If you’ve ever been to a magic show, you’re familiar with the phrase, “Now you see it, now you don’t.” This takes on new meaning with the Tax Cuts and Jobs Act signed into law by President Trump on Friday.
Touted by backers as the largest tax cut for individuals and businesses since the Tax Reform Act of 1986, there are several provisions of the new law that partially, or completely, negate what appear at first blush to be potential tax savings. This post discusses several of the more significant “gotchas” that will affect individuals and small business owners.
All changes are effective for years beginning after December 31, 2017 and before January 1, 2026 unless otherwise noted.
Standard Deduction Increased
Under pre-act law, taxpayers can reduce their adjusted gross income (AGI) by the greater of their standard deduction or the total of their allowable itemized deductions. The standard deduction is a fixed amount which increases as follows based on tax filing status:
|Filing Status||Prior 2018||New 2018|
|Head of Household||$9,550||$18,000|
|Married Filing Joint||$13,000||$24,000|
The above increases, which are approximately 85%, are a windfall for taxpayers who currently claim the standard deduction unless they have dependents.
Gotcha: Personal Exemptions Suspended
In addition to the greater of the standard deduction or allowable itemized deductions, taxpayers can currently reduce their AGI by a deduction for personal exemptions. In 2018, the amount was scheduled to be $4,150 for the taxpayer, the taxpayer’s spouse, and each dependent subject to a phaseout for higher income.
Beginning in 2018, the deduction for personal exemptions is suspended. This will partially, or completely, negate any benefit to be derived from the increased standard deduction depending upon number of dependents. The table below shows the new and adjusted standard deduction for each filing status for up to three dependents. The adjusted standard deduction is the applicable standard deduction reduced by previously allowed personal exemptions.
|Adjusted Standard Deduction|
|Standard||Number of Dependents|
|Head of Household||$18,000||$13,850||$9,700||$5,550||$1,400|
|Married Filing Joint||$24,000||$15,700||$11,550||$7,400||$3,250|
The suspension of the deduction for personal exemptions will be offset in many cases by favorable changes to the child tax credit. The credit increases from $1,000 to $2,000 per qualifying child under the age of 17. The income phaseout levels also increase significantly, resulting in more taxpayers qualifying for the credit.
State, Local, and Real Property Tax Deduction Limited
Twelve Republicans in the House of Representatives voted against the tax reform bill. Eleven of them are from three high income tax states: California, New York, and New Jersey. Individuals in these and other states with high state income taxes will be limited in their ability to deduct state, local, and real property taxes.
Whereas the deduction for state, local, and real property taxes is currently unlimited subject to the alternative minimum tax (AMT), the new law establishes a $10,000 ceiling for most taxpayers ($5,000 for married filing separate) on these deductions.
Gotcha: Charitable Deduction Cut for Middle-Income Taxpayers
As discussed in my November 20, 2017 post, middle-income taxpayers who are incentivized by income tax deductions may become less charitably inclined. Many taxpayers who currently itemize deductions will no longer do so as a result of the significant increase in the standard deduction.
While middle-income taxpayers living in states with high state income tax rates will be most affected, anyone who no longer itemizes will lose their deduction for charitable contributions. When they realize this, many individuals will reduce, or potentially eliminate, their donations to charitable organizations.
Gotcha: Mortgage Interest Deduction Dealt a Blow
To the extent that you convert from itemizing your deductions to taking the standard deduction, you will no longer benefit from deducting mortgage interest. Even if you have enough deductions to itemize, two changes to the mortgage interest deduction may make this deduction less attractive.
Beginning in 2018, the interest deduction for home equity loans, which can currently be taken on balances up to $100,000, is suspended. In addition, the current limit on outstanding mortgage indebtedness of $1 million ($500,000 for married filing separate) is reduced to $750,000 ($375,000 for married filing separate) on acquisition indebtedness after December 15, 2017.
Reduced Corporate Tax Rate and New Deduction for Qualified Business Income
Small businesses will potentially realize significant tax savings as a result of two changes introduced by the Tax Cuts and Jobs Act:
- Reduction in the corporate income tax rate from 35% to 21%
- New tax deduction of 20% of “qualified business income” from pass-though activities including Subchapter S corporations, partnerships, and sole proprietorships
Gotcha: 20% Deduction Reduced for High Income and Service Businesses
The 20% of qualified business income deduction is phased out for married filing joint taxpayers with taxable income exceeding $315,000 and $157,500 for all other taxpayers. It’s reduced further for taxpayers with taxable income exceeding $415,000 and $207,500, respectively. There’s an additional decrease for financial, brokerage, health, law, and consulting services whose owners’ taxable income exceeds the foregoing limits.
Gotcha: Excess Business Losses No Longer Allowed in Current Year
Subject to various limitations applicable to different types of business entities that are beyond the scope of this post, most business losses can generally be deducted in the year in which they’re incurred. A notable exception is Subchapter C net operating losses which can either be carried back two years or carried forward for up to 20 years.
Beginning in 2018, business losses for non-corporate taxpayers in excess of $500,000 for married filing joint and $250,000 for all other filing statuses will no longer be allowed as a deduction in the current year. Any excess losses can only be carried forward. Likewise, Subchapter C net operating losses after 2017 will also only be able to be carried forward.
How Will the New Tax Law Affect You?
How will your tax situation be affected by the Tax Cuts and Jobs Act? This post highlights several of the more significant “gotchas” that will partially, or completely, negate what appear at first blush to be potential tax savings. There are several other provisions, most notably decreased tax rates, which will generally reduce your tax liability if the net effect of the various changes results in a reduction in your taxable income.
As always, tax planning is essential. Once tax planning software is released that reflects the tax reform changes, you will be able to calculate your 2018 and future years’ federal income tax liability and plan accordingly.