On Nov. 2, 2017, the House Ways and Means Committee issued H.R. 1 called “Tax Cuts and Jobs Act.” Here are some planning considerations involving the individual tax planning provisions.
Many deductions will be modified or eliminated. The deduction for medical home improvements will be eliminated as part of the medical expense deduction. Any elderly or disabled taxpayers considering or needing home improvements should make these modifications before year end to secure a tax deduction. This is more important than the general media discussions of accelerating deductions that may be eliminated because of the quantum of the costs to modify a home. In many instances, these costs can run from tens to hundreds of thousands of dollars.
- Standard deduction. The standard deduction under current law is $12,700 for married taxpayers filing jointly and $6,350 for single taxpayers. The Act will increase the standard deduction to $24,000 for married taxpayers filing jointly and $12,000 for single taxpayers. While this change will simplify tax compliance for tens of millions of Americans and lower their tax burdens, it will have wide-ranging impact. Industries that have historically relied on deductions to fuel their business models may be adversely affected. Only the specifically identified deductions noted below will remain.
- Exemptions. The personal exemption for a taxpayer, the taxpayer’s spouse, and any dependents would be eliminated.
- Entertainment. Expenses for entertainment won’t be deductible (Act Section 3307).
- Adoption. Adoption expenses are eliminated (Act Section 1406).
- Mortgage interest. Home mortgage interest will continue to be deductible at a reduced level. Under current law, interest incurred on up to $1 million of mortgage debt is deductible, but under the Act that amount will be halved to $500,000. How might this affect the value of clients in the home construction business? Might it enhance the value of clients owning rental apartment buildings? Might it prove more advantageous for trusts to own homes and permit beneficiaries to use them if both mortgage interest and property tax (see below) deductions are reduced substantially? Might there be a means to convert vacation homes into rental properties and thereby transform the deductibility of interest and taxes?
- SALT. State and local income tax would only be deductible to the extent that they were paid in connection with carrying on a trade or business. The reduction in SALTs will have a very disparate and potentially profound impact.
- Property taxes. Real property taxes would continue to be deductible, but only to the extent of $10,000 per year. This could have a significant and costly impact on wealthy taxpayers in high tax states that own multiple homes. What impact might this have on communities with high property taxes? Are there alternative options as noted above to restructure ownership to make taxes deductible?
- Tax preparation. Repeal of deduction for tax preparation expenses. Under the provision, an individual won’t be allowed an itemized deduction for tax preparation expenses. The provision would be effective for tax years beginning after 2017. Under current law, these expenses are miscellaneous itemized deductions only deductible in excess of 2 percent of the adjusted gross income, so few likely got the benefit in any event.
- Medical expenses. Repeal of deduction for medical expenses. While there’s not much time left before year end, taxpayers who might benefit from costly elective surgery not covered by insurance, or those contemplating home modifications who might benefit from making a home accessible in light of medical issues, should all endeavor to plan before year end.
- Employee expenses. Denial of deduction for expenses attributable to the trade or business of being an employee. If this provision of the Act passes, employee/taxpayers should endeavor to take deductions in 2017, or there will be no deduction.
- Retirement plans. Although there had been discussions of restricting 401(k) plans, the Act generally retains the current rules for 401(k) and other retirement plans. The one change in this area is more intended to close a loophole. Taxpayers who’ve converted regular individual retirement accounts to Roth IRAs in 2017, intending to reconsider this conversion after reviewing the level of appreciation or depreciation in the account at year end had better do so before year end. Some taxpayers had converted regular IRAs to Roths and then invested aggressively to benefit from any gains (which are never subject to tax) by leaving them in the Roth, but then retroactively reversing the conversion if they incurred a loss inside the new Roth to avoid income taxes on some or all the converted amount. This strategy will no longer be feasible.
- Investing. Private activity bonds will no longer be able to be issued. The net investment income tax was to have been repealed but now isn’t being repealed. Tax advantages of carried interest don’t appear to have been restricted under the Act. The relative benefits of municipal bonds will be diminished as marginal tax rates for many taxpayers are reduced.
- AMT. The alternative minimum tax is eliminated.
Trust Income Tax Considerations
Trust tax brackets will be $2,550, $9,150 and last $12,500. The inflation adjustment begins after 2018.
The new rules on pass-through entities will raise issues for trusts owning such interests. It’s been common in estate and asset protection planning to create layers of trusts and entities. Now, the characterization of the trustee as a material participant under Internal Revenue Code Section 469, an issue on which there’s scant law and no clarity, may impact the application of the new 25 percent maximum tax on passive returns from flow-through entities.
Charitable contributions will continue to be deductible. But for most taxpayers, the doubling of the standard deduction would appear to mean no incremental tax benefit from donations. For many taxpayers, such as retirees, if they’ll be precluded by the Act from deducting state income taxes, as well as only be afforded a property tax deduction up to $10,000 and limited mortgage interests (which many retirees don’t have), itemized deductions may be unlikely in future years. That is, in fact, an intent of the Act. Many taxpayers won’t be able to itemize deductions after 2017 so it might be advantageous for those affected to contribute to donor-advised funds called DAFs before the end of 2017 and obtain a charitable contribution deduction now. Then, in future years, they can use that DAF to make contributions in later years. The result will be that few people will likely get a charitable contribution deduction after 2017 other than high income earners with substantial deductions in the categories that remain deductible.
- The 50 percent of thr AGI limitation that applies for cash contributions to public charities and private operating foundations would be increased to 60 percent. While this is a positive for very wealthy taxpayers who can afford to gift to such levels, it’s curious why the Act added this provision.
- The provision would retain the five-year carryover period to the extent that the contribution amount exceeds 60 percent of the donor’s AGI.
- The amount deductible per mile driven in service to a charitable organization would be adjustable for inflation.
- Under current law, private foundations are subject to a 2 percent excise tax on NII. However, they may reduce this excise tax rate to 1 percent by making distributions equal to the averages of their distributions from the previous five years plus 1 percent. The Act streamlines the excess tax to a single rate of 1.4 percent. Additionally, the rules providing for a reduction in the excise tax rate from 2 percent to 1 percent would be repealed. The provision would be effective for tax years beginning after 2017.
- Under current law, POFs, which are a form of a PF that may use tax-free donations to fund their own activities rather than make grants to other charities, are exempt from a 30 percent excise tax on certain undistributed earnings that other PFs must pay. Under the Act, an art museum claiming the status of a POF wouldn’t be recognized as such unless it’s open to the public for at least 1,000 hours per year. The provision would be effective for tax years beginning after 2017.
- Under current law, an entity exempt from tax under IRC Section 501(c)(3) is prohibited from “participating in, or intervening in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” This language, known as the “Johnson amendment,” is qualified so that entities described under IRC Section 508(c)(1)(A) wouldn’t fail to be treated as organized and operated exclusively for a religious purpose, assuming the speech is in the ordinary course of the organization’s business and its expenses are de minimus. This provision would be effective for tax years ending after date of enactment.
Education Tax Considerations
The Act makes several changes that effect planning to pay for education costs:
- After 2017, no new contributions could be made to Coverdell education savings accounts.
- The Hope Scholarship Credit will be eliminated, in which case it might be advantageous to pay certain bills before year end.
- The American Opportunity Tax Credit remains intact and is expanded to permit a fifth year of post-secondary education.
- Student loan debt forgiveness won’t be taxable in some situations.
- The qualified expenses that can be paid under a 529 plan will include elementary and high school education of up to $10,000 per year. For those sending their children to private schools, this could be a useful tax advantage. For taxpayers who’ve accumulated larger then needed colleges funds in a 529 plan, that might be a useful outlet.
If the Act becomes law, practitioners who have provisions in durable powers of attorney or revocable trusts permitting gifts to Coverdell accounts might wish to revise their language.
Residential Real Estate
There are a host of adverse changes that will impact residential real estate and vacation homes.
- The mortgage interest deduction will be severely limited. Taxpayers may continue to claim an itemized deduction for interest on acquisition indebtedness. For debt incurred after the effective date of Nov. 2, 2017, the $1 million limitation would be reduced to $500,000. Interest would be deductible only on a taxpayer’s principal residence. Like the current AMT rule, interest on home equity indebtedness incurred after the effective date wouldn’t be deductible. If a mortgage is refinanced prior to Nov. 2, 2017, it would be treated as incurred on the same date that the original debt was incurred for purposes of determining the limitation amount applicable to the refinanced debt.
- The deductibility of property taxes will be capped at a mere $10,000 (Act Section 1303). The aggregate amount of taxes (other than taxes that are paid or accrued in carrying on a trade or business or an activity described in IRC Section 212) considered for any taxable year shall not exceed $10,000 ($5,000 in the case of a married individual filing a separate return). Might this change the calculus as to whether a taxpayer should claim a deduction for a home-based business to secure some portion of the property taxes? Might more taxpayers formalize home-based businesses to address this and other limitations?
- Homeowners will continue to be able to exclude up to $500,000 of gain ($250,000 if single) from the sale of a qualified principal residence. However, to qualify as a principal residence, the homeowner must use the home as a principal residence for five out of eight years instead of the current three out of five. Further, a taxpayer may only use the exclusion once every five years. For homeowners contemplating a sale and meeting the three of five years but not the five of eight years requirement, it may be advantageous to sell the home prior to the end of 2017 if feasible.
- In another blow to the housing industry (and moving and relocation businesses), the deduction for moving expenses is eliminated.
- Deduction for personal casualty losses is eliminated. While this isn’t limited to hurricane, flood, fire, theft and other losses on homes, it’s likely that this change will be felt most acutely by those owning homes.
The larger macro implications of these and other changes on residential real estate are uncertain. For example, for ultra-high-net-worth taxpayers, these changes may be insignificant. For most Americans, they may be irrelevant. But for a large swath of what might be loosely referred to as moderately wealthy or wealthy Americans, these changes could have a substantial and unfair impact on the carrying costs of homes and vacation homes and perhaps undermine the values of those properties at the same time.
The Act eliminates the deduction available for up to 80 percent of the amount paid for the right to purchase athletic tickets. The Act disallows deductions for entertainment expenses. The Act also eliminates tax exemption on bonds used to finance sports stadiums. The term “professional stadium bond” means any bond issued as part of any proceeds used to finance or refinance capital expenditures allocable to a facility (or appurtenant real property) which, during at least five days during any calendar year, is used as a stadium or arena for professional sports exhibitions, games, or training (Act Section 3604).
Might these changes be intended to convey a personal message from the president to the NFL?
The Act includes several changes that could significantly impact matrimonial/divorce agreements. These provisions directly affecting divorce are in addition to the many indirect changes, such as impact on itemized deductions and SALT limits that may have a significant direct impact, positive or negative, on the ex-spouses:
- Alimony payments won’t be deductible by the payor spouse, but also won’t be included in income of the payee ex-spouse (Act Section 1309). This change could significantly impact agreements being negotiated now. The effective date indicates that this new rule will apply to any divorce or separation instrument as defined in IRC Section 71(b)(2) in effect before the date of the enactment of this Act executed after Dec. 31, 2017, and any divorce or separation instrument (as so defined) executed on or before such date and modified after such date if the modification expressly provides that the amendments made by this section apply to such modification. Practitioners should consider adding a provision to any agreement in process that if the law is changed as provided in the Act, the agreement can or must be renegotiated. It might, in some instances, be worth addressing the terms of the agreement with or without the change of the Act. It’s also important that if the Act becomes law, both matrimonial practitioners and accountants should put all divorced clients paying or receiving alimony on notice that they can modify the agreement to bring it under the new law if that proves advantageous for them. Making all prior agreements under prior law able to be modified and brought under the new tax paradigm is anything but simple.
- The Act eliminates the personal exemption for dependents. What becomes of the divorce agreements in which the parties expressly negotiated who would benefit from the exemptions? If the arrangement was to divide, split or alternate each year the exemptions, then perhaps the economic impact is equal between the ex-spouses and simply a tax benefit lost. But what if one spouse negotiated the benefit? Is that a basis to revisit or adjust the agreement?
- As noted above, the qualified expenses under 529 plans will include elementary and high school education of up to $10,000 per year. Will this undermine the intent of existing matrimonial settlement agreements that may have provided funding or confirmed balances in 529 plans for college which might now be dissipated for earlier education expense contrary to the parties’ intent? The governing agreements should be reviewed to ascertain whether the agreement specified college-only expenses be paid from an acknowledged 529 plan and whether that would suffice to restrict the ex-spouse account owner from using funds earlier.