Summary of the New Tax Law Changes effective in 2018
During 2018, I wrote a brief summary of the new tax law. Since then, there has been much clarifying information issued on the application of the new rules. I’ve updated my summary to reflect this information and added some practical examples. For the sake of brevity, I have not covered every nuance of the new tax law. And now the legal disclosure - this email is merely an educational communication, and nothing in this email can be construed as tax or legal advice.
Beginning in 2018, I’ve expanded my services to include tax and financial planning. Taxes are usually the single largest impediment to the growth of savings, and a good financial strategy should have a solid tax plan supporting it. To accelerate savings growth, I focus on tax-advantaged investments (real estate, qualified savings and retirement accounts, etc.), tailored to your personal situation. If you would like a complimentary introductory discussion about your tax or financial needs with no implied obligations, please contact me by phone or email.
1. Tax rates - The highest individual tax rate was reduced from 39.6% to 37%. The highest corporate tax rate was reduced from 35% to 21%, and the corporate Alternative Minimum Tax ("AMT") was repealed. The individual AMT was not repealed, but the exemption amount was increased, so fewer individuals should be subject to it.
2. Capital gain rates - There are three long-term capital gain tax rates for individuals in 2018 (0, 15, and 20 percent). Capital gains can only result from the sale of a capital asset (stocks, securities, and other capital assets.). To qualify for the long-term capital gain rates, a capital asset must be held for more than one year. In previous years, long-term capital gain rates were determined by an individual’s tax bracket. In 2018, they are determined by an individual’s taxable income, as shown below:
LTCG Tax Joint Single Head of Household
0% $0-$77,200 $0-$38,600 $0-$51,700
15% $77,201-$479,000 $38,600-$425,800 $51,701 - $452,400
20% $479,001 and up $425,801 and up $452,401 and up
For example, Married Filing Joint and Single taxpayers will pay 0% capital gains tax, if their 2018 taxable income is less than $77,200, and $38,600, respectively.
3. Dividends - Qualified dividends received by an individual in 2018 are combined with capital gain income, and taxed at the capital gain rates shown above. Nonqualified dividends are taxable at ordinary income rates. Most dividends issued from U.S. corporations are qualified. Form 1099-DIV received at year end, should indicate whether a dividend is qualified or nonqualified.
4. State and Local taxes - The maximum deduction for property, state, and sales taxes combined is limited to $10,000. The limitation is illustrated by the example below:
State withholding taxes on wages $12,000
Estimated tax payments made during 2018 $10,000
Taxes paid when filing your 2017 Form 540 $ 2,000
Property taxes paid on personal residence $24,000
Personal property taxes $ 2,000
Total deduction before Limitation $50,000
Disallowed deduction $40,000
5. Standard Deduction/Exemptions - The standard deduction almost doubles, but the deduction for personal exemptions has been repealed. This will result in less people itemizing deductions in 2018. The loss of state and local tax deductions discussed in #4 ($40,000), and the loss of personal exemptions ($4,050 per dependent), may result in an individual’s taxes to increase dramatically. For a family of 5, the loss of these two offsets to taxable income would equal $62,500 ($40K + $22.5K). The new tax rates will not be enough to offset this increase to taxable income.
6. Miscellaneous deductions - Miscellaneous deductions reported on Schedule A in 2017 (union dues, job hunting expenses, tax preparation fees, and some investment expenses), have been entirely eliminated. If you have business, real estate, or farming income, some miscellaneous deductions may be deductible on Schedule C, E, or F.
7. Section 529 Plans – The new tax act allows 529 plans to be established for tuition expenses of private, public, and religious schools from kindergarten through 12th grade. However, withdrawals to cover pre-college expenses are limited to $10,000 per year per child. Withdrawals in excess of $10,000 will be subject to a 10% penalty.
8. Mortgage Interest - For mortgages entered into after 12/15/17, taxpayers may only deduct interest on $750,000 of indebtedness ($375,000 for single taxpayers) on “qualified residences”. Qualified residences include your principal residence and a second home. The total indebtedness of each qualified residence must be combined when computing the limitation. Also, the allowable indebtedness of each qualified residence must not exceed the cost of each home. The pre-12/15/17 limit of $1,000,000 ($500,000 for single taxpayers), still apples for older debt.
9. Home Equity loans - It was originally thought that interest on home equity loans would not be deductible under the new law. However, the IRS issued a clarifying ruling in February 2018 that stated that interest on a home equity loan is deductible, if the proceeds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan. Interest on home equity loan proceeds used to pay personal expenses such as credit card debt or buying a new car are not deductible in 2018. The $750,000 limitation mentioned in the preceding paragraph for deductible mortgage interest applies to the combined mortgage and home equity indebtedness.
10. Retirement plans - No changes were made to retirement plans yearly contributions limits. However, the ability to "re-characterize" or undo Roth contributions after the taxpayer's year-end is eliminated.
11. Estate taxes - The estate tax wasn't repealed as previously proposed, but the estate tax exemption was doubled. This a temporary provision (it sunsets in 2025). With the doubling of the estate tax exemption, many taxpayers will no longer be required to pay federal estate tax.
12. Qualified Business Income/Section 199A – The Qualified Business Income deduction is a new deduction in 2018. It is the most complex provision of the new tax law, and interpretations are still being issued by the IRS and other organizations.
Eligible taxpayers may be entitled to a deduction of up to 20% of Qualified Business Income. The key word here is "eligible”. Qualified Business Income (“QBI”) is the net service income from a qualified trade or business within the U.S. It is typically income reported on Schedule C, E, or F, or through a pass-through entity. Pass-through entities are defined as sole proprietorships, partnerships, LLC’s, LLP’s, and S-Corporations. Income earned through a C Corporation, or by an employee receiving W-2 wages for providing services, are not eligible for this deduction. Is this enough complexity for you yet? There’s more to follow.
One of the key limitations is the amount of taxable income earned by the taxpayer. If the taxpayer is married and has taxable income of more than $315,000, or all other taxpayers with taxable income of more than $157,500, the 20% deduction will begin to be phased out. The QBI deduction is entirely phased out for married filed jointly taxpayers with taxable income in excess of $415,000, and all other taxpayers with taxable income in excess of $207,500. For married taxpayers with taxable income less than $315,000, and all others with taxable income less than $157,500, the deduction isn’t subject to the phase-out limitations.
Shown below is a very simplified example of the QBI deduction. It assumes that the taxpayer does not have any capital gains, Real Estate Investment Trust (“REIT”) dividends, or publically traded partnership income, which would affect the calculation of the QBI deduction.
Filing Status: Married Filing Jointly
Taxable income: $300,000 (no taxable income limitation applies)
Qualified Business: Real Estate (actively managed service business)
Qualified Business Income (“QBI”): $100,000
QBI deduction: $20,000 ($100,000 x 20%)
The $20,000 deduction computed above, is an above-the-line deduction. You don’t have to itemize deductions to claim it. There are some planning opportunities available in this area, but the computation is complex and you should not try to work through these issues by yourself. If you think that you may qualify for this deduction, contact a qualified tax professional for assistance.
13. Other observations - In many situations the loss of deductions won’t be offset by the changes in personal tax rates. On the other side, if you qualify for the new 20% QBI deduction, you may end up in a better tax situation. It’s best to evaluate any changes to your 2018 tax year as soon as possible, so that you’re not surprised by a large payment due when filing. With all of the changes under the new tax law, your taxes owed could change dramatically from 2017.