Tax Reform: Changes to the Standard Deduction, Exemptions, and Itemized Deductions

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the second of a series of articles reviewing some of the more important changes.  This post deals with changes to the standard deduction, personal exemptions, and itemized deductions.  Unless otherwise specified, these changes start in tax years beginning after 2017 and sunset after 2025.

Standard Deduction

The standard deduction increases from $13,000 in 2018 to $24,000 for married filing joint returns, from $6,500 to $12,000 for single taxpayers, and from $9,550 to $18,000 for head of household.  It is estimated that the percentage of taxpayers itemizing deductions will decline from 40 million to 9 million because of the increase in the standard deduction.  The additional standard deduction for the elderly and the blind is retained.

Personal Exemption

The personal exemption of $4,150 in 2018 is repealed as well as the rule phasing out the personal exemption when AGI exceeds a certain threshold (e.g., $320,000 MFJ).  However, the $100/$300/$600 personal exemptions of trusts and estates are not repealed.

Medical Itemized Deduction

The medical deduction is retained.  A favorable change was made retroactively for 2017 and for 2018.  The AGI percentage threshold that must be reached before medical expenses become deductible is lowered from 10% to 7.5%.  The percentage threshold reverts to 10% after 2018.

State and Local Tax (SALT) Itemized Deduction

The sum of state and local income or sales tax plus real and personal property tax is limited to $10,000 for MFJ, singles, and trusts and estates.

·      Real and personal property and sales taxes attributable to businesses reported on Schedules C, E, or F are deductible on those schedules and are not repealed or limited.

·      But individual income taxes attributable to business profits reported C, E, or F are considered itemized deductions and are subject to the $10,000 cap.

·      Foreign income taxes may be deducted without regard to the limit if they are not claimed as a credit.

·      However, foreign real property tax is no longer deductible unless it is incurred in a business.

·      Generation skipping transfer tax paid on a taxable trust distribution is not limited.

·      The new tax law specifically states that no 2017 deduction is permitted for prepaying 2018 state income tax.  What about excess 2017 prepayments applied to 2018 state tax?  Typically, refunds of overpaid state estimated taxes are taxable in the year of receipt if a tax benefit was received from the deduction.  Will this continue to be the rule?

·      Prepayments in 2017 of 2018 real estate tax was not specifically prohibited, but the IRS issued an advisory (IR-2017-2010) stating that the deduction would not be allowed if assessment of the tax did not occur before 2018.

·      The $10,000 tax deduction limit applies to both singles and MFJ, a marriage penalty.  This makes it harder for a MFJ couple to benefit from itemizing their remaining deductions because of the higher MFJ standard deduction.

·      There is no real impact of the $10,000 SALT limit for taxpayers subject to the AMT under old law.

·      If making gifts in trust for children, consider setting up separate trusts for each child beneficiary to get multiple $10,000 SALT limits instead of using a single trust for all the children.

Interest Itemized Deduction

Interest paid on total mortgages not exceeding $750,000 for debt incurred after 12/15/2017 is deductible for principal and/or secondary residences.  Refinancing of mortgages incurred on or before 12/15/17 is treated as incurred on the same date of the original debt (meaning the old $1 million limitation continues to apply).

·      Written binding contracts entered into before 12/15/2017 to purchase a principal residence before 1/1/2018, where the home is actually purchased before 4/1/2018, can still use $1 million limit.

·      Home equity loan interest after 2017 is not deductible with no grandfathering of existing loans.

·      Consider the “interest tracing” rules to preserve the home equity loan interest deduction if the loan was used to improve the home or used to acquire an investment.

·      The investment interest expense deduction is retained.

·      The mortgage insurance premium deduction expired at the end of 2016 and was not renewed.

·      Pay off non-deductible home equity debt.  Re-borrow it later to invest in a business or other investment.

Charitable Contribution Itemized Deduction

Charitable contributions are still allowed as itemized deductions.  However, with the increase in the standard deduction and with the $10,000 SALT limitation, the number of taxpayers benefiting from itemizing charitable donations is expected to fall significantly, particularly so for those who have no home mortgage interest expense.

·      The charitable contribution deduction is limited to a percentage of adjusted gross income for individuals.  The new law increases the limitation to 60% of AGI (from 50%) for cash donations made to public charities.

·      A carryover of unused pre-2018 cash contributions would continue to be limited to 50% of AGI.

·      No change was made to the 30% and 20% of AGI limitations for the donation of long-term appreciated property.

·      The 5-year carryover of excess contributions is retained.

·      However, the 80% deduction for contributions to obtain rights to purchase college athletic event seating is repealed.

·      Taxpayers age 70 ½ or older with traditional IRAs can make a direct charitable gift to a public charity (but not to a DAF) of up to $100,000 out of the IRA to get around the higher standard deduction and satisfy their RMD.

Casualty and Theft Loss Itemized Deduction

The casualty and theft loss itemized deductions are repealed except for casualty losses in presidentially declared disaster areas.

Miscellaneous Itemized Deductions Subject to the 2% of AGI Floor

The deduction of miscellaneous itemized expenses subject to the 2% AGI floor is repealed.  Examples of these types of expenses include:  tax preparation fees, home office, license fees, professional dues and subscriptions, legal fees for tax advice, unreimbursed employee business expenses, job hunting costs, investment management and advice, hobby loss expenses, and excess expenses upon a termination of a trust or an estate.

Miscellaneous deductions not subject to the 2% AGI floor are retained.  These include gambling losses to the extent of winnings and the deduction for estate tax paid on items of income in respect to a decedent (IRD).  Trusts and estates must distinguish administrative expenses not subject to the 2% floor from miscellaneous itemized deductions that are subject to the floor and therefore no longer deductible.

“Pease” Limitation on Itemized Deductions

Prior law required a reduction to the amount of the itemized deduction when a taxpayer’s AGI exceeded a certain threshold.  The reduction was generally 3% of the amount of AGI in excess of the threshold.  This provision was in effect a hidden 1.2% tax rate and was often referred to as the “Pease” limitation, named after the Senator who proposed the provision.  This limitation is repealed.

“Bunching Itemized Deductions”

If necessary, “bunch” remaining deductible itemized deductions into every other year to get over the increased standard deduction hurdle.  For example, if you bunched your 2018 itemized deductions into 2017 (e.g. by prepaying 2017 SALT and donations), then bunch your 2019, 2020, & 2021 itemized deductions into 2020.