One of the most extensive tax code overhauls in decades is now law. Below is a brief outline of some of the major changes you may see on your Form 1040 for 2018 due to this tax reform (remember these changes have almost no impact on your 2017 return):
Income Tax Rates and Brackets:
The number of income tax brackets remains steady at seven, although some income shifted into lower brackets. Click here for a breakdown of the new brackets. Below are a few examples of how the tax reform would impact your 2018 return:
- For example, for a married couple filing jointly with taxable income of $700,000, the total amount of federal tax assessed in 2017 would be $222,430 vs $198,379 under the new brackets. This is a reduction of ~11% (~$24,000).
- For a single tax filer with income of $700,000 the total amount of federal tax assessed in 2017 would be $233,018.85 vs. $224,689.50 under the new brackets. This is a decrease of ~3.5% ($8,329).
However, the change in tax rates only tells part of the story.
Itemized Deduction Changes:
The new tax code eliminates or reduces many itemized deductions. These reforms will drive more taxpayers to take the new higher standard deduction instead of itemizing.
State, local and property tax deductions are capped at $10,000, in the aggregate, for both individual and married filers. For example, a married couple who has $8,000 of state income tax and a property tax bill of $8,000 would only be able to itemize $10,000 of the total $16,000 tax liability. An individual with the exact same tax situation would also be limited to an itemized deduction of $10,000.
The mortgage interest deduction remains but only interest charged on the first $750,000 of home acquisition debt (indebtedness that is incurred in acquiring, constructing, or substantially improving a qualified residence of the taxpayer and which secures the residence) on a primary or secondary residence will qualify going forward. Interest charged on up to $1M of debt obtained before December 15, 2017, will still be deductible. Interest charged on non-acquisition debt will no longer be deductible, and there is no grandfathering for pre-2018 debt, as with the mortgage deduction.
Charitable deductions remain, increased to a maximum of 60% of adjusted gross income for cash contributions. The Casualty and Theft Losses deduction has been repealed (except for losses attributable to a Federal Disaster). The Medical Expense deduction for 2017 and 2018 AGI threshold has been reduced from 10% to 7.5%; it will then revert back to 10% in 2019. Additionally, moving expenses, other than those for members of the Armed Forces, are no longer deductible.
All miscellaneous Itemized deductions, those exceeding 2% of AGI, have been eliminated including unreimbursed job expenses, investment expenses, tax preparation fees, gambling losses, and hobby expenses.
Consider a married couple filing a joint return with the following expenses:
- Joint state income tax bill of $90,000.
- Property tax bill of $64,000.
- Mortgage interest of $10,000.
- Home Equity Line of Credit interest of $3,000.
- Charitable gifts of $13,000.
In 2017 the couple’s itemized deduction would equal $180,000 assuming no offsets due to Pease limitations (a largely esoteric rule limiting itemized deductions, that has been removed as a result of this tax reform) or the Alternative Minimum Tax. For a couple in the 35% marginal rate, their effective rate would be ~27%. Meaning the $180,000 of itemized deductions translates into a reduction of ~$48,600 from their Federal tax bill.
In 2018 the couple’s itemized deduction would be limited to $33,000 ($10k limit on state, local and property tax; $10k of mortgage interest; no HELOC deduction and the full $13k of charitable gifts). Assuming the couple’s marginal rate is still 35% their effective rate will drop to ~24%. The $33,000 of itemized deductions will reduce the couple’s Federal tax bill by ~$7,900.
What the couple could consider doing is lumping their charitable giving into a single tax year by using a Donor Advised Fund. These types of accounts allow a donor to make a charitable donation in a given year but not necessarily distribute those funds to a particular charitable organization until sometime in the future.
The capital gains long-term tax rates remain unchanged at 0%, 15% or 20%. In the past the capital gains rates have simply been based on the ordinary income tax brackets (with those falling in the 10% and 15% brackets taxed at 0% capital gains rate, income in the 25%-35% brackets taxed at 15% capital gains rate, and income in the top 39.6% bracket taxed 20% capital gains rate). Capital gains in 2018 will still follow the 2017 ordinary income brackets outlined above.
Short-term gains remain taxed at the (new) ordinary income rates. The 3.8% net investment income tax remains for joint filers with more than $250,000 of income or individuals with more than $200,000.
Standard Deductions, Personal Exemptions & Child Tax Credits:
The standard deduction increased from $12,700 to $24,000 for a married couple filing a joint return. And from $6,350 to $12,000 for an individual. The $4,050 personal and dependent exemption has been eliminated. Additionally, the child tax credit increased from $1,000 to $2,000 per eligible dependent. The child tax credit begins to phase out for married couples filing jointly when their modified adjusted gross income reaches $400,000 or $200,000 for individuals. This tax reform could result in a significant tax savings for large families earning less than $400,000 or $200,000 per year.
Kiddie Tax Changes:
An interesting, and somewhat under-the-radar change, was the adjustment made to the kiddie tax provision. Historically, children under 19 or full-time students under 24 were taxed at their own tax rates for earned income, whereas any unearned income (e.g., dividends and interest) over $2,100 was taxed at their parents’ marginal tax rate.
The change in the kiddie tax will see unearned income above the first $2,100 taxed according to the new trust tax brackets, which are significantly more compressed than for individuals. Capital gains would still be eligible for the preferential tax rates, however, the threshold to reach the 20% capital gains rate (which kicks in at only $12,500 of income) would be accelerated as a result of the change. See here for details on the numbers.
Under certain circumstances, this could lead to a reduction in taxes attributable to a child’s income. For example, a child’s UGMA account generates $5,250 of unearned income in 2018. Under the new tax reform law, $3,150 dollars (income in excess of $2,100) is taxed according to the new trust tax rates. The first $2,550 at 10% and the remaining $600 at 24%. The tax due would be $399. This is a reduction from the previous structure, where a couple earning $400,000 would see the $3,150 taxed at 33%, with a tax bill of $1,008. This is a reduction of ~60% from 2017 to 2018!
Alimony, an amount paid to a spouse or a former spouse under a divorce of separation instrument, as defined by the IRS, has historically been deductible for the payer spouse, and income for the recipient spouse. Under the new tax bill, alimony would no longer be reportable as income for the recipient, nor would it be deductible for the payer, rendering the payment of alimony a non-taxable event.
It is worthy to note, however, that the effective date for this change only applies to “any divorce or separation instrument executed after December 31, 2018”, or a divorce/separation instrument that was executed prior to December 31st, 2018, yet was modified after this date, and expressly provides that the amendments made apply to such modification.
Many planning opportunities will likely present themselves as we continue to unpack the ramifications of the new tax reform. As with any tax related matter, it is imperative that you review your personal situation with your tax advisor prior to taking any specific action.