In December 2017, Congress enacted the most far-reaching changes in the federal Tax Code in more than 30 years. Virtually every taxpayer is affected in some way by the sweeping modifications to the federal income, estate and gift taxes. But, who really does and doesn’t benefit from the changes? Let’s examine some possible scenarios.
Charities took heart early in the legislative process as lawmakers pledged to leave the 100-year-old deduction for charitable gifts intact, with no limits. This was good news as proposals had been floated during early phases of tax reform discussions that would have limited the amount and/or value of deductible charitable gifts in various ways.
The charitable deduction, along with mortgage interest and state and local taxes, is historically one of the “big three” when it comes to deductions that are most widely used by individuals.
Fortunately, the charitable deduction is the only one of the “big three” that wasn’t limited—and was actually expanded in some cases—by the final tax legislation.
State and local taxes were limited to $10,000. Mortgage interest was disallowed for home equity loans and limited to interest on mortgages of $750,000 or less (down from $1 million under current law).
In contrast, the amount of charitable gifts that can be deducted each year wasn’t limited and was actually increased to 60 percent of adjusted gross income (AGI) for cash gifts (30 percent of AGI remains the limit for appreciated property).
More good news is the repeal of the Pease limitation, which phased out as much as 80 percent of the benefits of charitable and other itemized deductions for higher income taxpayers under prior law. This repeal serves to negate the impact of lower maximum tax rates on the after-tax cost of charitable gifts and other deductions for high earners.
Another major change in the law designed to simplify tax returns for millions of taxpayers was the doubling of the standard deduction to at least $12,000 for individuals and $24,000 for married individuals.
This change will dramatically reduce the number of taxpayers who will itemize their deductions—including charitable gifts. As a result, many more donors will now have to make their charitable gifts from after-tax income.
One proposed solution intended to ameliorate the impact of tax reform on charitable giving by further limiting those who could benefit from deducting gifts was to return to a concept included in an earlier tax reform in 1981, under which all taxpayers were allowed to exclude all or a portion of charitable gifts from their income if they didn’t otherwise itemize their gifts.
Unfortunately, the so-called “universal charitable deduction” wasn’t included in the final tax reform compromise bill, though it was proposed either as an amendment or a separate bill by legislators in both the House and Senate. There have already been attempts to piggyback this provision on other bills, and it could well become law at some point in the future.
The net effect of the final legislation is to increase the number of non-itemizers from 70 percent of taxpayers under prior law to an estimated 85 percent today. Based on other estimates, individuals who won’t itemize their gifts account for just 23 percent of total charitable giving (based on 2015 returns) and just 40 percent of all giving by individuals.
Many observers predict tax reform should have little impact on charitable giving by lower and middle income individuals. That’s because there’s no reason to believe the donors who didn’t itemize in the past will suddenly discontinue their giving because they still can’t itemize.
In addition, the “new non-itemizers” are, for the most part, individuals who are giving an average of less than $3,000 per year, and it’s believed much of that amount is religious in nature and unlikely to be significantly reduced.
It can also be argued that higher standard deductions will provide new non-itemizers with more discretionary income from which most small charitable gifts are made.
Falling Through the Cracks
Consider this scenario: Cindy and Martin are both over age 65 and comfortably retired. They enjoy an income of over $200,000 per year. Their home is paid for, so they have no mortgage interest deduction. Their state income tax is $12,000, and property taxes are $8,000 per year. They make charitable gifts of $5,000 per year.
Last year, their total deductions of $25,000 substantially exceeded their standard deduction of $15,200, and their charitable gifts were thus fully deductible against a 28 percent marginal tax rate, saving $1,400 in taxes.
This year, their deductions, now limited to $15,000, will be less than their new standard deduction of $26,600 (taxpayers age 65 and older have an additional $1,300 per person added to the standard deduction), and they’ll no longer be able to deduct their charitable gifts.
In their new 24 percent tax bracket, it will require nearly $6,600 in pre-tax income to make the same gifts that required pre-tax income of just $5,000 last year. Keep in mind, however, that they’ll have $11,400 less income subject to tax on account of their higher standard deduction, and they’ll enjoy additional tax savings due to their lower tax rate.
They plan to continue making gifts of the same amount as before, as the gifts were fulfillment of religious affiliation pledges and gifts to class giving programs at their alma maters.
Note the situation would be different if Cindy and Martin were single. That’s because the standard deduction is only $13,600 for single taxpayers over 65, and the $10,000 cap on state taxes applies to both single and married taxpayers. Many more single donors will be able to clear the standard deduction hurdle and itemize their charitable gifts. In this case, some $1,400 of the charitable gifts would be deductible as that’s the amount the total deductions exceed the standard deduction amount.
No Significant Change for Some
Let’s look at another example of Mary and George, a couple who are only slightly affected by tax reform. George is a police captain earning $81,000 per year. Mary is a nursing supervisor and makes $83,000. Their total household income is $164,000. They pay state income tax of $7,900 per year. Their mortgage is $335,000, and they’ll pay interest of $14,964. Their property taxes are $6,300. Their property and income taxes exceed the aggregate limit of $10,000, so they’re capped at that amount.
Their total itemized deductions for 2018 prior to addition of charitable gifts amount to $24,964. Under this example, they would be able to itemize their deductions as their deductions slightly exceed their standard deduction amount of $24,000.
They make total gifts of $7,500 in 2018. Because their fixed deductions already exceed their standard deduction of $24,000, they’re able to fully deduct their charitable gifts, the same as under current law.
The difference is that in 2017, they would have deducted their gifts against a 28 percent rate, saving them $2,100 in taxes. In 2018, their marginal tax rate will be 24 percent. Their tax savings would decrease by $300 to $1,800. They don’t plan to significantly alter their charitable giving plans due to this change.
Had the last-minute change in the law not included the $10,000 additional state and local tax deduction, their total deductions of mortgage interest and charitable gifts would have totaled just $22,464. They would have been among the 95 percent of taxpayers who, under those circumstances, would no longer itemize and, depending on the amount of their gifts, would have to pay tax on all or a portion of the income used to make them.
Similar Impact on Higher Earners
Let’s look at the neutral impact on a couple in the highest income ranges.
Consider the case of Mike, a corporate executive making $750,000 per year, and Barbara, an architect making the same amount. Their household income of $1.5 million was well into the highest marginal tax bracket of 39.6 percent under prior law and will be taxed at the 37 percent maximum rate under the new legislation.
They have a $1.5 million mortgage on their home and pay interest of $67,000, of which $44,000 is currently deductible given the $1 million mortgage limit for interest deductibility. (The maximum mortgage for which interest can be deducted is reduced to $750,000 for mortgages incurred after 2017.) Their state income taxes are $75,000, and their property taxes are $25,000 per year. They also make annual charitable gifts totaling $25,000.
Under prior law, their total deductions were $169,000. They weren’t, however, allowed to deduct this entire amount under prior law because the Pease limitation required them to reduce their total itemized deductions by 3 percent of the amount their income exceeded $313,800, or $35,586.
Under the new law, their deductions will be reduced to $10,000 worth of state and local taxes and their mortgage interest deduction of $44,000. Along with their $25,000 in charitable gifts, they’ll still have total deductions of $79,000. Because the Pease limitation is repealed, they won’t have to reduce this amount.
Their new standard deduction is $24,000. Even without their charitable gifts, the $54,000 in other deductions places them well above that amount.
Note that when the dust settles, they’re still able to fully deduct their $25,000 in charitable gifts, and they won’t have to pay tax on the income required to make their gifts. So, what’s the extent of the damage from tax reform in this case?
Under prior law, they would have paid federal income tax of 39.6 percent on income of $25,000 if they didn’t donate to charity. That means their gift would have saved them $9,900 in taxes, and the after-tax cost of making their gift was $15,100.
Under the new law, their maximum tax rate is 37 percent. If they didn’t make the gift, they would pay $9,250 in tax on the income, and the after-tax cost of the gift rises to $15,750.
Let’s stop and think for a moment. Does anyone really believe this couple will cut the amount of their gift when it takes the same amount of their pre-tax discretionary cash to make the gift, and the after-tax cost of a $25,000 gift increases by only $650?
The Real Winners
There are also instances in which higher income individuals making larger gifts will actually see the cost of their gifts decline under the new law due to the interplay of lower marginal tax rates and the repeal of the Pease limitation.
Take the case of Harvey and Louise. Their AGI is $2 million. They have an outstanding capital gift pledge to a university campaign of $300,000.
In 2009, they decided to “take a flyer” and invested $200,000 in Ford Motor Company stock. It’s now worth $1 million. Their state and federal capital gains tax liability would be over $250,000 if they sell the stock.
The couple decides instead to use $300,000 worth of the stock to satisfy their pledge. By so doing, they will bypass $75,000 in capital gains tax while their charitable deduction will be based on the entire value of the securities. The $300,000 amount is also well within the 30 percent of AGI limit for gifts of appreciated assets.
They’ll itemize their charitable gift deductions, as their mortgage interest and state taxes alone exceed their standard deduction amount. Their accountant surprised them with the news that their federal income tax savings as a result of this gift will actually be greater in 2018 than in the past. How’s that possible?
Keep in mind that their other tax deductions are fixed expenses, and their charitable gifts are deducted “at the margin.” Had they made their gift last year, the Pease limitation would have required them to reduce their charitable deduction by $50,586 (3 percent of the amount their income exceeds the Pease threshold of $318,800).
Their net deduction of $249,414 would have been deducted against the 2017 maximum tax rate of 39.6 percent, saving them some $98,768 in federal taxes.
Because the new tax law repealed the Pease limitation, they’ll be able to take the full $300,000 deduction in 2018. This will be deducted against the 2018 maximum tax rate of 37 percent and yield tax savings of $111,000, which is $12,232, or 12 percent more than what their 2017 savings would have been.
Welcome to the world of tax simplification. The devil is in the details in many cases, but there are actually “angels” in the details for some high income individuals making larger charitable gifts. While only a very small number of donors enjoy incomes at this level, those who reported income of $2 million or more itemized $55 billion in charitable gifts in 2015, some 25 percent of total itemized charitable gifts that year.1
Despite early attempts to limit gifts of real estate to cost basis, the final legislation made no changes in the tax treatment of gifts of appreciated assets. This will be especially important going forward as Baby Boomers will hold a greater percentage of their donatable assets in the form of highly appreciated real estate and business interests. In many cases, the bulk of their marketable securities will be locked up in 401(k)s, 403(b)s, individual retirement accounts and other qualified retirement plans where the securities can’t be directly accessed for charitable purposes.
Gifts of appreciated securities and other qualified property will also be more important than ever for consideration by donors who may no longer be able to fully deduct their charitable gifts.
As described earlier, it may now require more pre-tax income for some donors to make their gifts. If affected donors instead give appreciated assets, they won’t have to use any income to make the gift, and they won’t owe capital gains tax that would be due in the event of a sale.
Reduction or elimination of income tax deductions has no impact on the capital gains tax issues associated with gifts of appreciated property. Regardless of whether a deduction is allowed, there’s no sale of the property and no gain realized. The capital gains tax isn’t due until the charity sells the property, and as the charity is tax-exempt, no one ever pays the capital gains tax.
Direct Gifts from IRAs
The ability for those 70½ or older to make “qualified charitable distributions,” also known as IRA rollover gifts, wasn’t changed by tax reform. It will still be possible for these donors to make tax-free gifts of up to a total of $100,000 per year from their IRAs, which will also qualify as part of their mandatory withdrawal for the year.
When donors give funds directly from an IRA to charity, they’re not required to report the income on their tax returns. This achieves the same result as if they reported the withdrawal, made a gift of the funds and were able to fully deduct their gift. This method of giving will now be more attractive to donors over age 70½ who don’t itemize due to lack of a mortgage and/or sufficient other deductions to make them itemizers.
The IRA rollover will also assume greater importance as the Baby Boomers who will hold a large percentage of their assets in IRA accounts are now moving into their early 70s and qualify for this benefit.
Split-Interest Gifts Win
Finally, the laws governing gifts in the form of charitable remainder trusts, charitable gift annuities, lead trusts and other split-interest gifts weren’t changed under the terms of the 2017 tax legislation.
Whether a donor can use tax deductions associated with such gifts is, however, affected in the same manner as outright gifts of cash and other property.
Other important tax savings associated with such gifts continue unabated.
Still to Come
Next month, I’ll examine the impact of tax reform on gifts through estates and how donors may wish to accelerate such gifts to enjoy current tax benefits. I’ll also examine how split-interest gifts and other gift planning strategies can be used to restore itemizer status to those who’ll otherwise be unable to realize full tax benefits from their gifts.
1. Internal Revenue Service Tax Stats (SOI)—Statistics of Income.