Last week, our tax team provided a quick rundown of some of the key changes affecting individual and business taxpayers following the passage of the Tax Cuts and Jobs Act (TCJA). We posted an article for our readers and hosted a webinar for our viewers and listeners. Now, we provide a deeper dive into the TCJA's specific impact on individuals, estate plans and businesses.
IMPACT ON INDIVIDUALS
The TCJA is the most sweeping federal tax legislation in more than three decades, and it includes significant changes for individual taxpayers, most of which take effect for 2018 and expire after 2025. Here are some of the most notable changes.
Under the TCJA, annual inflation adjustments will be calculated using the chained consumer price index (also known as C-CPI-U). This will increase tax bracket thresholds, the standard deduction, certain exemptions and other figures at a slower rate than is the case with the consumer price index currently used, potentially pushing taxpayers into higher tax brackets and making various breaks worth less over time. The law adopts the C-CPI-U on a permanent basis.
The TCJA maintains seven income tax brackets but temporarily adjusts the tax rates as follows:
The top rates, which currently kick in at $418,400 of taxable income for single filers and $470,700 for joint filers, will now take effect at $500,000 and $600,000, respectively. The brackets will continue to be adjusted for inflation.
Personal Exemptions and Standard Deduction
For 2017, taxpayers can claim a personal exemption of $4,050 each for themselves, their spouses and any dependents. If they choose not to itemize deductions, they can also take a standard deduction based on their filing status: $6,350 for singles and separate filers, $9,350 for head of household filers, and $12,700 for married couples filing jointly.
For 2018-2025, the TCJA suspends personal exemptions but roughly doubles the standard deduction amounts to $12,000 for singles and separate filers, $18,000 for heads of households, and $24,000 for joint filers. The standard deduction amounts will be adjusted for inflation beginning in 2019.
For some taxpayers, the increased standard deduction could compensate for the elimination of the exemptions, and perhaps even provide some additional tax savings. But for those with many dependents or who itemize deductions, these changes might result in a higher tax bill — depending in part on the extent to which they can benefit from the family tax credits.
Family Tax Credits
The child credit was the subject of much debate during the reconciliation process, with some senators pushing to expand it more than the original House of Representatives and Senate bills did. In the end, the negotiators opted to double the credit to $2,000 per child under age 17 beginning in 2018. The maximum amount refundable (because a taxpayer's credits exceed his or her tax liability) is limited to $1,400 per child.
The TCJA also makes the child credit available to more families than in the past. Under the new law, the credit doesn't begin to phase out until adjusted gross income exceeds $400,000 for married couples or $200,000 for all other filers, compared with the 2017 phaseouts of $110,000 and $75,000. The phaseout thresholds won't be indexed for inflation, though, meaning the credit will lose value over time.
The TCJA also includes, beginning in 2018, a $500 nonrefundable credit for qualifying dependents other than qualifying children (for example, a taxpayer's 17-year-old child, parent, sibling, niece or nephew, or aunt or uncle).
These provisions all expire after 2025.
State and Local Tax Deduction
The deduction for state income and sales taxes was another bone of contention, with congressional representatives from high-tax states protesting its proposed elimination. The deduction ultimately survived but has been scaled back substantially — and, of course, is available only to those who choose to itemize. With the increased standard deduction, it's expected that fewer taxpayers will do so.
For 2018-2025, taxpayers can claim a deduction of no more than $10,000 for the aggregate of state and local property taxes and either income or sales taxes. Note, though, that the TCJA explicitly forbids taxpayers from claiming an itemized deduction in 2017 for prepayment of state or local income tax for a future year to avoid the dollar limitation applicable for future tax years. It doesn't, however, include such a prohibition against prepayment of property taxes for a future year.
Mortgage Interest Deduction
The TCJA tightens limits on the itemized deduction for home mortgage interest. For 2018-2025, it generally allows a taxpayer to deduct interest only on mortgage debt of up to $750,000. However, the limit remains at $1 million for mortgage debt incurred before December 15, 2017, which will significantly reduce the number of taxpayers affected.
The new law also suspends the deduction for interest on home equity debt: For 2018-2025, taxpayers can't claim deductions for such interest at all, regardless of when the debt was incurred or how it's used.
Additional Deductions, Exclusions and Credits
Here are some other tax breaks that have been affected by the TCJA:
- Medical expense deduction. This itemized deduction lives on and is, in fact, enhanced for two years. The threshold for deducting such unreimbursed expenses is reduced from 10% of adjusted gross income (AGI) to 7.5% for all taxpayers for both regular and alternative minimum tax (AMT) purposes in 2017 and 2018. You may want to bunch eligible expenses into 2018 to the extent possible to maximize your deduction.
- Miscellaneous itemized deductions subject to the 2% floor. This deduction for expenses such as certain professional fees, investment expenses and unreimbursed employee business expenses is suspended for 2018-2025. If you're an employee and work from home, this includes the home office deduction.
- Moving expenses. The deduction for work-related moving expenses is suspended for 2018-2025, except for active-duty members of the Armed Forces (and their spouses or dependents) who move because of a military order that calls for a permanent change of station.
For 2018-2025, the exclusion from gross income and wages for qualified moving expense reimbursements is also suspended, again except for active-duty members of the Armed Forces who move pursuant to a military order.
- Personal casualty and theft loss deduction. For 2018-2025, this deduction is suspended except if the loss was due to an event officially declared a disaster by the president.
- Charitable contributions. For 2018-2025, the limit on the deduction for cash donations to public charities is raised to 60% of AGI from 50%. However, charitable deductions for payments made in exchange for college athletic event seating rights are eliminated. Also keep in mind that you must itemize to benefit from the charitable contributions deduction.
- Alimony payments. Alimony payments won't be deductible — and will be excluded from the recipient's taxable income — for divorce agreements executed (or, in some cases, modified) after December 31, 2018. Because the recipient spouse would typically pay income taxes at a rate lower than the paying spouse, the overall tax bite will likely be larger under this new tax treatment. This change is permanent.
- 529 plan savings plans. 529 plan distributions used to pay qualifying education expenses are generally tax-free. The definition of qualified education expenses has been expanded to include not just postsecondary school expenses but also primary and secondary school expenses. This change is permanent.
Notably, the TCJA leaves untouched many breaks that would have been reduced or eliminated under the original House or Senate bills, such as the:
- Principal residence gain exclusion
- Exclusion for employer-provided adoption assistance
- Lifetime Learning credit
- Deduction for student loan interest
- Deduction for graduate student tuition waivers
Also on the plus side, the law suspends the overall limitation on itemized deductions for 2018-2025.
- AMT and estate tax. The House lost the battle over repeal of the AMT and the estate tax — both continue to apply. But the TCJA makes them applicable to fewer taxpayers than in the past. Beginning in 2018, the new law increases both the AMT exemption amount (to $109,400 for married couples, $70,300 for singles and heads of households, and $54,700 for separate filers) and the AMT exemption phaseout thresholds (to $1 million for married couples and $500,000 for all other taxpayers other than estates and trusts). These amounts will be adjusted for inflation until the provision expires after 2025. Similarly, the TCJA doubles the estate tax exemption to $10 million for 2018-2025. The exemption is adjusted for inflation and is expected to be $11.2 million for 2018. But because the exemption doubling is only temporary, taxpayers with assets in the $5 million to $11 million range (twice that for married couples) will still have to keep estate taxes in mind in their planning.
- Roth conversions. Taxpayers who convert a pretax traditional IRA into a post-tax Roth IRA lose their ability to later "recharacterize" (that is, reverse) the conversion. Those who wish to recharacterize a 2017 Roth conversion must do so by December 31, 2017. Recharacterization is still an option for other contributions, though. For example, an individual can make a contribution to a Roth IRA and subsequently recharacterize it as a contribution to a traditional IRA (before the applicable deadline).
IMPACT ON ESTATE PLANS
For the estates of persons dying, and gifts made, after December 31, 2017, and before January 1, 2026, the gift and estate tax exemption and the GST tax exemption amounts increase to an inflation-adjusted $10 million, or $20 million for married couples with proper planning (expected to be $11.2 million and $22.4 million, respectively, for 2018). Absent further congressional action, the exemptions will revert to their 2017 levels (adjusted for inflation) beginning January 1, 2026. The marginal tax rate for all three taxes remains at 40%.
According to some estimates, the increased exemption amounts will reduce the number of U.S. estates subject to estate tax from approximately 5,000 to around 2,000. But just because the possibility of estate tax liability seems remote for most families, it doesn't mean the end of estate planning as we know it.
For one thing, there are many nontax issues to consider, such as asset protection, guardianship of minor children, family business succession, and planning for loved ones with special needs. Plus, it's not clear how states will respond to the federal tax law changes. If you live in a state that imposes significant state estate taxes, many traditional tax-reduction strategies will continue to be relevant.
It's also important to keep in mind that the exemptions are scheduled to revert to their previous levels in 2026 — and there's no guarantee that a future administration won't reduce the exemption amounts even further. As discussed below, however, the exemption increases planning opportunities that can help you shield your wealth against tax changes down the road.
Record-high exemption amounts, even if temporary, create a rare opportunity to take advantage of strategies for "locking in" those exemptions and permanently avoiding future transfer taxes. These include:
- Lifetime gifts. By using some or all of the increased exemption amount to make additional tax-free lifetime gifts, you can shield that wealth — together with any future appreciation in value — from taxation in your estate, even if smaller exemptions have been reinstated when you die. Keep in mind, though, that lifetime gifts, unlike assets transferred at death, aren't entitled to a stepped-up basis. This can increase income taxes on any gain realized by the recipients should they sell a gifted asset. So, when considering lifetime gifts, it's important to weigh the potential estate tax savings against the potential income tax costs.
- Dynasty trusts. Now may be an ideal time to establish a dynasty trust. These irrevocable trusts allow substantial amounts of wealth to grow and compound free of federal gift, estate and GST taxes, providing tax-free benefits for your grandchildren and future generations. The longevity of a dynasty trust varies from state to state, but it's becoming more common for states to allow these trusts to last for hundreds of years or even in perpetuity. Avoiding the GST tax is critical. An additional 40% tax on transfers to grandchildren or others that skip a generation, the GST tax can quickly consume substantial amounts of wealth. The key to avoiding the tax is to leverage your GST tax exemption, which will be higher than ever starting in 2018. Let's say you haven't yet used any of your gift and estate tax exemption. In 2018, you transfer $10 million to a properly structured dynasty trust. There's no gift tax on the transaction because it's within your unused exemption amount. And the funds, together with all future appreciation, are removed from your taxable estate. Most important, by allocating your GST tax exemption to your trust contributions, you ensure that any future distributions or other transfers of trust assets to your grandchildren or subsequent generations will avoid GST taxes. This is true even if the value of the assets grows well beyond the exemption amount or the exemption is reduced in the future.
The TCJA makes several other changes that may have an impact on estate planning strategies. For example:
- 529 plans. The new law permanently expands the benefits of 529 college savings plans. These plans, which permit tax-free withdrawals for qualified educational expenses, also offer some unique estate planning benefits. Contributions are removed from your estate even though you retain the right to change beneficiaries or get your money back. And you can bunch five years' worth of annual gift tax exclusions into one year. So, for example, in 2018, when the annual exclusion is $15,000, you can contribute $75,000 to a plan ($150,000 for married couples) without triggering gift or GST taxes or using any of your exemptions. Under the TCJA, beginning in 2018, tax-free distributions from 529 plans can be used for elementary and secondary school expenses, not just higher-education expenses, making them even more valuable.
- Child tax. The TCJA also makes an important change to the child tax. One popular estate planning technique is to transfer investments or other income-producing assets to your children to take advantage of their lower tax brackets. The kiddie tax makes this difficult to do. Under pre-TCJA law, it taxes all but a small portion of a child's unearned income at the parents' marginal rate (if higher), defeating the purpose of income shifting. The kiddie tax generally applies to children age 18 or younger, as well as to full-time students age 19 to 23 (with some exceptions). The TCJA makes the kiddie tax even harsher by taxing a child's unearned income according to the tax brackets used for trusts and estates, which are taxed at the highest marginal rate (37% for 2018) once 2018 taxable income reaches $12,500. In contrast with all other filers, for a married couple filing jointly, the highest rate doesn't kick in until their 2018 taxable income tops $600,000. In other words, in many cases, children's unearned income will be taxed at higher rates than their parents' income.
- Charitable planning. The TCJA raises the adjusted gross income limitation for deductions of cash donations to public charities from 50% to 60% from 2018 through 2025. On the other hand, because fewer people will be subject to federal gift and estate taxes, charitable strategies designed to reduce those taxes will be less valuable from a tax-saving perspective.
IMPACT ON BUSINESSES
If your business is buying new assets in 2018, you'll be able to benefit in several ways under the TCJA. You even may be able to take advantage of some of the enhancements on your 2017 tax return.
Under pre-TCJA law, for qualified new assets that your business places in service in 2017, you can claim a 50% first-year bonus depreciation deduction. Used assets don't qualify. This tax break is available for the cost of new computer systems, purchased software, vehicles, machinery, equipment, office furniture and so forth.
In addition, 50% bonus depreciation can be claimed for qualified improvement property, which means any qualified improvement to the interior portion of a nonresidential building if the improvement is placed in service after the date the building is placed in service. But qualified improvement costs don't include expenditures for the enlargement of a building, an elevator or escalator, or the internal structural framework of a building.
Bonus depreciation improves significantly under the TCJA: For qualified property placed in service between September 28, 2017, and December 31, 2022 (or by December 31, 2023, for certain property with longer production periods), the first-year bonus depreciation percentage is increased to 100%. In addition, the 100% deduction is allowed for both new and used qualifying property.
The new law also allows 100% bonus depreciation for qualified film, television and live theatrical productions placed in service on or after September 28, 2017. Productions are considered placed in service at the time of the initial release, broadcast or live commercial performance.
In later years, bonus depreciation is scheduled to be reduced as follows:
- 80% for property placed in service in 2023
- 60% for property placed in service in 2024
- 40% for property placed in service in 2025
- 20% for property placed in service in 2026
Important: For certain property with longer production periods, the preceding reductions are delayed by one year. For example, 80% bonus depreciation will apply to long-production-period property placed in service in 2024.
Section 179 Deduction
When 100% first-year bonus depreciation isn't available, the Sec. 179 tax break can provide similar benefits. Sec. 179 allows eligible taxpayers to deduct the entire cost of qualifying new or used depreciable property and most software in Year 1, subject to various limitations.
Under pre-TCJA law, for tax years that began in 2017, the maximum Sec. 179 depreciation deduction is $510,000. The maximum deduction is phased out dollar for dollar to the extent the cost of eligible property placed in service during the tax year exceeds the phaseout threshold of $2.03 million.
Qualified real property improvement costs are also eligible for the Sec. 179 deduction. This real estate break applies to:
- Certain improvements to interiors of leased nonresidential buildings
- Certain restaurant buildings or improvements to such buildings
- Certain improvements to the interiors of retail buildings
Deductions claimed for qualified real property costs count against the overall maximum for Sec. 179 deductions ($510,000 for tax years that began in 2017).
The TCJA permanently enhances the Sec. 179 deduction. Under the new law, for qualifying property placed in service in tax years beginning in 2018, the maximum Sec. 179 deduction is increased to $1 million, and the phaseout threshold amount is increased to $2.5 million. For later tax years, these amounts will be indexed for inflation. For purposes of determining eligibility for these higher limits, property is treated as acquired on the date on which a written binding contract for the acquisition is signed.
The new law also expands the definition of eligible property to include certain depreciable tangible personal property used predominantly to furnish lodging. The definition of qualified real property eligible for the Sec. 179 deduction is also expanded to include the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems.
Business Passenger Vehicles
For new or used passenger vehicles that are placed in service in 2018 and used over 50% for business, the maximum annual depreciation deductions under the TCJA are as follows:
- $10,000 for Year 1
- $16,000 for Year 2
- $9,600 for Year 3
- $5,760 for Year 4 and thereafter, until the vehicle is fully depreciated
For years after 2018, these amounts will be increased for inflation.
While the Year 1 amount is a little lower than the Year 1 amount under pre-TCJA law, the TCJA allows much faster depreciation overall. For example, the 2017 limits for passenger cars are $11,160 for Year 1 for a new car ($3,160 for a used car). For subsequent years for new and used cars, the limits are $5,100 for Year 2, $3,050 for Year 3, and $1,875 for Year 4 and thereafter. Slightly higher limits apply to light trucks and light vans.
REVIEW YOUR PERSONAL AND BUSINESS TAX PLAN
These and other changes made by the TCJA may have a significant impact on your tax planning strategies. Contact your local Armanino tax advisor to review your tax plan in light of the new tax law to ensure that you're taking full advantage of the opportunities the TCJA creates, and minimizing any downsides that may impact you, your family or your business.
Original article posted on Armanino.com