax bill, close loopholes, and provide concrete guidance.
What is your opinion of the new tax code? How do you see it affecting your personal situation?
Consulting with a tax advisor is critical when an investor is attempting any tax mitigation strategies. Be sure that your individual goals and circumstances are carefully weighed against any tax mitigation action. As the year comes to a close before tax season gets underway, talk to your CPA about year-end tax strategies that may be appropriate for you.
Now go give your boss two-weeks notice.
- Individual Tax Planning Under The Tax Cuts And Jobs Act Of 2017 - Michael Kitces, CFP®
- If You Want to Know How the New Tax Code Affects You, Read This First -- The New York Times
- The Games They Will Play
- The Journal of Accountancy
- Big Trouble For Biglaw Partners From ‘Tax Reform’? -- Above the Law
- Policy Highlights
- The Tax Bill Is Finalized: Who's Happy, And Who's Not? -- Forbes
- Full Text of The Tax Cut and Jobs Act
- Here’s What the Republican Tax Plan Means for You -- Nerd Wallet