In 2018, changes to individual and corporate income tax rates become effective under the new tax legislation called the Tax Cuts and Jobs Act (TCJA).
Rate changes for individuals. Individuals are subject to income tax on “ordinary income,” such as compensation, and most retirement and interest income, at increasing rates that apply to different ranges of income depending on their filing status (single; married filing jointly, including surviving spouse; married filing separately; and head of household). Currently, those rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
New rates. Beginning with the 2018 tax year and continuing through 2025, there will still be seven tax brackets for individuals, but their percentage rates will change to: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The following tables show the dollar ranges of these new brackets.
Single Individuals’ 2018 Income Tax Rates
|If taxable income is:||The tax is:|
|Not over $9,525||10% of taxable income|
|Over $9,525 but not over $38,700||$952.50 plus 12% of the excess over $9,525|
|Over $38,700 but not over $82,500||$4,453.50 plus 22% of the excess over $38,700|
|Over $82,500 but not over $157,500||$14,089.50 plus 24% of the excess over $82,500|
|Over $157,500 but not over $200,000||$32,089.50 plus 32% of the excess over $157,500|
|Over $200,000 but not over $500,000||$45,689.50 plus 35% of the excess over $200,000|
|Over $500,000||$150,689.50 plus 37% of the excess over $500,000|
Married Filing Jointly and Surviving Spouse 2018 Income Tax Rates
|If taxable income is:||The tax is:|
|Not over $19,050||10% of taxable income|
|Over $19,050 but not over $77,400||$1,905 plus 12% of the excess over $19,050|
|Over $77,400 but not over $165,000||$8,907 plus 22% of the excess over $77,400|
|Over $165,000 but not over $315,000||$28,179 plus 24% of the excess over $165,000|
|Over $315,000 but not over $400,000||$64,179 plus 32% of the excess over $315,000|
|Over $400,000 but not over $600,000||$91,379 plus 35% of the excess over $400,000|
|Over $600,000||$161,379 plus 37% of the excess over $600,000|
Married Filing Separate 2018 Income Tax Rates
|If taxable income is:||The tax is:|
|Not over $9,525||10% of taxable income|
|Over $9,525 but not over $38,700||$952.50 plus 12% of the excess over $9,525|
|Over $38,700 but not over $82,500||$4,453.50 plus 22% of the excess over $38,700|
|Over $82,500 but not over $157,500||$14,089.50 plus 24% of the excess over $82,500|
|Over $157,500 but not over $200,000||$32,089.50 plus 32% of the excess over $157,500|
|Over $200,000 but not over $300,000||$45,689.50 plus 35% of the excess over $200,000|
|Over $300,000||$80,689.50 plus 37% of the excess over $300,000|
Head of Household 2018 Income Tax Rates
|If taxable income is:||The tax is:|
|Not over $13,600||10% of taxable income|
|Over $13,600 but not over $51,800||$1,360 plus 12% of the excess over $13,600|
|Over $51,800 but not over $82,500||$5,944 plus 22% of the excess over $51,800|
|Over $82,500 but not over $157,500||$12,698 plus 24% of the excess over $82,500|
|Over $157,500 but not over $200,000||$30,698 plus 32% of the excess over $157,500|
|Over $200,000 but not over $500,000||$44,298 plus 35% of the excess over $200,000|
|Over $500,000||$149,298 plus 37% of the excess over $500,000|
Bottom line. While these changes will lower rates at many income levels, determining the overall impact on any particular individual or family will depend on a variety of other changes made by the TCJA, including increases in the standard deduction, loss of personal and dependency exemptions, a dollar limit on itemized deductions for state and local taxes, and changes to the child tax credit and the taxation of a child’s unearned income, known as the Kiddie Tax.
Capital gain rates. Three tax brackets currently apply to net capital gains, including certain kinds of dividends, of individuals and other noncorporate taxpayers: 0% for net capital gain that would be taxed at the 10% or 15% rate if it were ordinary income; 15% for gain that would be taxed above 15% and below 39.6% if it were ordinary income, or 20% for gain that would be taxed at the 39.6% ordinary income rate.
The TCJA, generally, keeps the existing rates and breakpoints on net capital gains and qualified dividends. For 2018, the 15% breakpoint is: $77,200 for joint returns and surviving spouses (half this amount for married taxpayers filing separately), $51,700 for heads of household, and $38,600 for other unmarried individuals. The 20% breakpoint is $479,000 for joint returns and surviving spouses (half this amount for married taxpayers filing separately), $452,400 for heads of household, and $425,800 for any other individual (other than an estate or trust).
Important: These new tax rates will not affect your tax on the return you will soon file for 2017, however they will almost immediately affect the amount of your wage withholding and the amount, if any, of estimated tax that you may need to pay.
A related change is that the future annual indexing of the rate brackets (and many other tax amounts) for inflation, which helps to prevent “bracket creep” and the erosion of the value of a variety of deductions and credits due solely to inflation, will be done in a way that understates inflation more than the current method does. While it won’t be very recognizable immediately, over the years this will push some additional income into higher brackets and reduce the value of many tax breaks.
Corporate income tax rate drop. C corporations currently are subject to graduated tax rates of 15% for taxable income up to $50,000, 25% (over $50,000 to $75,000), 34% (over $75,000 to $10,000,000), and 35% (over $10,000,000). Personal service corporations pay tax on their entire taxable income at the rate of 35%. (The benefit of lower rate brackets was phased out at higher income levels.) Beginning with the 2018 tax year, the TCJA makes the corporate tax rate a flat 21%. It also eliminates the corporate alternative minimum tax.
TCJA Repeals Corporate AMT and Temporarily Eases Individual AMT
Beginning in 2018, changes to the Alternative Minimum Tax (AMT) take effect under the TCJA. Before the TCJA, a second tax system called the alternative minimum tax (AMT) applied to both corporate and noncorporate taxpayers. The AMT was designed to reduce a taxpayer’s ability to avoid taxes by using certain deductions and other tax benefit items. The taxpayer’s tax liability for the year was equal to the sum of (i) the regular tax liability, plus (ii) the AMT liability for the year.
A corporation’s tentative minimum tax equalled 20% of the corporation’s “alternative minimum taxable income” (AMTI) in excess of a $40,000 exemption amount, minus the corporation’s AMT foreign tax credit. AMTI was figured by subtracting various AMT adjustments and adding back AMT preferences. The $40,000 exemption amount gradually phased out at a rate of 25% of AMTI above $150,000. “Small” corporations-those whose average annual gross receipts for the prior three years didn’t exceed $7.5 million ($5 million for startups)-were exempt from the AMT. A taxpayer’s net operating loss (NOL) deduction, generally, couldn’t reduce a taxpayer’s AMTI by more than 90% of the AMTI (determined without regard to the NOL deduction). Very complex rules applied to the deductibility of minimum tax credits (MTCs). All-in-all, the AMT was a very complicated system that added greatly to corporate tax compliance chores.
Corporate AMT repeal. The TCJA repealed the AMT on corporations. Conforming changes also simplified dozens of other tax code sections that were related to the corporate AMT. The TCJA also allows corporations to offset regular tax liability by any minimum tax credit they may have for any tax year. And, a corporation’s MTC is refundable for any tax year beginning after 2017 and before 2022 in an amount equal to 50% (100% for tax years beginning in 2021) of the excess MTC for the tax year, over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the corporation’s MTC will be allowed in tax years beginning before 2022.
Temporary easing of individual AMT. The TCJA does not repeal the AMT for individuals, but it does increase its exemption amounts for tax years 2018 through 2025, making it less likely to hit at lower income levels. Before the TCJA, individual AMT exemptions for 2018 (as adjusted for inflation) would have been $86,200 for marrieds filing jointly and surviving spouses; $55,400 for other unmarried individuals; $43,100 for marrieds filing separately. Those exemption amounts would have been reduced by 25% of the amount by which the individual’s AMTI exceeded:
- $164,100 for marrieds filing jointly and surviving spouses (completely phased out at $508,900);
- $123,100 for unmarried individuals (completely phased out at $344,700); and
- $82,050 for marrieds filing separately (completely phased out at $254,450, with an additional add-back to discourage separate filing by marrieds).
Exemption increases and higher phaseouts. The TCJA increases the individual AMT exemption amounts for tax years 2018 through 2025 to $109,400 for marrieds filing jointly and surviving spouses; $70,300 for single filers; and $54,700 for marrieds filing separately. These increased exemption amounts are reduced (not below zero) by 25% of the amount of the taxpayer’s alternative taxable income above $1 million for joint returns and surviving spouses, and $500,000 for other taxpayers except estates and trusts. All of these amounts will be indexed for inflation after 2018 under a new measure of inflation that will result in smaller increases than under the method previously used.
For trusts and estates, the base figure AMT exemption of $22,500, and phase-out threshold of $75,000, remain unchanged.
If you were subject to the individual AMT in the past, you may be able to reduce your wage withholding or pay reduced amounts of estimated taxes going forward due to the exemption increases and higher phaseout levels.
TCJA Greatly Eases Rules for Bonus Depreciation, Code Sec. 179 Expensing and Regular Depreciation
The TCJA has effectively lowered the cost of acquiring capital assets by making substantial changes to the income tax rules for bonus depreciation and other “cost recovery.” There’s a good chance that one or more of these changes will change your tax bill.
Bonus depreciation. Before the TCJA, taxpayers were allowed to deduct 50% of the cost of most new tangible property (other than buildings and some building improvements) and most new computer software in the year placed in service (with adjustment of the regular depreciation deductions allowed in that year and later years). The “50% bonus depreciation” was to be phased down to 40% for property placed in service in calendar year 2018, 40% in 2019 and 0% in 2020 and afterward.
But for property placed in service and acquired after Sept. 27, 2017 (with no written binding contract for acquisition in effect on Sept. 27, 2017), the TCJA raised the 50% rate to 100%. (Appropriately, 100% bonus depreciation is also called “full expensing” or “100% expensing”.)
Additionally, the post-Sept. 27, 2017 property eligible for bonus depreciation can be new or used. Also, certain film, television and live theatrical productions are now eligible.
On the other hand the TCJA repealed the eligibility of “qualified improvement property” (certain improvements to buildings other than residential rental buildings). And the TCJA excluded from bonus depreciation public utility property and property owned by certain vehicle dealerships.
The 2018/2019/2020 phase down (above) does not apply to post-Sept 27, 2017 property. Instead, 100% depreciation is decreased to 80% for property placed in service in calendar year 2023, 60% in 2024, 40% in 2025, 20% in 2026 and 0% in 2027 and afterward.
Code Sec. 179 expensing. Before the TCJA, most smaller taxpayers could immediately deduct the entire cost of section 179 property up to an annual limit of $500,000 adjusted for inflation. For property placed in service in tax years that begin in 2018, the inflation adjusted limit was scheduled to be $520,000. The annual limit was reduced by one dollar for every dollar that the cost of all section 179 property placed in service by the taxpayer during the tax year exceeded a $2 million threshold adjusted for inflation. For property placed in service in tax years that begin in 2018, the threshold was scheduled to be $2,070,000. But for tax years beginning after 2017, the TCJA substitutes as the annual dollar limit $1 million (inflation-adjusted for tax years beginning after 2018) and $2.5 million as the phase down threshold (similarly inflation adjusted).
Before the TCJA, section 179 property included most tangible personal property as well non-customized (“off-the-shelf”) computer software. Generally, the only buildings or other land improvements that qualified were restaurant buildings and certain improvements to leased space, retail space or restaurant space that were treated as section 179 property under an election. The TCJA, for tax years beginning after 2017, eliminated these categories and substituted as an elective category the much broader qualified improvement property category (that is no longer eligible for bonus depreciation, see above). Also, taxpayers can, for buildings other than rental real estate buildings, elect to treat as section 179 property previously ineligible building components that are roofs, heating, ventilation and air conditioning property, fire protection and alarm systems, or security systems.
Additionally, items (for example refrigerators) used in connection with residential buildings (though not the buildings themselves) are eligible to be section 179 property.
Other rules for real property depreciation. If placed in service after 2017, qualified improvement property, in addition to no longer qualifying for bonus depreciation and being newly eligible as section 179 property, has a 15 year depreciation period (rather than the usual 39 year period for non-residential buildings).
Apartment buildings and other residential rental buildings placed in service after 2017 generally continue to be depreciated over a 27.5 period, but should the alternative depreciation system (ADS) apply to a building either under an election or because the building is subject to one of the conditions (for example, tax-exempt financing) that make ADS mandatory, the ADS depreciation period is 30 years instead of the pre-TCJA 40 years.
For tax years beginning after 2017, if a taxpayer in a real property trade or business “elects out” of the TCJA’s limits on business interest deductions, the taxpayer must depreciate all buildings and qualified improvement property under the ADS.
Vehicles. The TCJA triples the annual dollar caps on depreciation (and Code Sec. 179 expensing) of passenger automobiles and small vans and trucks. Also, because of the extension of bonus depreciation, the increase, allowed only to vehicles allowed bonus depreciation, of $8,000 in the otherwise-applicable first year cap is extended through 2026 (with no phase-down).
Computers and peripheral equipment. Under the TCJA, computer or peripheral equipment placed in service after 2017 isn’t treated as “listed property” whether or not used in a business establishment (or home office) and whether or not an employee’s use is for employer convenience. So an item doesn’t have to pass a more-than-50%-qualifed-business-use test to be eligible for Code Sec. 179 expensing and to avoid mandatory use of the ADS.
Farm property. For items placed in service after 2017, the TCJA shortens the depreciation period for most farming equipment and machinery from seven years to five and allows many types of farm property to be depreciated under the 200% (instead of 150%) declining balance method.
If a taxpayer elects to not have a farming business be subject to the TCJA’s limits on business interest deductions, the taxpayer must depreciate under the ADS the business’s buildings and other assets property that have a depreciation period of 10 years or more.
Elective rules that sometimes make it easier for fruit-or-nut-bearing trees and vines to qualify for bonus depreciation continue to apply.
Alternative minimum tax. Property eligible for bonus depreciation continues to be exempt from the unfavorable depreciation adjustments that apply under the AMT. However, the corporate AMT has been repealed; accordingly, the election that corporations could make to give up bonus and other accelerated depreciation for bonus-depreciation-eligible property in exchange for a refund of otherwise-deferred AMT credits was eliminated.
New 20% Deduction for “Qualified Business Income” (“Pass-Through” Income) Under the TCJA
A significant new tax deduction taking effect in 2018 under the new tax law. It should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.
The deduction is 20% of your “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. But it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.
Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here is how the phase-in works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, viz., $415,000.) If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. So, e.g., if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). (For joint filers, the same operation would apply using the $315,000 threshold, and a $100,000 phase-out range.)
Additionally, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000. And if your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. (For joint filers, the same operations would apply using the $315,000 threshold, and a $100,000 phase-out range.)
Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
Obviously, the complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the threshold discussed above.
TCJA Doubles Estate and Gift Tax Exemption to $11.2 Million Per Person
Changes to the estate and gift tax exemption made by the massive Tax Cuts and Jobs Act (TCJA) effective beginning in 2018 will result in many fewer estates being subject to the 40% tax, and larger estates owing less tax.
Before the TCJA, the first $5 million (as adjusted for inflation in years after 2011) of transferred property was exempt from estate and gift tax. For estates of decedents dying and gifts made in 2018, this “basic exclusion amount” as adjusted for inflation would have been $5.6 million, or $11.2 million for a married couple with proper planning and estate administration allowing the unused portion of a deceased spouse’s exclusion to be added to that of the surviving spouse (known as “portability”).
Exclusion doubled. The new law temporarily doubles the amount that can be excluded from these transfer taxes. For decedents dying and gifts made from 2018 through 2025, the TCJA doubles the base estate and gift tax exemption amount from $5 million to $10 million. Indexing for post-2011 inflation, brings this amount to approximately $11.2 million for 2018, and $22.4 million per married couple, with some basic portability techniques.
A related transfer tax called the generation-skipping transfer (GST) tax is designed to prevent avoidance of estate and gift taxes by skipping transfers to the next successive generation. The TCJA doesn’t specifically mention generation-skipping transfers, but since the GST exemption amount is based on the basic exclusion amount, generation-skipping transfers will also benefit from the post-2017 increased exclusion.
This increased exclusion amount may have an impact on your current estate plan and cause you to consider the need to redraft some important documents, including wills and trusts.
Overview of Provisions of the TCJA Affecting Individuals
The recently enacted Tax Cuts and Jobs Act (TCJA) is a sweeping tax package. Here is a look at some of the more important elements of the new law that have an impact on individuals. Unless otherwise noted, the changes are effective for tax years beginning in 2018 through 2025.
- Tax rates. The new law imposes a new tax rate structure with seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The top rate was reduced from 39.6% to 37% and applies to taxable income above $500,000 for single taxpayers, and $600,000 for married couples filing jointly. The rates applicable to net capital gains and qualified dividends were not changed. The “kiddie tax” rules were simplified. The net unearned income of a child subject to the rules will be taxed at the capital gain and ordinary income rates that apply to trusts and estates. Thus, the child’s tax is unaffected by the parent’s tax situation or the unearned income of any siblings.
- Standard deduction. The new law increases the standard deduction to $24,000 for joint filers, $18,000 for heads of household, and $12,000 for singles and married taxpayers filing separately. Given these increases, many taxpayers will no longer be itemizing deductions. These figures will be indexed for inflation after 2018.
- Exemptions. The new law suspends the deduction for personal exemptions. Thus, starting in 2018, taxpayers can no longer claim personal or dependency exemptions. The rules for withholding income tax on wages will be adjusted to reflect this change, but IRS was given the discretion to leave the withholding unchanged for 2018.
- New deduction for “qualified business income.” Starting in 2018, taxpayers are allowed a deduction equal to 20 percent of “qualified business income,” otherwise known as “pass-through” income, i.e., income from partnerships, S corporations, LLCs, and sole proprietorships. The income must be from a trade or business within the U.S. Investment income does not qualify, nor do amounts received from an S corporation as reasonable compensation or from a partnership as a guaranteed payment for services provided to the trade or business. The deduction is not used in computing adjusted gross income, just taxable income. For taxpayers with taxable income above $157,500 ($315,000 for joint filers), (1) a limitation based on W-2 wages paid by the business and depreciable tangible property used in the business is phased in, and (2) income from the following trades or businesses is phased out of qualified business income: health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
- Child and family tax credit. The new law increases the credit for qualifying children (i.e., children under 17) to $2,000 from $1,000, and increases to $1,400 the refundable portion of the credit. It also introduces a new (nonrefundable) $500 credit for a taxpayer’s dependents who are not qualifying children. The adjusted gross income level at which the credits begin to be phased out has been increased to $200,000 ($400,000 for joint filers).
- State and local taxes. The itemized deduction for state and local income and property taxes is limited to a total of $10,000 starting in 2018.
- Mortgage interest. Under the new law, mortgage interest on loans used to acquire a principal residence and a second home is only deductible on debt up to $750,000 (down from $1 million), starting with loans taken out in 2018. And there is no longer any deduction for interest on home equity loans, regardless of when the debt was incurred.
- Miscellaneous itemized deductions. There is no longer a deduction for miscellaneous itemized deductions which were formerly deductible to the extent they exceeded 2 percent of adjusted gross income. This category included items such as tax preparation costs, investment expenses, union dues, and unreimbursed employee expenses.
- Medical expenses. Under the new law, for 2017 and 2018, medical expenses are deductible to the extent they exceed 7.5 percent of adjusted gross income for all taxpayers. Previously, the AGI “floor” was 10% for most taxpayers.
- Casualty and theft losses. The itemized deduction for casualty and theft losses has been suspended except for losses incurred in a federally declared disaster.
- Overall limitation on itemized deductions. The new law suspends the overall limitation on itemized deductions that formerly applied to taxpayers whose adjusted gross income exceeded specified thresholds. The itemized deductions of such taxpayers were reduced by 3% of the amount by which AGI exceeded the applicable threshold, but the reduction could not exceed 80% of the total itemized deductions, and certain items were exempt from the limitation.
- Moving expenses. The deduction for job-related moving expenses has been eliminated, except for certain military personnel. The exclusion for moving expense reimbursements has also been suspended.
- Alimony. For post-2018 divorce decrees and separation agreements, alimony will not be deductible by the paying spouse and will not be taxable to the receiving spouse.
- Health care “individual mandate.” Starting in 2019, there is no longer a penalty for individuals who fail to obtain minimum essential health coverage.
- Estate and gift tax exemption. Effective for decedents dying, and gifts made, in 2018, the estate and gift tax exemption has been increased to roughly $11.2 million ($22.4 million for married couples).
- Alternative minimum tax (AMT) exemption. The AMT has been retained for individuals by the new law but the exemption has been increased to $109,400 for joint filers ($54,700 for married taxpayers filing separately), and $70,300 for unmarried taxpayers. The exemption is phased out for taxpayers with alternative minimum taxable income over $1 million for joint filers, and over $500,000 for all others.
TCJA Puts $10,000 Aggregate Limit on State and Local Tax Deduction
New limit placed on individuals’ itemized deductions of various kinds of nonbusiness taxes, which was made by the massive Tax Cuts and Jobs Act (TCJA), effective beginning with the 2018 tax year.
Before the changes were effective, individuals were permitted to claim the following types of taxes as itemized deductions, even if they were not business related:
- state, local, and foreign real property taxes;
- state and local personal property taxes; and
- state, local, and foreign income, war profits, and excess profits taxes.
Taxpayers could elect to deduct state and local general sales taxes in lieu of the itemized deduction for state and local income taxes.
Tax deduction cuts. For tax years 2018 through 2025, TCJA limits deductions for taxes paid by individual taxpayers in the following ways:
- It limits the aggregate deduction for state and local real property taxes; state and local personal property taxes; state and local, and foreign, income, war profits, and excess profits taxes; and general sales taxes (if elected) for any tax year to $10,000 ($5,000 for marrieds filing separately). Important exception: The $10,000 limit doesn’t apply to: (i) foreign income, war profits, excess profits taxes; (ii) state and local, and foreign, real property taxes; and (iii) state and local personal property taxes if those taxes are paid or accrued in carrying on a trade or business or in an activity engaged in for the production of income.
- It completely eliminates the deduction for foreign real property taxes unless they are paid or accrued in carrying on a trade or business or in an activity engaged in for profit.
To prevent avoidance of the $10,000 deduction limit by prepayment in 2017 of future taxes, the TCJA treats any amount paid in 2017 for a state or local income tax imposed for a tax year beginning in 2018 as paid on the last day of the 2018 tax year. So an individual may not claim an itemized deduction in 2017 on a pre-payment of income tax for a future tax year in order to avoid the $10,000 aggregate limitation.
TCJA Lowers Maximum Debt on Which Home Mortgage Interest is Deductible and Eliminates Deduction For Home Equity Loan Interest
Changes in the rules for deducting qualified residential interest, i.e., interest on your home mortgage, under the Tax Cuts and Jobs Act (TCJA).
Under the pre-Act rules, you could deduct interest on up to a total of $1 million of mortgage debt used to acquire your principal residence and a second home, i.e., acquisition debt. For a married taxpayer filing separately, the limit was $500,000. You could also deduct interest on home equity debt, i.e., debt secured by the qualifying homes. Qualifying home equity debt was limited to the lesser of $100,000 ($50,000 for a married taxpayer filing separately), or the taxpayer’s equity in the home or homes (the excess of the value of the home over the acquisition debt). The funds obtained via a home equity loan did not have to be used to acquire or improve the homes. So you could use home equity debt to pay for education, travel, health care, etc.
Under the TCJA, starting in 2018, the limit on qualifying acquisition debt is reduced to $750,000 ($375,000 for a married taxpayer filing separately). However, for acquisition debt incurred before Dec. 15, 2017, the higher pre-Act limit applies. The higher pre-Act limit also applies to debt arising from refinancing pre-Dec. 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount. This means you can refinance up to $1 million of pre-Dec. 15, 2017 acquisition debt in the future and not be subject to the reduced limitation.
Starting in 2018, there is no longer a deduction for interest on home equity debt. This applies regardless of when the home equity debt was incurred. Accordingly, if you are considering incurring home equity debt in the future, you should take this factor into consideration. And if you currently have outstanding home equity debt, be prepared to lose the interest deduction for it, starting in 2018. (You will still be able to deduct it on your 2017 tax return, filed in 2018.)
Lastly, both of these changes last for eight years, through 2025. In 2026, the pre-Act rules come back into effect. Therefore, beginning in 2026, interest on home equity loans will be deductible again, and the limit on qualifying acquisition debt will be raised back to $1 million ($500,000 for married separate filers).
TCJA Limits Like-Kind Exchange Nonrecognition Rules to Real Estate
One of the changes made by the recently enacted Tax Cuts and Jobs Act (TCJA) that relates to like-kind exchanges.
In a like-kind exchange, a taxpayer doesn’t recognize gain or loss on an exchange of like-kind properties if both the relinquished property and the replacement property are held for productive use in a trade or business or for investment purposes. For exchanges completed after Dec. 31, 2017, the TCJA limits tax-free exchanges to exchanges of real property that is not held primarily for sale (real property limitation). Thus, exchanges of personal property and intangible property can’t qualify as tax-free like-kind exchanges.
Although the real property limitation applies to exchanges completed after Dec. 31, 2017, transition rules provide relief for certain exchanges. Specifically, the real property limitation does not apply to an exchange if the relinquished property is disposed before Jan. 1, 2018, or the replacement property is received by the taxpayer before Jan. 1, 2018. If the transition rules apply and all other requirements for a tax-free exchange are satisfied, an exchange of personal property or intangible property that is completed after Dec. 31, 2017 can qualify as a tax-free like-kind exchange.
TCJA Business Credit Changes Include A New Employer Credit For Paid Family and Medical Leave
The Tax Cuts and Jobs Act makes changes to the general business credit by adding a new component credit for paid family and medical leave, and changing two current component credits, i.e., the rehabilitation credit and the orphan drug credit.
First, the Act introduces a new component credit for paid family and medical leave, i.e. the paid family and medical leave credit, which is available to eligible employers for wages paid to qualifying employees on family and medical leave. The credit is available as long as the amount paid to employees on leave is at least 50% of their normal wages and the leave payments are made in employer tax years beginning in 2018 and 2019. That is, under the Act, the new credit is temporary and won’t be available for employer tax years beginning in 2020 or later unless Congress extends it further.
For leave payments of 50% of normal wage payments, the credit amount is 12.5% of wages paid on leave. If the leave payment is more than 50% of normal wages, then the credit is raised by .25% for each 1% by which the rate is more than 50% of normal wages. So, if the leave payment rate is 100% of the normal rate, i.e. is equal to the normal rate, then the credit is raised to 25% of the on leave payment rate. The maximum leave allowed for any employee for any tax year is 12 weeks.
Eligible employers are those with a written policy in place allowing (1) qualifying full-time employees at least two weeks of paid family and medical leave a year, and (2) less than full-time employees a pro-rated amount of leave. On that note, qualifying employees are those who have (1) been employed by the employer for one year or more, and (2) who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.
Second, the Act changes the rehabilitation credit for qualified rehabilitation expenditures paid or incurred starting in 2018, by eliminating the 10% credit for expenditures for qualified rehabilitation buildings placed in service before 1936, and retaining the 20% credit for expenditures for certified historic structures, but reducing its value by requiring taxpayers to take the credit ratably over five years starting with the date the structure is placed in service. Formerly, a taxpayer could take the entire credit in the year the structure was placed in service. The Act also provides for a transition rule for buildings owned or leased at all times on and after Jan. 1, 2018.
Third, the Act also makes significant changes to another component credit of the general business credit, i.e., the orphan drug credit for clinical testing expenses for certain drugs for rare diseases or conditions. For clinical testing expense amounts paid or incurred in tax years beginning in 2018, the former 50% credit is cut in half to 25%. Taxpayers that claim the full credit have to reduce the amount of any otherwise allowable deduction for the expenses regardless of limitations under the general business credit. Similarly, taxpayers that capitalize, rather than deduct, their expenses have to reduce the amount charged to a capital account. The credit has been reduced and now equals 25 percent of qualifying clinical testing expenses. However, the Act gives taxpayers the option of taking a reduced orphan drug credit that if elected allows taxpayers to avoid reducing otherwise allowable deductions or charges to their capital account. The election for the reduced credit for any tax year must be made on a tax return no later than the time for filing the return for that year (including extensions) and in a manner prescribed by IRS. Once the reduced credit election is made, it is irrevocable.
TCJA Doubles The Child Tax Credit And Allows A New Lower Credit For Other Dependents
The Tax Cuts and Jobs Act (the “Act”) made changes to the child tax credit, i.e., the credit available for taxpayers with children under the age of 17 (“qualifying children”), and created a new credit for other dependents.
Under pre-Act law, the child tax credit was $1,000 per qualifying child, but it was reduced for married couples filing jointly by $50 for every $1,000 (or part of a $1,000) by which their adjusted gross income (AGI) exceeded $110,000. (The threshold was $55,000 for married couples filing separately, and $75,000 for unmarried taxpayers.) To the extent the $1,000-per-child credit exceeded your tax liability, it resulted in a refund up to 15% of your earned income (e.g., wages, or net self-employment income) above $3,000. For taxpayers with three or more qualifying children, the excess of the taxpayer’s social security taxes for the year over the taxpayer’s earned income credit for the year was refundable. In all cases the refund was limited to $1,000 per qualifying child.
Starting in 2018, the TCJA doubles the child tax credit to $2,000 per qualifying child under 17. It also allows a new $500 credit (per dependent) for any of your dependents who are not qualifying children under 17. There is no age limit for the $500 credit, but the tax tests for dependency must be met. Under the Act, the refundable portion of the credit is increased to a maximum of $1,400 per qualifying child. In addition, the earned threshold is decreased to $2,500 (from $3,000 under pre-Act law), which has the potential to result in a larger refund. The $500 credit for dependents other than qualifying children is nonrefundable.
The Act also substantially increases the “phase-out” thresholds for the credit. Starting in 2018, the total credit amount allowed to a married couple filing jointly is reduced by $50 for every $1,000 (or part of a $1,000) by which their AGI exceeds $400,000 (up from the pre-Act threshold of $110,000). The threshold is $200,000 for all other taxpayers. So, if you were previously prohibited from taking the credit because your AGI was too high, you may now be eligible to claim the credit.
In order to claim the credit for a qualifying child, you must include that child’s Social Security number (SSN) on your tax return. Under pre-Act law you could also use an individual taxpayer identification number (ITIN) or adoption taxpayer identification number (ATIN). If a qualifying child does not have an SSN, you will not be able to claim the $2,000 credit, but you can claim the $500 credit for that child using an ITIN or an ATIN. The SSN requirement does not apply for non-qualifying-child dependents, but you must provide an ITIN or ATIN for each dependent for whom you are claiming a $500 credit. The changes made by the Act should make these credits more valuable and more widely available to many taxpayers.
TCJA Allows $10,000 Per Year Of 529 Plan Account Funds To Be Used For Elementary or Secondary School Tuition
The TCJA has made some changes to qualified tuition programs (“QTPs,” also commonly known as “529 plans”) that you might be interested in. These changes take effect for 529 plan distributions after 2017.
As you know, a 529 plan distribution is tax-free if it is used to pay “qualified higher education expenses” of the beneficiary (student). Before the TCJA made these changes, tuition for elementary or secondary schools wasn’t a “qualified higher education expense,” so students/529 beneficiaries who had to pay it couldn’t receive tax-free 529 plan distributions.
The TCJA provides that qualified higher education expenses now include expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school. Thus, tax-free distributions from 529 plans can now be received by beneficiaries who pay these expenses, effective for distributions from 529 plans after 2017.
There is a limit to how much of a distribution can be taken from a 529 plan for these expenses. The amount of cash distributions from all 529 plans per single beneficiary during any tax year cannot, when combined, include more than $10,000 for elementary school and secondary school tuition incurred during the tax year.
Overview Of The Retirement Plan Changes In The TCJA
Here is a look at some of the more important changes in the TCJA that affect retirement plans. Except with regard to the disaster-related provisions (which contain special effective dates), the changes are effective for tax years beginning in 2018.
- Recharacterization of IRA contributions. An individual who makes a contribution to a regular or Roth IRA can recharacterize it as made to the other type of IRA via a trustee-to-trustee transfer before the due date of the return for the contribution year. Under the new law, however, once a contribution to a regular IRA has been converted into a contribution to a Roth IRA, it can no longer be converted back into a contribution to a regular IRA, i.e., a recharacterization cannot be used to “unwind” a Roth conversion.
- Extended rollover period for plan loan offset amounts. If an employee’s loan from his qualified retirement plan, Code Sec. 403(b) plan, or Code Sec. 457(b) plan is treated as distributed from the plan due to the plan’s termination or the employee’s failure to meet the repayment terms due to his separation from service, the employee may roll over the deemed distribution to an eligible retirement plan. The new law allows the rollover to be made any time up to the due date (including extensions) of the employee’s tax return for the year of the deemed distribution. Pre-Act law allowed the employee only 60 days from the date of the distribution.
- Length of service awards to public safety volunteers. Under pre-Act law, a plan that only provides length of service awards to bona fide volunteers or their beneficiaries for qualified services performed, is not treated as a deferred compensation plan for Code Sec. 457 purposes. Qualified services are fire fighting and prevention services, emergency medical services, and ambulance services, including services performed by dispatchers, mechanics, ambulance drivers, and certified instructors. The new law increases the limit on the aggregate amount of length of service awards that can accrue in a year of service for a bona fide volunteer from $3,000 to $6,000, to be adjusted annually for inflation. For a defined benefit plan, the limit applies to the actuarial present value of the aggregate amount of awards accruing for any year of service.
- Qualified disaster distributions taxable over three-year period. Under the new law, a “qualified 2016 disaster distribution” will be included in a taxpayer’s gross income ratably over a three-year period starting with the year it is received, unless the taxpayer elects to have the distribution fully taxed in the year it is received. A “qualified 2016 disaster distribution” is a distribution received from an “eligible retirement plan” in 2016 or 2017 by an individual whose place of abode was in a Presidentially declared disaster area at any time during 2016, and who sustained an economic loss from the disaster. An eligible plan is an IRA, individual retirement annuity, qualified plan, Code Sec. 403(a) qualified annuity plan, Code Sec. 403(d) plan, governmental Code Sec. 457(b) plan, or Code Sec. 403(b) annuity contract. There is a $100,000 aggregate limit on qualifying distributions for these purposes.
- Qualified 2016 disaster distributions not subject to 10% early withdrawal penalty. In general, unless an exception applies, withdrawals from qualified plans and IRAs before age 59 and a half are subject to a 10% penalty in addition to regular taxation. Under the new law, a “qualified 2016 disaster distribution,” defined above, will not be subject to the 10% penalty on early withdrawals from qualified plans and IRAs.
- Three-year period to recontribute qualified 2016 disaster distributions. In general, eligible distributions from qualified plans and IRAs can be rolled over into eligible plans within 60 days to avoid being taxed. Under the law new, qualified 2016 disaster distributions, defined above, can be recontributed to a qualified plan or IRA in which the taxpayer is a beneficiary up to three years beginning the day after the date of distribution and avoid taxation. A recontribution is treated as a direct trustee-to-trustee rollover.
- Period to amend qualified plans and IRAs for new law changes extended. Under the new law, a qualified plan or IRA can be amended for new law changes retroactively any time up to the last day of the first plan year beginning after 2017 without losing its qualified status for actions taken in compliance with the law changes. Thus, e.g., a qualified plan can make a qualified 2016 disaster distribution in 2017 without first amending the plan to allow such a distribution, as long as the amendment is made retroactively before the end of the extension period. For governmental plans, the amendment may be made up to the last day of the first plan year beginning after 2019.
Overview of Provisions in the TCJA on Partnerships, S Corporations, and Pass-Through Income
Here is a look at some of the more important elements of the new tax law that have an impact on partnerships, S corporations, and pass-through income. In general, they are effective starting in 2018.
- New deduction for pass-through income. The new law provides a 20% deduction for “qualified business income,” defined as income from a trade or business conducted within the U.S. by a partnership, S corporation, or sole proprietorship. Investment items, reasonable compensation paid by an S corporation, and guaranteed payments from a partnership are excluded. The deduction reduces taxable income but not adjusted gross income. For taxpayers with taxable income above $157,500 ($315,000 for joint filers), (1) a limitation based on W-2 wages paid by the business and the basis of acquired depreciable tangible property used in the business is phased in, and (2) the deduction is phased out for income from certain service related trades or businesses, such as health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
- S corporation conversion to C corporation. Under the new law, on the date of its enactment, any Code Section 481(a) adjustment of an “eligible terminated S corporation” attributable to the revocation of its S corporation election (i.e, a change from the cash method to the accrual method) is taken into account ratably during the 6-tax-year period starting with the year of change. An “eligible terminated S corporation” is any regular (C) corporation which meets the following tests: (1) it was an S corporation the day before the enactment of the new law, (2) during the 2-year period beginning on the date of enactment it revokes its S corporation election, and (3) all of the owners on the date the election is revoked are the same owners (in identical proportions) as the owners on the date of enactment. If money is distributed by the eligible corporation after the post-termination transition period, the distribution will be allocated between the accumulated adjustment account and the accumulated earnings and profits, in the same ratio as the amount in the accumulated adjustments account bears to the amount of the accumulated earnings and profits.
- Partnership “technical termination” rule repealed. Before the new law, partnerships experienced a “technical termination” if, within any 12-month period, there was a sale or exchange of at least 50% of the total interest in partnership capital and profits. This resulted in a deemed contribution of all partnership assets and liabilities to a new partnership in exchange for an interest in it, followed by a deemed distribution of interests in the new partnership to the purchasing partners and continuing partners from the terminated partnership. Some of the tax attributes of the old partnership terminated, its tax year closed, partnership-level elections ceased to apply, and depreciation recovery periods restarted. This often imposed unintended burdens and costs on the parties. The new law repeals this rule. A partnership termination is no longer triggered if within a 12-month period, there is a sale or exchange of 50% or more of total partnership capital and profits interests. A partnership termination will still occur only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.
- Partnership loss limitation rule. A partner can only deduct his share of partnership loss to the extent of his basis in his partnership interest as of the end of the partnership tax year in which the loss occurred. IRS has ruled, however, that this loss limitation rule should not apply to limit a partner’s deduction for his share of partnership charitable contributions. Additionally, while the regulations under the loss limitation rules do not address the foreign tax credit, taxpayers may elect the credit instead of deducting foreign taxes, thus avoiding a basis adjustment. The new law addresses these issues by providing that the rule limiting a partner’s losses to his basis in his partnership interest is applied by reducing his basis by his share of partnership charitable contributions and foreign taxes paid. However, in the case of partnership charitable contributions of property with a fair market value that exceeds its adjusted basis, the partner’s basis reduction is limited to his share of the basis of the contributed property.
- Look-through rule on sale of partnership interest. Under the new law, gain or loss on the sale of a partnership interest is effectively connected with a U.S. business to the extent the selling partner would have had effectively connected gain or loss had the partnership sold all of its assets on the date of sale. Such hypothetical gain or loss must be allocated as non-separately stated partnership income or loss is. Unless the selling partner certifies that he is not a nonresident alien or foreign corporation, the buying partner must withhold 10% of the amount realized on the sale. This rule applies to transfers on or after 11/27/2017 and will cause gain or loss on the sale of an interest in a partnership engaged in a U.S. trade or business by a foreign person to be foreign source.
TCJA Provisions On Tax-Exempt Organizations
Here is a look at some of the more important elements of the new tax law that have an impact on tax-exempt organizations. In general, the provisions involved are effective starting in 2018.
- Excise tax on exempt organization’s excessive compensation. Before the new law, executive compensation paid by tax-exempt entities was subject to reasonableness requirements and a prohibition against private inurement. The new law adds an excise tax that is imposed on compensation in excess of $1 million paid by an exempt organization to a “covered” employee. The tax rate is set at 21%, which is the new corporate tax rate. Compensation for these purposes is the sum of (1) remuneration (other than an excess parachute payment) over $1 million paid to a covered employee by a tax-exempt organization for a tax year; plus (2) any excess parachute payment paid by the organization to a covered employee. A covered employee is an employee or former employee of the organization who is one of its five highest compensated employees for the tax year, or was a covered employee of the organization or its predecessor for any preceding tax year beginning after 2016. Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to the remuneration.
- Excise tax on private college’s investment income. Before the new law, private colleges and universities were generally treated as public charities, as opposed to private foundations, and were therefore not subject to the private foundation excise tax on their net investment income. The new law imposes an excise tax on the net investment income of colleges and universities meeting specified size and asset requirements. The excise tax rate is 1.4% of the institution’s net investment income, and applies only to private colleges and universities with at least 500 students, more than half of whom are in the U.S., and with assets of at least $500,000 per student. For this purpose, assets used directly in carrying out the institution’s exempt purpose are not counted. The number of students is based on a daily average of “full-time equivalent” students, i.e., two students carrying half loads would count as a single full-time equivalent student. For purposes of the excise tax, net investment income is the institution’s gross investment income minus expenses incurred to produce it, but without the use of accelerated depreciation or percentage depletion.
- Exempt organization’s UBTI computed separately for separate businesses. Before the new law, a tax-exempt organization computed its unrelated business taxable income (UBTI) by subtracting deductions directly connected with the unrelated trade or business from its gross income from the unrelated trade or business. If the organization had more than one unrelated trade or business, the organization combined its income and deductions from all of the trades or businesses. Under that approach, a loss from one trade or business could offset income from another unrelated trade or business, thus reducing overall UBTI. Under the new law, an exempt organization cannot use losses from one unrelated trade or business to offset income from another one. Gains and losses are calculated and applied to each unrelated trade or business separately. There is an exception for net operating losses from pre-2018 tax years that are carried forward.
- Exempt organization’s UBTI to include disallowed fringe benefit costs. Under the new law, an exempt organization’s unrelated business taxable income (UBTI) is to include any nondeductible entertainment expenses, and costs incurred for any qualified transportation fringe, parking facility used in connection with qualified parking, or any on-premises athletic facility. However, UBTI is not to include any such amount to the extent it is directly connected with an unrelated trade or business regularly carried on by the organization.
These changes are complicated and complex. Please contact us regarding your situation.