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New year, new tax code.  Let’s talk about The Tax Cuts and Jobs Act of 2017.

We trust you’ve gotten your fill of opinions and interpretations of this legislation from your news outlet of choice, so we’ll keep this strictly to what the law says and how it will impact you.  Spoiler alert: most individuals and businesses will see at least a temporary reduction in their federal income tax over the next several years due to changes in deductions, credits, and tax rates.

While many aspects of the tax code have changed, your federal income tax is still calculated as follows:

Changes to Deductions

A deduction reduces the amount on which you are taxed.  Its value depends on which tax bracket you are in; if you are in the 10% bracket a $1 deduction is worth $.10, if you are in the 35% bracket, a $1 deduction is worth $.35.

Everyone is given at least one deduction – the standard deduction, which is a fixed dollar amount you subtract from your gross income.  The new law increases the standard deduction to $12,000 per person ($24,000 per couple).  People only itemize when their deductions add up to more than the standard deduction.  In this example, Couple 1 would take the standard deduction; whereas, Couple 2 would itemize.

Popular deductions for mortgage interest and taxes survived the new legislation; however, for people like Couple 1 who will take the standard deduction, these expenses will not provide a tax benefit.  Those who have previously itemized due to high state and real estate taxes are now faced with a $10,000 cap on state, local and real estate tax deductions.  As illustrated in the Couple 2 Revised column, they too would now take the standard deduction.

The shift from itemizing to taking the standard deduction requires a change in thinking for many of us.  We can no longer assume charitable giving or mortgage interest result in an automatic tax break.  They will only help us if our total deductions exceed the $12,000 or $24,000 standard deductions.  Consequently, timing charitable giving and tax payments will be more important than ever.

Other changes to deductions include new limits on home mortgage Interest deductions.  Mortgages taken after December 15, 2017, will qualify for an interest deduction on up to $750,000 of debt (down from $1M).  Taxpayers who refinance older loans can still deduct interest on up to $1M.  Home equity loan interest will only be deductible if it’s used to acquire, build or substantially improve your home.  After 2017, there will be no more home equity deductions for money used for new cars, student loans or any other purpose.  How the IRS plans to track that is anyone’s guess, but you should keep good records of how any home equity borrowing is used going forward.

There is good news for those with high medical expenses in 2017 and 2018, as the threshold for deductibility was reduced from 10% of adjusted gross income to 7.5% for these two years only.  Many will also be happy that the 3% reduction to itemized deductions for high-income taxpayers, the so-called Pease limitation, was repealed.  On the downside, miscellaneous deductions were eliminated entirely, so write-off for professional fees (attorneys, financial advisors, tax preparation) are gone.

One of the most discussed deductions is the new Qualified Business Income (QBI) deduction for pass-through entities (i.e. sole proprietors, independent contractors, partnerships, LLCs, S corporation shareholders).  Such business owners were granted a 20% deduction on their income, effectively making $1 out of every $5 earned free of federal income tax.  There are caps and limitations that apply, the most notable of which is an income phase-out for people in service industries such as law, finance, accounting, health, consulting, arts, athletics or any trade or business where the business is based on the reputation or skill of 1 or more of its employees.  Said individuals will only qualify for the full QBI deduction if their taxable income is less than $157,500 for individuals and $315,000 for married couples.  By $207,500 (or $415,000) the credit is entirely phased out.  It’s expected that nearly all independent contractors will be classified as service businesses for the purposes of this deduction.

Changes to Tax Rates

As noted in Table 1, most of the 7 individual tax rates have been reduced by a few percentage points.  With our progressive tax system, you only move into a higher bracket by filling up the lower brackets first.  It used to take $418,000 of taxable income for a single ($470k for a couple) before they reached the highest bracket.  With the new law, the highest bracket will not kick in until $500k for individuals and $600k for couples.

Capital gains rates remain unchanged at 0%, 15%, and 20% and the 3.8% net investment income tax remains in effect.

While many in Congress wanted to ax the Alternative Minimum Tax (AMT) for individuals, it survived.  Fortunately, the AMT should affect far fewer taxpayers going forward due to changes in the AMT exemption and phaseout amounts.

For C corporations, the top tax rate is now 21% (down from 35%) and the corporate AMT was eliminated altogether.

Changes to Tax Credits

The personal exemption, a $4,050 deduction for each member of your household, was eliminated.  This change disadvantages families with multiple children; to lessen the blow, changes were made to the Child Tax Credit.

Unlike a deduction, which reduces the total amount on which you are taxed, a credit is a dollar-for-dollar reduction in the tax you owe.  The Child Tax Credit was doubled to $2,000 per dependent child under 17 and the phaseout for the credit was changed so that more high-income families will now be able to claim it.  For children up to 23 in college and other dependents such as aging parents, a new $500 credit replaces the personal exemption.

Other Notable Provisions

The home sale exclusion, which excludes capital gains of up to $250,000 per individual ($500k per couple), was not changed in the new law.

Roth conversions will no longer be eligible for recharacterization, meaning you can’t undo a Roth conversion the following year, as you could in the past.

Qualified Tuition Plans, commonly known as 529s, have been modified to allow tax-free distributions of up to $10,000 per year per student for primary and secondary education.  Distributions can be used to pay for expenses for public, private, religious or home schools.

The estate tax remains in effect at 40% of taxable estates; however, the estate tax exemption was doubled to $11.2 million per individual ($22.4M for couples).  The number of estates hit with estate tax was already very limited but will now be even lower.

Future of Tax Law

All the corporate changes in the bill have been made permanent, as is a deceptively minor change to the way tax brackets are increased for inflation.  The new chained-CPI inflation adjustment is likely to result in smaller adjustments to the tax bracket breakpoints, meaning more income will be taxed at higher rates as time goes on.  That could prove especially painful when the individual tax rules sunset and revert to prior law.  Unless a future Congress extends the changes, the lapse of these tax breaks combined with smaller tax bracket adjustments would likely mean higher taxes for individuals starting in 2026.

Believe it or not, I’ve given you the short version of this 1,100-page bill.  Thank the person who recently reminded me that normal people don’t find this as interesting as I do.  For those of you that share my interest, we’d be happy to discuss this further and review it in the context of your individual situation; otherwise, give yourself a pat on the back for making it to the end of this blog!

Wishing you all a happy and rewarding 2018!