The Tax Cuts and Jobs Act: What It Means for You
The Tax Cuts and Jobs Act was signed into law on December 22, 2017, and introduces a host of changes to the nation’s tax regime. Many provisions are targeted to sunset, making tax planning even more complex. The Treasury Department will be busy providing guidance, rulings and regulations for years to come, and there is always the potential for further changes by future administrations.
The maximum tax rate is lowered from 39.6% to 37%, offering little in the way of savings for higher-income households.
Breakpoints for qualified dividend/ long-term capital gain rates
15% marginal rate
$77,200 (married filing jointly)
$38,600 (single filer)
20% marginal rate
$479,000 (married filing jointly)
$425,800 (single filer)
Unchanged are the net investment income tax (3.8% surtax) and the additional Medicare tax on wages (0.9% tax). The reduced capital gain rates still apply, although they no longer line up cleanly with the ordinary income tax rate brackets. It is possible that a future technical correction could realign these.
Bunching deductions may help you stay above the new higher standard deduction threshold.
Evaluating business entity structuring could help you take advantage of the new lower corporate tax rate and more favorable pass-through business deductions.
Adjusting advance planning techniques can leverage increased federal estate and gift tax exemptions.
Types of Deductions
The standard deduction has been increased and consolidated with the personal exemption, resulting in a single larger standard deduction. The standard deduction is now $12,000 (single filer) and $24,000 (married filing jointly). More households will claim the standard deduction, since certain itemized deductions are being reduced.
However, it still makes sense for those at higher income levels to itemize as long as your allowable itemized deductions are above the larger standard deduction. We will review many of the most important deductions later in this paper.
The periodic bunching of deductions may help you exceed the higher thresholds. You will want to plan to bunch discretionary medical expenses or charitable deductions in a target year. Alternatively, instead of a making a number of smaller donations, you could consider making a single larger donation to a donor-advised fund or a charitable remainder trust in a target year.
There are a few charitable strategies that are valuable regardless of whether you itemize or not:
- For individuals over age 70½, opting for an IRA charitable rollover or qualified charitable distribution may provide a more tax-efficient way to make charitable gifts.
- When you donate appreciated property such as stocks, bonds or other assets instead of cash, you will still benefit from the capital gain bypass.
State and local income, sales, and property tax (SALT)
The impact of limiting the SALT deduction to $10,000 per year will vary depending upon the taxpayer’s state of residence and circumstances. Those who own larger homes in high-tax states benefited significantly from large SALT deductions in the past. The lower threshold may lead to a significant tax increase for these individuals, although not as much for taxpayers who previously received no benefit for SALT due to the alternative minimum tax (AMT).
The reduction in the SALT deduction will not be as meaningful in low-tax states. Those in high-tax states who are faced with a much higher tax bill as a result of this change may want to consider moving to states with lower taxes.
Qualified home interest
Moving forward, individuals purchasing new homes will lose some of the prior tax benefits of home ownership.
- Mortgage interest deductibility is now limited to the first $750,000 of acquisition indebtedness. For existing mortgages (prior to December 15, 2017), home mortgage interest remains deductible up to the first $1,000,000 of acquisition indebtedness. If original acquisition indebtedness is refinanced it will still qualify for the $1,000,000 limit—but only to the extent of the remaining debt balance, not for additional new debt.
- The deduction for home equity indebtedness has been eliminated. Home equity indebtedness is any home equity debt where the proceeds are used for any purpose other than to acquire, build or substantially improve a primary residence.
- Use of the terms “home equity loan” or “home equity line of credit” will not automatically make the debt home equity indebtedness. The determination of whether a debt is home acquisition indebtedness or home equity indebtedness is based upon how the mortgage proceeds were used. Property owners with existing home equity lines that were previously used to finance other purchases might want to evaluate repaying the debt sooner than originally planned.
You may want to consider converting vacation homes to income-producing rental properties, thereby transforming the deductibility of mortgage interest and property taxes as a business expense. Keep the following considerations in mind:
- If the residence is for personal use for more than the greater of (1) 14 days or (2) 10% of the number of days the residence was rented during the year at “fair rental” price, owners can only deduct the expenses to the extent of gross income received from the residence.
- Expenses must be allocated between personal and business use even if the residence was used personally for a single day during the year.
The long-term impact of these decisions must be considered in making the decision about converting homes to rental properties, not just the effect on the current tax situation.
Removal of the Pease Limitation
The elimination of the personal exemption and the increase in the standard deduction may not impact many high-net-worth individuals, since you may have already lost the personal exemption in prior years due to the income-level phase-out. However, many individuals had been impacted by the Pease limitation, which reduced the amount of allowable itemized deductions and occasionally created an effective 1% to 1.2% surtax. The new law removes the Pease limitation, resulting in a further reduction in the marginal tax rates for those who will still be able to take advantage of itemized deductions instead of the new higher standard deduction.
Alternative Minimum Tax (AMT)
For many individuals, the AMT eliminated a number of itemized deductions and increased the overall tax liability. While the AMT was not fully repealed, there are higher exemption amounts and higher thresholds for the phase-out of AMT exemptions. The regular tax calculation may now be more like the current AMT computation, resulting in fewer taxpayers being exposed to the AMT in the future.
The tax treatment of corporations represents one of the most significant changes in the Tax Cuts and Jobs Act. The changes to the corporate taxes are permanent, unlike the revisions to individual taxes.
Closely-Held Business Ownership
With the current corporate tax rate reduced to 21%, the difference between the maximum corporate rate and the individual tax rate may warrant an evaluation of business structure. C-corporation status may now produce a lower effective tax rate on income. You may even consider whether you should hold your investment assets through corporations. However, this may not make sense in many cases due to some disadvantages of C-corporation status, such as the tax on removal of assets from a C-corporation, tax on appreciated assets held in a C-corporation, and the potential application of the personal holding company tax and accumulated earnings tax. Any changes in business form should be taken only after careful evaluation of your unique circumstances and goals.
Personal Service Businesses and Pass-Through Businesses
The non-wage portion of pass-through business income is eligible for a 20% deduction, which begins to phase out if taxable income exceeds $315,000 (married filing jointly) or $157,500 (single filer) and is not available at all if taxable income exceeds $415,000 (married filing jointly) or $207,500 (single filer). The deduction for individuals above the phase-out threshold is subject to further limitation by a wage and qualified property test.
Those involved in specialized service businesses utilizing the reputation or skill of one or more employees such as health, law, accounting, consulting, financial services, performing arts and athletics (architects and engineers are the only exception) will qualify for the deduction if taxable income is below $315,000 (married filing jointly) or $157,500 (single filer). The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers and $50,000 for single filers. Therefore, if taxable income is greater than $415,000 (married filing jointly) or $207,500 (single filer), there is no deduction allowed to specified service businesses.
Some higher-income individuals may not be able to benefit from this deduction and should evaluate the following:
- As a business owner, if you aren’t eligible for the 20% pass-through business deduction because of taxable income limitations, you should consider whether C-corporation status is preferable. In addition, owners of very large service businesses who might not benefit from this deduction could consider converting to C-corporations.
- Another possible strategy may be to distribute ownership to multiple family members who are each below the threshold. This assumes that the owner is willing to give up some equity.
- To take advantage of the 20% pass-through business deduction, employees may consider shifting to independent contractor businesses or forming a separate business entity that would contract back with their prior employer. However, this approach could not be used for consulting work that would be classified as a specialized service business, and income would need to remain below the threshold.
The Tax Cuts and Jobs Act includes a new tax deduction for owners of pass-through entities, including:
Partners in partnerships
Sole proprietors and members of limited-liability companies
Divorcing spouses may have been able to negotiate increased alimony payments because the payor spouse was allowed to take a deduction for alimony paid. Under the new law, alimony payments will no longer be deductible by the payor spouse for divorce decrees on or after Jan. 1, 2019. The elimination of the alimony deduction, which is permanent, could reduce the bargaining power of a divorcing spouse aiming to receive alimony.
Some divorced individuals may have also negotiated who would benefit from claiming personal exemptions for children. With the personal exemptions eliminated under the new law, a prior tax benefit that may have been used in negotiations is now lost.
Previously, Coverdell education savings accounts (ESAs) were the only tax-advantaged way to save for K–12 expenses. Up to $10,000 per year from Section 529 plan distributions can now be used to pay for tuition for a beneficiary at a public, private, or religious elementary or secondary school. Parents and grandparents can also make additional gifts to 529 accounts to fund elementary or secondary school tuition.
Transfer Tax Changes
The estate and transfer landscape changed significantly with the new tax law:
- The federal estate and gift tax exemption has nearly doubled to $11.2 million. A married couple can transfer $22.4 million free of estate and gift tax with the use of inter vivos planning or portability.
- While the rules governing the stepped-up basis at date of death remain the same, basis maximization planning will continue to increase in relevance, as fewer estates are subject to federal estate tax. With the increased generation-skipping transfer tax (GST) exemption levels, you should consider taking advantage of this increase by making allocations of GST to trusts that were previously not GST exempt.
- If you had a charitable bequest in your estate plan, you may not benefit from the related estate tax deduction. You may consider accelerating those gifts to charity during your lifetime to possibly obtain an income tax deduction.
The new law did not provide for the ultimate repeal of the federal estate tax. Individuals should continue to use advanced planning techniques to reduce their estates, and leverage the increased exemption amount with additional wealth transfers (i.e., gifts).
All estate documents should be reviewed in light of the changes, and some documents may not work as intended. While high exemption levels may make prior plans feel unnecessary, estate planning is more than just minimizing estate taxes. It has other important advantages, including asset protection and distribution planning benefits. As always, tax implications vary considerably depending on individual circumstances.
Starting in 2018, there are major new opportunities to minimize the tax cost of transferring wealth. The Tax Cuts and Jobs Act doubles the exemption base for gift, estate and generation-skipping transfer taxes.
Trusts are subject to the highest individual tax rate (37%) at taxable income above $12,500. Because trusts and estates are subject to the same income reporting and deduction rules as individuals, with a few exceptions, trusts and estates will have fewer deductions under the new law. Tax rate changes for trusts and estates are minimal. As a result, taxes paid by trusts and estates will likely increase, as will the taxable income that flows through to beneficiaries.
There are a few changes that impact trusts and estates:
- Although miscellaneous itemized deductions for certain trust expenses will disappear, this should not affect the deductions incurred in connection with administration of the estate or trust.
- The rules for whether an estate or trust can deduct qualified residence interest are subject to the new dollar limitations for home acquisition and home equity indebtedness. However, it is unclear if estates and trusts are subject to the $10,000 SALT deduction limit.
- Trusts and estates are eligible for the 20% pass-through business deduction. This will likely be a flowthrough to the beneficiary level or remain at the trust level, depending on whether distributions are paid to beneficiaries.
Because tax rates for trusts and estates changed little while tax rates for most individuals are falling, the disparity between the trust’s tax rate and the beneficiary’s tax rate is likely to be greater in future years.
While many individual provisions are expected to sunset, lawmakers could make these rules permanent. It will likely take months to interpret and adapt to the new law, evaluating provisions and developing new strategies.
About Tina A. Myers, CFP®, CPA/PFS, MTax, AEP®
As a senior financial planner with Key Private Bank, Tina offers her clients sophisticated financial planning advice and a comprehensive set of strategies to grow and preserve their wealth. She collaborates with her team’s Relationship and Portfolio Managers, coordinates strategies with attorneys and accountants and follows up on a regular basis to ensure the plan is performing optimally. Tina received the 2016 Exceptional Service Award from the Cleveland Estate Planning Council and 2016 Circle of Excellence Award by Key Private Bank.