In recent weeks, most of us have filed our individual income tax returns or requested an extension of time to file any required tax returns. Some glitches at the Internal Revenue Service (IRS) and its computer systems did allow for an extra day for filing 2017 individual income tax returns without an extension. If we fast forward to this time a year from now, we will definitely take note of some differences in our tax returns and tax liability. These differences may impact any withholding requirements or estimated tax payments that occur during the 2018 year. Having an understanding of the new tax math might assist in analyzing the 2018 results, as a few items in tax reform may change the actual liability amounts many families might pay for the 2018 tax year.
For many years, many homeowners have been able to itemize and claim deductions related to home ownership. This includes property taxes and mortgage interest expenses. These deductions were in addition to other itemized deductions, such as charitable contributions, and state and local income taxes. These itemized deductions, in most cases, exceeded the standard deduction and reduced taxable income and one’s ultimate federal income tax liability.
The recent 2017 tax reform enacted as part of the Tax Cuts and Jobs Act changed this result in some respects. Tax rates and brackets did change, but other items also will impact many individual tax returns. For 2018, the standard deduction is increased to $12,000 for a single filer and $24,000 for a married filing joint filer. In addition, the itemized tax deduction for property taxes and state and local income taxes is capped at $10,000. These changes may change many tax returns. The changes in the standard deduction and itemized deductions can be best highlighted in a short example. For sake of our discussion, let’s look at a hypothetical family that earns $150,000 and has a $250,000 home with a $150,000 mortgage with a 4 percent interest rate. The 2018 tax math will differ from the 2017 tax math in this situation. Mortgage interest is $6,000, property taxes are $5,000 and state and local income taxes are $7,000. Let’s also assume the family also contributes $4,000 in charitable gifts. Allowed itemized deductions are the mortgage interest, only $10,000 in property and income taxes (not the $12,000 incurred), and the charitable gifts. The eligible itemized deductions total $20,000, which is less than the $24,000 standard deduction. Thus, there is no actual benefit of itemizing as in prior years using the above numbers. The standard deduction changes may simplify the tax return but may come as a surprise to many who thought the mortgage interest and property taxes reduced their taxable income and the resulting federal income tax liability.
The next change for this family (let’s assume two minor children) is the loss of any personal exemption deductions for the family. In 2017, the four personal exemptions were worth $16,200 ($4,050 each). Thus, for 2018 and future years, this deduction in determining taxable income is no longer available at the federal level. States have taken note and have made some adjustments. Michigan recently changed its tax law to still allow for personal exemptions in determining one’s state income tax liability.
The news isn’t all bad for this sample family in 2018. The child tax credit is increased in 2018 to $2,000 from $1,000 in prior years for each dependent child that is under age 17. There are some income limitations and phaseouts with the child credit, but many families likely will benefit from this change.
Another change that many may see for 2018 is the changes in the dreaded alternative minimum tax (AMT). The AMT was once thought of as a tax to capture high-income taxpayers who were paying a small amount of federal income tax. Its reach was a surprise over the years, as its mechanics resulting from the 1986 tax reform resulted in capturing many middle-income families in its grasp. A couple of recent changes that may impact (in a good way) the number of families that actually will get dinged by the AMT in future years. The itemized deduction limitation (discussed earlier) for state and local income and property taxes will result in lower amounts being added back in determining the AMT base, as these taxes aren’t deductible for AMT purposes. Also, certain miscellaneous itemized deductions were eliminated in tax reform, and so this AMT addback won’t occur in 2018 and future years. And last but not least, the AMT exemption amount was significantly increased for 2018 and later tax years. The exemption increase changed the exemption amount from $89,500 to $109,400 for a married filing joint taxpayer. All of these items are intended to reduce the number of families that fall into the grasp of the AMT in future tax years. As with anything dealing with taxes, the AMT has many items that impact the actual tax calculation, so the changes may not eliminate its reach for some taxpayers.
Individuals who are business owners also might see an impact on their tax liability for 2018. This may hold true for those that own a business interest that is a pass-through (operating as a sole proprietorship, partnership, limited liability company (LLC), or S corporation). The new 20 percent pass-through deduction for qualified business income may be available for many of these business owners. The mechanics and the various rules make the application and determination of the eligibility for the deduction a bit complex. Additional guidance from the IRS is likely to be forthcoming this year, as many questions have arisen with some of the calculation mechanics.
Another favorable change for business owners that operate in a pass-through structure is the capital expensing provisions that will enhance depreciation deductions for certain asset additions. These provisions actually apply to both pass-through structures and C corporations. Many pass-through owners might see the benefits of reduced taxable income by taking advantage of the additional depreciation deductions when they place eligible assets into service.
Tax math is something we don’t take in high school or college. It is not calculus or linear algebra, and it has its own rules that often seem just as complex. A professional tax adviser is needed in many cases to help translate and apply the rules, especially when changes occur. When April 15, 2019, comes around for 2018 tax returns, we all might be a bit surprised at the actual results in applying the 2017 tax reform changes. Hopefully, the results will be pleasant surprises. The good news is that many have a year to plan and prepare for the impact of the changes that will show up in 2018 tax filings next April.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP. The views expressed above are the author’s and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.