Where Have All the Deductions Gone?
You don’t need to remember Pete Seeger’s iconic folk song about flowers and war to realize many former income tax deductions are now pushing daisies in the graveyard created by the Tax Cuts and Jobs Act (TCJA) of 2017. A closer examination of the new tax law and the deductions it suspended will help us better anticipate its impact on our personal income tax liability.
Corporate and Business Taxes
The TCJA accomplishes many things in the name of cutting taxes – primarily for businesses. Most significantly, the newly enacted law reduces the top marginal tax rate for corporations from 35% to 21%. Corporate Alternative Minimum Tax (AMT) is eliminated under the new law. Owners of entities like sole proprietorships, S corporations, partnerships and limited liability companies (LLCs), are now eligible for a 20% qualified business income deduction. However, this income deduction is subject to a complex array of qualification requirements, income phase-out thresholds, as well as wage and asset limitations.
While business tax cuts are certainly the cornerstone of the TCJA, the elimination of two corporate tax deductions is worth noting from a social and cultural perspective. First, in recognition of the #MeToo movement, the new law disallows the deduction of settlement payments and attorneys’ fees associated with sexual harassment and sexual abuse claims if those payments are subject to a non-disclosure agreement. Secondly, while employers have retained their ability to deduct 50% of their food and beverage expenses associated with operating their business (e.g. employee meals when traveling), the TCJA eliminates any business deduction for activities related to entertainment, amusement or recreation, as well as membership dues for clubs or facilities organized for business, pleasure or social purposes.
Understanding just how the TCJA reduces taxes for individuals may be a trickier proposition. Most taxpayers – particularly those married filing jointly – will notice their marginal tax rates have been reduced between two and nine percentage points. However, this phenomenon of lower rates is not universal. Under the new law, single taxpayers with taxable income between roughly $200,000 and $400,000 will now face a 35% marginal rate, rather than their old 33% rate.
The primary source of uncertainty as to how the TCJA will impact individual taxpayers lies in the in the relationship between a more favorable standard deduction, and the new limitations and reductions involving most itemized deductions. Throw in the elimination of the personal dependent exemption, an enhanced dependent child credit, and a myriad of other tax tweaks that only a CPA (Certified Public Accountant) would love, and you may be left with many questions about whether the TCJA actually lives up to its name for individuals.
Taxpayers are permitted a handful of deductions for the purpose of determining their Adjusted Gross Income (AGI). A couple of these “above the line” deductions have been eliminated under the new law. For instance, moving expenses are no longer deductible, except those pertaining to the job relocations of military personnel. Beginning in 2019, the deduction for alimony paid will be eliminated. Even old divorce decrees will be governed by the new law’s non-deductibility provision. Although alimony received will no longer be included in the recipient’s taxable income, alimony payers are nearly always in higher tax brackets than alimony recipients. Accordingly, the net effect of the new treatment of alimony will be more dollars lost to the IRS (Internal Revenue Service) from the incomes of divorcing and divorced couples.
After arriving at a calculation of AGI, taxpayers can choose to reduce this figure by either:
- a standard deduction, or
- the sum of itemized deductions
Of course, taxpayers select the largest number, because that number will best reduce their taxable income figure.
As shown in the table below, the TCJA nearly doubles the aforementioned standard deduction for all taxpayers regardless of filing status.
The table noted here in the article compares the year 2017 and 2018 under the Tax Cuts and Jobs Act, highlighting the standard deduction for each class of taxpayer. The table includes five columns and three rows with the top row featuring headers for the columns. The headers of the chart (from left to right) include year, single, married filing jointly or qualified widow, married filing separately, and head of household.
For single individuals, listed in the second column of the table, data shows the tax deduction going from $6,350 in 2017 to $12,000 in 2018 under the Tax Cuts and Jobs Act.
The next table column then shows individuals who are Married Filing Jointly or Qualified Widows and their standard tax deduction increasing from $12,700 in 2017 to $24,000 in 2018 under the Tax Cuts and Jobs Act.
In the next column of the table, it then shows individuals Married Filing Separately and how their standard tax deduction went from $6,350 up to 12,000.
In the final column of the table, Head of Household is shown as increasing from a $9,350 standard deduction in 2017 to $18,000 in 2018 under the Tax Cuts and Jobs Act.
Deductions, Exemptions, Credits – Who Comes Out Ahead?
What the TCJA ‘giveth’ in the nearly two-fold increase in the standard deduction amounts, it ‘taketh away’ by eliminating personal and dependent exemptions. For example, in 2017 each personal or dependent exemption reduced taxable income by $4,050. Thus, for a married couple with 1 dependent child filing a joint return in 2018, the $11,300 increase (from $12,700 to $24,000) in their standard deduction amount will be more than offset by the loss of $12,150 ($4,050 multiplied by 3) in their personal and dependent exemption amount.
Unfortunately, an apples-to-apples comparison using standard deduction and personal and dependent exemption amounts is woefully incomplete. For most taxpayers, there are multiple layers to this give and take analysis comparing their tax liability under prior and current law. One such layer for some taxpayers is the child tax credit.
The TCJA increases the child tax credit from $1,000 to $2,000, while dramatically increasing the income levels at which this dollar-for-dollar tax savings begins to phase out.
The table below helps show that some of the trade-offs involved with child tax credits and personal and dependent exemptions. Depending on their family size, make-up and income levels, not all taxpayers will benefit under the new law.
Therefore, before taking advantage of those lower personal tax rates established by the TCJA, taxpayers must first calculate their taxable income amid this swirl of favorable and unfavorable changes to deductions, exemptions, and credits. As mentioned previously, one critical step in determining taxable income is selecting between the higher figure of the new more favorable standard deduction amount and the sum of itemized deductions, which deductions have been significantly reduced.
The table titled “Differences in the Child Tax Credit” appears next on the page, and is split into 3 columns with headers and 4 rows total. The headers for each column are Provision, Old Law (2017), and New Law. The table compares each tax provision, highlighting the differences between the old law in 2017 and the new law in 2018 under the Tax Cuts and Jobs Act.
The first row under the header lists the personal and dependent exemption provision—and under the old law this provision allowed $4,050 per exemption, whereas under the new law this provision was eliminated.
The next row lists the Child Tax Credit provision—under the old law, this provision allowed $1,000 per qualifying child, whereas under the new law the credit was increased to $2,000.
The final row lists the other provisions within the Child Tax Credit. Under old law the Child Tax Credit began to phase out at $110,000, was refundable up to $1,000, and was a credit for children only. Under the new law, phase out begins at $400,000, is refundable up to $1,400, and taxpayers receive a $500 credit for qualifying other family members.
The Disappearing and Shrinking Itemized Deductions
Focusing on the more restrictive rules and limits pertaining to itemized deductions helps illuminate the type of taxpayers who – if not harmed – certainly benefit the least from those purported “tax cut” provisions of the new law. Under the TCJA, tax deductions for property taxes, state and local income taxes, and the interest paid on mortgages and home equity loans have been curtailed. Miscellaneous deductions like investment advisory and tax preparation fees, as well as deductions for casualty and theft losses have been effectively eliminated.
The itemized deduction for charitable gifts emerges from the TCJA relatively unscathed. A taxpayer’s cash donations to a public charity now enjoy a more favorable first-year deduction limitation (60%, up from 50%) with respect to AGI. In prior years taxpayers at fairly high income levels could find the tax savings accompanying their charitable gifts were muted by complex formulas, phase outs, and exclusions of other deductions imposed by the Pease limitation and/or the Alternative Minimum Tax (AMT) schedule.
Now that the Pease limitation has been repealed, and the AMT exemptions increased, taxpayers making significant gifts to charity can realize more tax savings as a result of their philanthropy. Of course, charitable donations may decline for those taxpayers whose itemized deductions fall below their standard deduction figure.
A table titled “Changes to Certain Itemized Deductions” is included on the page as well, and lists several common tax deductions in the first column, then lists deduction requirements or policy related to the old law in 2017 in the middle column, and deduction requirements or policies for the new law under the Tax Cuts and Jobs in the third and last column. The table includes three columns and eight rows with the top row being headers for each column.
The first row under the header of the table assesses the medical expenses deduction—under the old law, deductibles to the extent exceeding 10% adjusted gross income (AGI) where deductible, whereas 2018 law under the Tax Cuts and Jobs Act allows for two years to be deductible to extent exceeding 7.5% of AGI.
The second table row under the header describes the State and Local Taxes (SALT) deduction—under the old law, property taxes and state and municipal income taxes were deductible. Taxpayers could elect to deduct sales tax in lieu of state income tax. Under the new law in 2018, the deduction was retained, but limited to $10,000 for the year, and foreign real property tax is not deductible.
The third table row lists the mortgage interest deduction—under old law mortgage interest was considered deductible up to $1,000,000 on primary and secondary homes, as well as interest on up to $100,000 of home equity debt. Under 2018 law, the mortgage interest deduction is limited to $750,000 of secured, acquisition debt on a primary or secondary home.
The fourth row of the table lists Tier 2 Miscellaneous Itemized Deductions—and under the old law miscellaneous expenses such as unreimbursed business expenses, tax preparation fees and investment expenses are deductible to the extent they exceed 2% AGI. Under the new 2018 law this deduction was eliminated.
The fifth row of the table explores casualty and theft losses. Under the old law in 2017, this deduction was allowed to the extent it was unreimbursed by insurance and that the loss exceeded 10% AGI and $100 floor. The new 2018 law eliminated this deduction except for casualty losses attributable to federally declared disasters.
In the sixth row of the table, the charitable donations deduction is listed. Under old law, the charitable donations deduction was available for the current year, limited to 50% AGI for cash donations to public charity (other deduction limitations apply; balances carryforward). Under the new law, charitable donations deduction limit was increased to 60% AGI for cash donations to public charities.
The final row of the chart lists the overall limitation on itemized deductions. Under the old law in 2017, ‘Pease’ limitations applied, whereas under the new law this limitation was eliminated—however, our expert highlights this point with an asterisk that relative to prior law, these provisions are favorable to the taxpayer.
Impact on Taxable Income and Tax Liability
By eliminating and restricting some very significant itemized deductions, the TCJA achieves one of its primary goals: tax simplification. A large percentage of taxpayers will no longer need to track and document a shrinking field of itemized deductions whose sum total is likely to fall below the former standard deduction numbers, let alone the new, more ‘generous’ ones.
Many former “itemizers” will select the higher standard deduction figure to subtract from their AGI, but still see their taxable incomes rise in 2018 due to the loss of personal and dependent exemptions and other factors. Other taxpayers will still itemize, but with a much smaller sum of itemized deductions than prior years, their taxable incomes will increase as well.
For many taxpayers, particularly those who expend a large portion of their income on real estate taxes and/or state and local income taxes, the loss of these itemized deductions will effectively increase their taxable income relative to their 2017 number.
Like the flowers vanishing in Pete Seeger’s classic song, many of the old reliable tax deductions have gone missing under the TCJA, leaving open questions for taxpayers and advisers alike.
Will the reduction of tax rates in 2018 be enough to counteract potential increases in the taxable income figure? Does the TCJA actually cut the taxes you have to pay? Or will these disappearing itemized deductions leave taxpayers wondering, “where have all the tax refunds gone?”
Interestingly, most of the individual tax provisions – including those impacting itemized deductions – are scheduled to expire at the end of 2025. If no additional changes are made (and that’s a big “if”), the pre-TCJA provisions and all the old itemized deductions – will be resurrected! Until then though, a majority of deductions are, as Pete Seeger would say, “gone to graveyards”.