The highly anticipated tax reform we have been hearing much about lately is expected to be passed into law today. While the economic and political implications of this bill will be unknown for some time, we at least have an understanding of the individual changes taking shape that will impact your planning in the years ahead.
My focus in this email is to give you a very general take on what is changing for individuals, and what to consider right away from a planning perspective. Nearly everything available in the mainstream media right now ought to be taken with a grain of salt…on either side of the political spectrum. Very little of what I have been seeing contains much real substance for people. Instead, they either focus on slivers of the bill, or on making a politically biased opinion or hysterical predictions of the impact. And as usual, that goes both directions. Don’t fall for the click bait.
You know where we stand on predictions, whether that be the direction of markets, economic consensus, or the ability of the CBO to project pretty much anything beyond a year or two. We simply don’t know yet, and acknowledging that will help you stay focused on what matters and what you can control.
You also have to look at the bill as a whole, rather than isolating certain components to make a statement. For example, arguing that taking away personal exemptions from families is harmful is extremely misleading without considering that a higher child tax credit will typically more than make up the difference. You are probably hearing / reading that you ought to consider prepaying income or property taxes this year, as those deductions will be limited in the years ahead. However, if you are subject to AMT, prepaying these taxes will save you exactly $0 in Federal income taxes.
The most comprehensive summary I have seen thus far can be found at the blog of my friend and colleague, Michael Kitces: http://bit.ly/2CAtgVQ. Michael does a terrific job in his (37 page!) summary outlining virtually all of the individual changes and how they will impact and shape planning strategies. For those of you looking for a deeper dive and understanding, this is it. As he concludes at the end of his blog, it will take some time to fully understand the gravity of these changes, and many new planning strategies will evolve in the years ahead.
Further, the “to-do’s” from this bill are exceptionally personal – ranging from doing absolutely nothing for a lot of people, accelerating deductions for some, to pushing off deductions for others. What makes sense for your friends and family may not make any sense for you.
As it pertains to our clientele, in particular, the most significant changes are centered around two primary areas – itemized deductions and the alternative minimum tax (AMT). While these two areas are intimately intertwined, the planning realities are quite different depending on your phase of life and tax bracket. I will attempt to tackle both of these simultaneously.
Yes, there are also reductions in the tax rates applied to taxable income, but the impact on actual taxes paid is altered far greater by the aforementioned items. In other words, just because one’s tax rate may have dropped a couple percentage points, that does not necessarily result in lower taxes. Similarly, just because you are “losing deductions,” that does not necessarily mean your taxes are going up. Again…this is more of a reason to focus on the whole picture rather than isolated components.
First and foremost, we were told repeatedly that the AMT was going to go away. While it will technically still exist, it is going to become exceedingly rare in the years ahead. As Michael points out in his detail, barring some very rare and specific instances, falling into AMT will be nearly impossible.
Under current law, income taxes paid to a state or local government are deductible on schedule A of the tax return. In high tax states such as Minnesota (and several of you along the east coast or in California), these are often the biggest deductions we receive on schedule A.
However, as a byproduct of that, we also have a disproportionately high number of tax filers subject to the AMT. This is because state income taxes paid are one of the “preference items” that are added back in the AMT calculation.
For those of you that own valuable homes or multiple properties, the property taxes you pay can add up to a considerable deduction as well. These taxes, however, are also AMT preference items.
Ultimately, if you are currently subject to AMT, you aren’t actually getting the (full) benefit of these deductions in the first place, so “losing” that deduction is not exactly a loss, especially after we account for the changes in tax rates.
One important thing to note at this point is that if you are expected to be subject to AMT for 2017, it does you no good to pre-pay your property taxes before 12/31. Ignore that suggestion from friends, family, radio personalities, CNN, FoxNews, etc. If you are curious, just take a look at last year’s tax return, turn to page 2, and check line 45. If there is a number there, you were subject to AMT last year. Barring significant changes in your life, income, or a meaningful reduction in your itemized deductions, you are very likely to be hit with it again for this tax year.
Another important change is the elimination of the deduction for home equity debt. Debt incurred as a cash out refinance, or home equity loans that were used for anything other than making significant home improvements are no longer deductible.
On the flip side of the coin, the doubling of the standard deduction is going to result in many clients no longer itemizing. For some of you, this creates more incentive to do things like paying down mortgage balances, as your interest payments are no longer deductible.
For others, this will give rise to strategies that may involve bunching or lumping itemized deductions into a certain tax year. Donor-advised funds (or charitable gift funds) are likely to rise in popularity.
For example, if I know I am not going to incur enough deductible expenses to itemize in 2018, I may elect to do the following:
- Accelerate my 2018 charitable giving into 2017 by using a donor-advised fund
- Plan to take the standard deduction in 2018
- Make sure to max out the $10k of state and local tax deductions. Ideas:
- Consider prepaying property taxes for 2020 in 2019
- Deliberately underpay state income taxes in 2018 so you have a large portion paid in 2019
- In 2019, “pre-fund” several years worth of charitable giving into the donor-advised fund
If I “bunch” a number of these deductions into a given tax year, I benefit by taking the same deduction I would otherwise get in most years, but may be able to achieve a greater benefit every other year (or every third year) by grouping deductions that will exceed the standard deduction.
At the end of the day, the impact and planning implications are going to vary widely from household to household, so try to avoid knee-jerk decisions before year-end, and don’t believe everything you hear over the holidays!