Top Three Changes My Clients Will See in Their 2018 Federal Tax Returns
- Because of the 2018 Tax Cuts and Jobs Act, most of my clients will receive tax cuts due to lower marginal tax rates across brackets, and reforms to AMT (Alternative Minimum Tax)
- Because of the expanded standard deduction, most of my clients will have simpler tax returns (i.e., they will not itemize)
- For the clients who will itemize deductions, they will be subject to new limits for certain itemized deductions (in particular, State and Local Taxes, and mortgage interest)
In my last post, I discussed the difference between tax refunds and tax liability. Today, I will discuss the three main ways in which the 2018 Tax Cuts and Jobs Act (TCJA) has impacted my clients.
How Taxes Are Calculated
Let’s start with an overview of income taxes:
- Add up all sources of income: base salary, bonus, RSU vesting, stock option exercise, etc.
- Reduce your income by taking deductions as allowed by tax law.
- Calculate taxable income.
I’ll illustrate with “Jennifer”, a single filer. Jennifer is a renter who lives in California, a state with high income taxes. Her base salary in 2018 was $163,000. Let’s assume she doesn’t have other income (e.g., no bonuses, no equity compensation).
- Income: Jennifer’s income is $144,000, not $163,000. That’s because the IRS allows Jennifer to exclude her pre-tax 401(k) contributions and health insurance premiums.
- Deductions: she takes the standard deduction. She itemized $10,000 California state income taxes + $500 charitable contributions.
- Taxable income: $132K ($144K – $12K).
Next, I will discuss the three ways TCJA has impacted my clients.
Impact #1: Standard Deduction Instead of Itemizing
- The standard deduction means you reduce income by a fixed amount.
- Alternatively, filers can itemize their deductions. They track certain expenses and subtract them from income.
The standard deduction nearly doubled as a result of TCJA:
Single filers like Jennifer should itemize deductions if the total > $12,000. In this illustration, she can only itemize $10,500: $10,000 CA state income tax + $500 charitable contributions. She’s better off taking the standard deduction of $12,000. Jennifer doesn’t need to dig up $500 receipts as proof of her 2018 charitable gifts. Higher standard deduction –> less time organizing –> simpler tax return.
If Jennifer’s charitable contributions were $3,000 rather than $500, she would be better off itemizing: $13,000 ($10,000 state income tax + $3,000 charitable contributions). Note: this is an example of tax strategy I provide for clients by “bunching” their charitable contributions so that they can itemize.
Impact #2: Caps on Certain Itemized Deductions
There are caps on how much you can deduct for: (1) state and local taxes, and (2) mortgage interest. These caps affect people in high income tax states like California and New York. They also affect homeowners in these states.
Cap #1: $10,000 for State and Local Tax (“SALT”)
Starting with your 2018 tax return, the maximum State and Local Tax deduction is $10,000 ($5,000 a year for married filing separate taxpayers). Previously, there was no limit. In a recent audit, the Treasury Department estimates that this will affect 11 million taxpayers.
There are two components of State and Local Taxes (sometimes referred to as “SALT” in the news):
- Deduction for either: (a) state income taxes, or (b) state sales taxes, whichever is higher.
- Deduction for state/local property taxes.
The state and local tax deduction was the most significant tax break before TCJA. In 2014, for example, 34% of California returns included a deduction for State and Local Taxes. The average deduction was $17,148. This table from the Tax Foundation shows the top 10 counties for State and Local Deductions. These are Bay Area and NYC counties. Not surprisingly, this cap generated a lot of opposition from politicians in high tax “blue” states.
Cap #2: Mortgage Interest
TCJA limits the mortgage interest deduction to the interest from a mortgage that’s up to $750,000. You can borrow more than $750K, which is likely in the Bay Area. But you can only deduct the interest on the first $750K of the mortgage principal. Before TCJA, the limit was $1,000,000.
This lower limit applies to new mortgages taken out after December 15, 2017. The $750K limit also applies to both your primary residence and your second home.
Special note on home equity loans (a.k.a. HELOC, or home equity line of credit). Interest on home equity debt will generally not be deductible. But if you use the HELOC for “acquisition indebtedness”, the interest is fully deductible.
In other words, whether the loan is called a “mortgage” or “HELOC”, what matters is that the loan proceeds were used to acquire, build, or substantially improve the home that’s securing the loan.
Are you a homeowner with an older mortgage? Any mortgages pre-12/15/2017 are grandfathered into the old $1M limit. Refinancing these mortgages will retain the $1,000,000 mortgage limit.
Impact #3: Tax Cuts
Most taxpayers will get a tax cut due to TCJA. It’s easy to lose sight of this after intense news coverage of the caps on itemized deductions (see “Impact #2” above). There are two reasons for the tax cuts: lower tax rates, and AMT affecting far fewer taxpayers.
Tax Cuts Due to Lower Rates
The federal income tax is levied at seven rates; it is a progressive tax, in which the marginal tax rate on income increases for higher levels of income. Each tax bracket shows the tax rate an individual will pay on that particular portion of income; so, reaching higher tax brackets does not mean an individual pays that higher rate on all income, only the income within that particular tax bracket.
Here’s a detailed breakdown of the progressive tax rates:
Progressive tax rates refer to higher tax rates applying to higher income earners. Jennifer is in the 24% federal income tax bracket. This does not mean that she’s paying a flat 24% (in other words, she’s not paying $31,680, or 24%*$132K). Instead, her taxable income is divided into brackets, and each bracket is taxed at gradually increasing rates of tax. The last $49,500 “chunk” of her income is subject to 24% tax. In total, her federal income tax liability is $26K.
If the old tax rates applied, her tax liability would have been $30K. Jennifer received a $4,000 tax cut due to TCJA. I highlighted the tax rates that were higher under the old rules (before TCJA).
Tax Cuts Due to AMT Changes
In 1979, Congress passed laws creating the Alternative Minimum Tax (AMT) to ensure the wealthiest Americans paid income taxes. The AMT requires all taxpayers to calculate their taxes twice: under regular tax rules, and under the stricter AMT rules. You must pay the higher amount owed.
According to the Tax Policy Center, the TCJA reduced the number of taxpayers who pay the AMT from 5 million in 2017 to 200,000 in 2018. Unfortunately, this fix expires after 2025 (which is also true of most of the TCJA’s changes). In 2026, the number of AMT taxpayers will jump to 7.1 million.
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