Mortgage Interest and Charitable Contributions
With 2017 taxes complete for most families, we can turn our attention to the changes in store for 2018. The Tax Cuts and Jobs Act of 2017, passed into law in December, represents significant new changes that will affect many families. We plan to explore a number of issues related to this new tax law in future blogs. Here I’d like to look at two significant changes to the deductions many people take on their tax return – mortgage interest and charitable gifts. Please note that though we as a firm have a policy to not offer tax recommendations, the changes involved in the new law have some big planning implications that warrant discussion. That said, this blog is not meant to offer tax advice, and individuals should seek guidance from tax professionals about their unique circumstances.
“Is my mortgage interest still deductible?”
Yes, mortgage interest is still deductible, but only if you itemize. So then, the logical question becomes: will you itemize moving forward? It’s very possible that you may not under the new law, even if you are a high-income earner. In the past, the threshold to itemize was only $12,700 for married couples. Now you need to have $24,000 in deductions to itemize. In addition, the new tax law places a cap on the combination of property taxes and state income tax deductions of $10,000 and eliminates miscellaneous deductions. That leaves only mortgage interest and charitable contributions as the main deductions realized by most taxpayers. What this means is that if these two items don’t exceed $14,000 per year, they are, for all intents and purposes, no longer deductible for most families.
Will that impact behavior? I believe it will, but not likely until 2019, after 2018 returns are completed and people realize they no longer benefit from the deductions they historically relied upon to reduce their taxes. Charitable contributions (discussed below), while continuing to be important to many families for non-tax reasons, may need to be restructured.
Mortgage interest, when deductible, was frequently considered on a tax adjusted rate. For example, a 4% mortgage in the 25% marginal tax bracket, effectively costs a family 3%. Or, said differently, the economic considerations of retaining versus paying off the mortgage could be evaluated by what return an investor would need to earn on a risk-equivalent investment to net out ahead. Some might say that an intermediate- to long-duration bond yield would be a reasonable comparison. Now, if a taxpayer doesn’t itemize, as may be more common under the new tax law, the economic considerations are different. Instead of a net cost of 3% for the mortgage, the net cost is now 4%. This would be akin to shifting the comparative return from a taxable bond to a tax-exempt bond (which, of course, typically yields considerably less than its taxable counterpart). What might this lead a person do? If they have sufficient non-retirement assets sitting in low risk/low return instruments, paying off the mortgage and saving the interest cost could be wise. Essentially, if a person could sell their 10-year Treasury bonds currently yielding close to 3% and pay off 4% debt, they would end up increasing their net worth by the difference (assuming they took the money they otherwise would have paid toward the mortgage and reinvested in rebuilding their non-retirement assets). We expect some taxpayers may make a change to their strategy.
“Are my charitable contributions still deductible?”
Like the answer above about mortgage interest, the answer is yes, provided you continue to itemize on your tax return – which is far less likely in 2018 than in previous years. Not only has the standard deduction increased for married couples from $12,700 to $24,000, but with the combination of property taxes and state income taxes now capped at $10,000 per year, many may not have enough of the two-major remaining schedule A deductions for charity and mortgage interest to itemize.
We recognize that many people give for non-financial reasons. Outstanding! There are many worthy causes that we hope continue to receive your financial support. The question remains, “can I continue my charitable support in a more tax efficient manner in light of the new tax rules?” We believe the answer is yes! Here are a few ways:
- If one is 70 ½ or older and has pre-tax retirement accounts, the “Direct to Charity” strategy is now more compelling than ever. This enables one to make a contribution directly from your IRA to a charitable institution without recognizing either the income or taking the deduction. But, isn’t that the same as taking the money out of the IRA and then writing a check to charity? It is not the same for many people – especially if one isn’t itemizing in the future. If one takes the standard deduction, the IRA distribution is taxable, but there is no offsetting deduction. Even if one is going to itemize, you still may be worse off due to deductions such as medical which are deductible only above certain AGI thresholds. Similarly, higher income can also cause a higher percentage of social security to be taxed and cause future Medicare premium surcharges. If you are near 70 ½, you might consider delaying charitable contributions for several years and then making a larger charitable contribution from your IRAs the year in which you turn 70 ½. This is equivalent to converting your gifts from after-tax sources to pre-tax sources – enabling you to keep more of your money (or give more away).
- For those who are well under 70 ½, one strategy that can be of significant benefit is to make a large charitable contribution in a given year with no contributions for several years thereafter. The contribution in the first year (say 2018) can be made into a Donor Advised Fund or Community Foundation and then later distributed in a manner consistent with your past giving strategies to charities of your choice. For example, if you have historically given $500/month to your church, you could make a single contribution of $18,000 to a charitable account and instruct the account to make $500 monthly distributions on your behalf for the next three years. This $18,000 contribution likely will enable you to itemize in the first year and claim the standard deduction in years two and three. It is even better if you have appreciated assets that you can use as the funding mechanism for the charitable account; by donating appreciated assets one can avoid capital gains tax on the imbedded gain. Note there are specific limitations on the amount you can deduct based on your adjusted gross income – for example, cash gifts are limited to 60% of AGI (was 50% in 2017 and prior), 30% for direct gifts of appreciated securities, 30% for cash to certain charitable trusts, and 20% for appreciated stock to certain charitable trusts. This strategy can be even more powerful if you consider making the larger contribution in a year in which your income is high (relative to future years expectations) due to a large bonus, sale of stock or other factors.
- Said differently, regular donors who may be approaching the $24,000 standard deduction threshold may employ a strategy to bundle donations into alternate years. These donors can seek to accelerate or delay gifts into alternate years thereby itemizing in a heavy giving year and taking the standard deduction in the off year (or years). The same logic holds for non-cash contributions such as donations to worthy organizations like Goodwill or Salvation Army.