The Big Tax Code Revision
Major news! The tax code revision is now law. In this blog post I want to review the major changes on individual tax returns. In subsequent posts I’ll cover the changes to business taxation, and then given an opinion on the whole thing. This will of necessity be a long post, so please bear with me.
The new individual provisions mostly take place in 2018, and expire at the end of 2025. The changes to corporate changes are permanent. This has to do with the arcane way bills move through the legislative process in Congress.
The general flow of the form 1040, or the long form, is this:
Income goes on lines 7-22
This is taxable income from wages and business interests, and from investment earnings. Taxable income also includes alimony received, capital gains and losses, IRA and retirement account distributions, rental real estate income, farm income, unemployment compensation, and social security benefits. Yes; social security benefits are taxable; see a special
Adjustments to income go on lines 23-37
These are items that subtract out from otherwise taxable income. The most common: the health savings account deduction, the deductible half of self-employment tax for business owners, retirement plan contributions for the self-employed (SEPs and SIMPLES), the self-employed medical insurance deduction, alimony paid, deductible IRA contributions, and the student loan interest deduction. Subtract these out from taxable income to arrive at AGI, or Adjusted Gross Income, which is found on lines 37 and 38.
Next, Taxes and Credits
In lines 38 – 56 you list taxes owed and credits. You begin with AGI on line 38, and then subtract out either your standard deduction or your itemized deductions on line 40. The taxpayer uses whichever number is the more favorable.
In line 42 the taxpayer subtracts out the personal exemptions. In 2017 this is $4050 per person. The result is the taxable income. In line 45 the alternative minimum tax is calculated. This is an alternate way of calculating tax, designed to increase the tax bill of those with lots of deductions or a high amount of investment income relative to earned income. There are various other credits on lines 46-56.
Calcualate these on lines 57-63, and include self-employment tax for business owners, and the Obamacare penalty for those without health insurance. Line 63 is the total income tax due. From there the taxpayer subtracts out the payments made during the year. These are the amounts withheld from employers and estimated payments made. The result is the amount due or the amount overpaid to be refunded.
What’s Changed Above the Line?
Above the line refers to everything that happens on the front page of the 1040 – adjustments for AGI. Turn the page over, and you’re below the line, making adjustments from AGI.
Line 31. Come 2019 (not 2018), alimony will no longer be deductible by the payer ex-spouse, nor recognized as income by the payee ex-spouse. Currently that is the case. For example, an insurance policy that the ex-wife owns on the ex-husband is paid for by the ex-husband per divorce decree, he can deduct those premiums from his income, and she needs to recognize the premium payments as taxable income – even though she receives no cash flow.
Most commonly used adjustments above the line remain the same. Student loan interest is still deductible on line 33 up to $2500. The capital gains rates remain the same.
What’s Changed Below the Line?
Line 39. The personal exemptions have gone away. There is no longer a $4050 personal exemption subtracted out from taxable income.
Line 40. The taxpayer deducts the amount of the standard deduction or the itemized deductions, whichever is more favorable.
The standard deduction has roughly doubled. It has gone from $6350 to $12,000 for single filers, and $12,700 to $24,000 for joint filers. In many cases the loss of the personal exemption is recouped here in the increase in the standard deduction.
On line 40 the taxpayer chooses to deduct the standard deduction or the itemized deductions. The itemization is accounted for on Schedule A. It used to be that without owning real property, with its mortgage interest and tax deductions, it was difficult to itemize deductions. Now, that is even more so the case.
The flow of Schedule A is this:
- Medical and Dental Expenses
- Taxes You Paid
- Interest You Paid
- Gifts to Charity
- Casualty and Theft Loses
- Miscellaneous Deductions
- Other Miscellaneous Deductions
For itemizing deductions to make sense, then, they need to exceed the amount of the standard deduction.
Here’s what’s changed on Schedule A, section-by-section:
Medical and Dental Expenses
Now deductible once they exceed 7.5% of AGI. This is a very favorable change – currently the threshold is 10% of AGI. Deduct here any out-of-pocket medical expense not covered by insurance, but exclude over-the-counter medications. Include your long-term care premiums are partly deductible here. The strategy is to try to group medical expenses into one calendar year if possible. For example, if you have two children needed braces, try to get them both done in the same year, so this deduction can work for you.
Taxes You Paid
Deductible only up to $10,000. This is a huge change. In Florida we don’t have a state income tax, which goes here. We can do a deduction here for real estate property taxes and an amount for general sales taxes – but now, only up to $10,000. This is a big loss for people in high-tax states, such as the Tri-State NY area, IL, and CA.
Interest You Paid
Two big changes here. On new mortgages, only the amount of interest on the first $750,000 of indebtedness is deductible. Currently interest on the first $1,000,000 of mortgage debt is deductible. Also, the deduction for $100,000 of home equity loans and lines of credit goes away.
Homeowners who sell their house for a gain will still be able to exclude up to $500,000 (or $250,000 for single filers) from capital gains, so long as they’re selling their primary home and have lived there for two of the past five years.
Gifts to charity
The previous limit to deductibility of charitable gifts was 50% of AGI. If a taxpayer exceeded this amount, it could be carried forward for up to five years. In 2018 the deductibility limit has increased to 60% of AGI, with the same 5-year carry forward rule.
Casualty and Theft losses
These are now deductible only if the loss is the result of a federally-declared disaster. Currently such losses are deductible after a $100 subtraction and only to the extent that they are not insured and exceed 10% of AGI.
Miscellaneous itemized deductions
Lines 21-27 include several miscellaneous deductions, which all go away. These deductions are currently subject to a 2% of AGI threshold. For example, if you have a $100,000 AGI, then it is only the next dollar of deductions after $2000 that does you any good, tax-wise. Unfortunately, you used to deduct your investment advisor’s fee here, but no more! Nor can you deduct your tax preparation fees here, nor your unreimbursed employee business expenses.
Back to the 1040
On line 63 you calculate your tax due. This is where major changes – reductions – have occurred. Still seven tax brackets, but the rates changed:
- The 10% bracket remains unchanged. Income up to $9,525 for individuals; up to $19,050 for married filing jointly
- The 15% bracket reduces to 12%. $9,525 to $38,700 single; over $19,050 to $77,400 married
- The 25% bracket reduces to 22%. $38,700 to $82,500 single; over $77,400 to $165,000 married
- The 28% bracket reduces to 24%. $82,500 to $157,500 single; over $165,000 to $315,000 married
- The 33% bracket reduce to 32%. $157,500 to $200,000 single; over $315,000 to $400,000 married
- The 35% bracket remains unchanged. $200,000 to $500,000 single; over $400,000 to $600,000 married
- The 39.6% bracket reduces to 37%. Over $500,000 single; over $600,000 married
Apply Tax Credits
Once the taxes are calculated, the credits are applied. There are two child-related credits, not to be confused: the child tax credit, and the credit for dependent care expenses.
Line 49, the credit for child and dependent care expenses remains unchanged. You can take a credit of 20% of eligible child care expenses for up to $3000 per child, or $6000 for more than one child. The credit, then, maxes out at $1200.
Line 50. The education credits remain the same. These are the American Opportunity Credit and the Lifetime Learning Credit.
Line 52, the child tax credit doubles to $2000 for children under age 17. In order to use the credit your income must be below a certain level, known as the phase-out. These income phase-outs also increase greatly: $200K single, currently only $75K, and $400K married filing jointly; currently $110,000.
The credit is also refundable up to $1400. For example, you’ve completed your tax calculation, and owe $1000 in taxes. You have 3 children under age 17, so your credit is ($2000 * 3) $6000. This results in you owing ($1000 taxes less $6000 credits) -$5000. The IRS will send you a check for not more than $1400. This was Marco Rubio’s big contribution to the tax bill, BTW.
Line 61, the health care individual responsibility as it is euphemistically called. This is the Obamacare penalty assessed if one doesn’t have government approved health insurance. This is repealed come 2019. Better than never, I guess.
Up to this point I’ve covered entries that occur on the form 1040. Here are some other notable changes:
There is a new temporary credit for parents to take a $500 credit for each non-child dependent whom they’re supporting. These could be children over age 16, or an elderly parent or an adult child with a disability.
Estate and gift taxes
Estate and gift tax thresholds double to $11,200.000 single and $22,400,000 married. The estate tax is still with us, but the limit is twice as high as it is now. Clearly only those with substantial taxable estates who’ve done no tax planning will pay this tax. Estate taxes remain largely voluntary, in that there are plenty of tax planning tools which can significantly mitigate or even eliminate the amount of estate tax due.
529 accounts are even more of a deal than they were before! As with a Roth IRA, there’s no taxation of the growth within the account, not is there taxation at distribution from the account to pay qualified educational expenses. These expenses included tuition, room & board, books, and other education-related costs for any post-secondary education in the 50 states. Under the new law, up to $10,000 can be distributed annually to cover the cost of sending a child to a public, private or religious elementary or secondary school. This is major! Although amounts contributed to a 529 account are not deductible, there are no income limits either. Each state sponsors its own 529 plan, and the plan limits annual contributions to roughly the level of costs of the most expensive school in that state. Gift taxes should be kept in mind here.
New pass-through deduction
For the owner of a business pass-through entity, such as S-corporations, LLCs and partnerships, there is a new break. These are pass-through entities in that these owners pay their share of the business’ taxes through their individual tax returns. The new break is a 20% deduction on the amount of the income that passes through. The 20% deduction is prohibited for anyone in a service business — unless their taxable income is less than $315,000 if married ($157,500 if single). Clearly this is big. If the pass-through income was $100,000, now $20,000 of it won’t be taxed. At a 22% marginal rate, that’s a savings of $4400!
There’s a lot to digest here, and the full scope of the changes isn’t yet widely disseminated. We’ll keep you posted, though. Meanwhile, as you prepare your 2017 tax returns, look at the affected line numbers I’ve indicated, and see how your taxes might change.