Major New Tax Law Changes That Affect Individuals
The 2017 tax reform legislation colloquially referred to as the Tax Cuts and Jobs Act (the Act) made some significant changes in the taxation of individuals, and these changes have already begun to generate new planning ideas. While some changes, such as the limits on state and local income tax deductions and mortgage interest deductions, have received a lot of attention, others are equally significant, and not all individuals will be affected in the same way by the changes. As a result, much of the thinking that has been done about how to save taxes will have to be revised. The Act presents opportunities as well as challenges, and any tax planning needs to bear in mind that many of the Act’s provisions will sunset at the end of 2025. This Alert discusses some provisions relating to individuals that are relevant to income and estate planning.
Income Tax Changes
Lowered rates, elimination of personal and dependent exemptions, and increased standard deduction
The individual income tax rates applicable for 2018 and subsequent years through 2025 have been reduced. The maximum rate has been lowered from 39.6% to 37%. The brackets for single and married couples filing jointly are as follows:
This change, coupled with two other significant changes, will result in lower withholding for many people, but not everyone. First, the Act repeals the personal and dependent exemptions, which were $4,150 per person, subject to a phase-out at higher income brackets. While this in theory could represent a tax increase for individuals at lower brackets, the Act also significantly increases the standard deduction. For single filers, the deduction is increased from $6,500 to $12,000, and for married filers from $13,000 to $24,000, almost double. The result is a net win for smaller families whose itemized deductions were already below the standard deduction in past year, but could be a net negative for larger families. For example, a family of four (filing jointly) would have been entitled to personal and dependent exemptions of $16,600 plus a standard deduction of $13,000, totaling $29,600, which is $5,600 more than the standard deduction under the new rules. This is not the end of the analysis, though. In addition to the lower rates discussed above, the child tax credit has been increased, so every family will be affected differently by these changes.
The increase in standard deduction (coupled with other limitations on itemized deductions discussed below, such as the limitation on state and local tax deductions) undoubtedly means that many more people will use the standard deduction, rather than itemizing deductions. There is concern in the charitable giving community that this will adversely affect smaller charitable contributions for which the itemized deduction has always been an incentive, though as discussed below the Act also increased incentives for large-scale charitable giving.
Changes to itemized deductions
The Act made other changes in deductions for individual taxpayers who still want to itemize. The deduction for state and local taxes is limited to $10,000. Taxpayers in states with high state and local income tax rates and/or high property tax rates will find their deductible amount reduced. Affected states already are considering approaches to circumvent this limitation, such as allowing individuals to make charitable contributions to governments in lieu of taxes. Most miscellaneous itemized deductions that were subject to a 2% floor will no longer be available. Among the deductions no longer allowed will be those for tax preparation and investment management. The Act allows an itemized deduction for medical expenses, subject to a 7.5% floor through 2018, after which the floor reverts to the pre-2013 level of 10%. Unlike under prior law, that 7.5% threshold applies to all taxpayers, not just senior citizens, and it applies for alternative minimum tax purposes, as well as regular tax purposes.
Modifications to allowable deductions
The deduction for home mortgage interest has been cut back. Interest on a home equity line of credit will no longer be deductible, and this applies to existing lines. For new mortgages on principal and secondary residences, the interest deduction is limited to the portion of purchase mortgages not exceeding a total of $750,000. Mortgages prior to the new law are not subject to the restriction, and there are some specific rules allowing these grandfathered mortgages to be refinanced, but care must be taken to avoid getting caught in the new restrictions. Charitable contributions to public charities had been limited to 50% of adjusted gross income. That limitation has now been increased to 60%. The charitable deduction for contributions made to obtain athletic seating rights at universities has been repealed. (The cost of the tickets themselves never was deductible as a charitable contribution, though in the right circumstances, under prior law it could have been partially deductible as a business expense).
Deductions for alimony (previously an “above the line” deduction available to even non-itemizers) will be eliminated for payments under orders executed after December 31, 2018. This puts pressure on divorcing spouses to reach a settlement this year if they want to be able to take advantage of the typically lower tax rate of the alimony recipient.
Itemized deductions were previously subject to a reduction as income levels rose. That reduction has been temporarily eliminated.
Increased child tax credit
The child tax credit, which had been $1,000 for each qualified child, has been increased to $2,000. Of that $2,000, $1,400 is refundable. The credit begins to phase out at higher income levels, $200,000 for single taxpayers and $400,000 for married taxpayers.
Alternative Minimum Tax: higher exemption and phase-out
Alternative minimum taxes, which were originally enacted so that wealthy individuals would have some level of taxation despite the use of tax-free investments and high deductions, has changed gradually to “catch” more and more taxpayers. While the AMT was not eliminated under the new law, the exemption has been increased to $70,300 for single taxpayers and $109,400 for married taxpayers. Very importantly, the income level of which those exemptions phase out has been greatly increased. The phase-out now begins at $500,000 for single taxpayers and $1,000,000 for married taxpayers, up from $123,100 and $164,100, respectively.
529 plans usable for K-12 tuition
For individuals who have 529 plans, those plans can now be used for up to $10,000 per student per year for K-12 tuition. This makes 529 plans more valuable in states that allow tax deductions for contributions to them, given the new itemized deduction limitations discussed above. In addition, this change may make it easier for taxpayers, particularly those who funded 529 plans when their children were very young, to use the full balances of those plans.
Overall the changes to individual tax are a “mixed bag.” While the law does limit many tax deductions, numerous tax benefits remain available and some have been expanded. Especially accounting for the elimination of the phase-out of itemized deductions and reduced impact of AMT, many individual taxpayers will have significant income tax planning opportunities under the Act in the near term. In that planning, they should not lose sight of state taxes. While many states will follow federal rules automatically, others are “decoupled” and there may be increasing differences between the federal and state tax computations, and state tax planning may take on increased importance in overall income tax planning. Planners also should take into account that, unless Congress acts, many of these new rules will be gone and the old rules take effect again starting in 2026.
Estate and Gift Tax Changes
The exemption for federal estate and gift taxes has been doubled from a base of $5,000,000 per person to $10,000,000 per person. This number is adjusted for inflation, but the measurement of inflation has been changed by the new law, so the exact amount of the current exemption isn’t known yet, although it surely will be in excess of $11,000,000. This is a dramatic change in the taxation of wealth transfers, and fewer people will be subject to federal estate and gift tax. As with many of the income tax changes, this increase in the exemption will expire at the end of 2025. But, in the meantime, individuals whose aim is to minimize their overall tax liability may need to shift to a greater emphasis on income tax planning.
Here’s an example: When people give away assets, such as stock or land, the recipient of the gift takes the same basis as the giver. If the recipient later sells the asset, capital gains tax liability will be calculated using that original basis. But if an individual dies owning an asset, it takes on a new basis, which is its date of death value. Whatever capital gains were built up have escaped taxation. If individuals no longer have to worry about estate and death taxes, perhaps they should not engage in the lifetime planning to give away assets, but instead hold them until death to save income taxes. And perhaps some planning techniques to minimize estate tax liability that are no longer needed should be reversed or undone, to the extent that’s possible. This is particularly true if estate planning documents determine what beneficiaries get what assets on the basis of exemption amounts. For instance, assume an individual dies with an estate of $10 million. If that person’s will provides that the children get all assets up to the exemption amount and the surviving spouse gets the balance, then under the old exemption amount the $10 million would be split roughly equally between the children, on the one hand, and the surviving spouse, on the other hand. Now, the children would get all of the estate and the surviving spouse would get none.
And yet, if the higher exemption amounts sunset at the end of 2025, how should that deadline be factored into the planning? It is clear that while there are rewards for careful estate and gift/income tax planning under the new law, there is also a need for careful analysis to achieve the best obtainable overall tax results. Finally, while changes to the federal estate and gift tax rules are extensive, it remains important that individuals residing (or owning assets) in states with a state death tax also consider the impact of those state death taxes in their planning.