Sikich Series on Tax Reform: What to Expect this Tax Filing Season – Part 1: Individuals

You may recall about a year ago all the articles and published materials covering tax reform that Congress and President Trump enacted on December 22, 2017. As you might remember, 2018 is the first full year that this new law, the “Tax Cuts and Jobs Act,” is effective. So, what should you expect as you start to gather your tax records for 2018? Will your taxes go up or down? Will it be easier to file, or more complicated? Will the IRS be ready to handle all these changes? Here are some of the highlights.

Lower Taxes

More than likely, you will have a lower tax bill in 2018 than 2017, if you have similar income between the years. Many taxpayers will benefit in 2018 from the lower tax rates and expanded tax brackets. For instance, married taxpayers with taxable income of $500,000 in 2017 landed in the highest federal tax bracket of 39.6%. For 2018, however, the same married taxpayers filing jointly with taxable income of $500,000 would reside in the 35% bracket. The income tax reduction in 2018 on the $500,000 of taxable income for this couple is nearly $17,000. Again, most taxpayers will pay less taxes for 2018 vs. 2017.

Itemized Deductions Trimmed

A common misconception is that taxpayers lost their itemized deductions as part of tax reform. For example, many taxpayers believe they can no longer deduct charitable contributions. There were a number of changes with itemized deductions, so let’s clear up this confusion.

Miscellaneous Deductions. For taxpayers that deducted employee business expenses, investment fees, or possibly tax preparation fees, these deductions are lost for 2018. However, many taxpayers reported these deductions in the past but only realized a partial, or maybe no tax benefit, due to limitations. Remember that in 2017 and prior, the deductible portion of these expenses, in total, needed to exceed 2% of your Adjusted Gross Income (AGI). Depending on your situation, the elimination of these deductions may or may not impact your overall tax liability.

State and Local Taxes (SALT). Second the tax bill curbs the SALT deduction. State and local taxes, including real estate taxes on personal residences, has been capped as a deduction. Only $10,000 of the total can now be deducted beginning in 2018. If your total state and local taxes will be less than $10,000, then this limitation will not impact you. If your total will exceed $10,000 you might feel as if Congress is rubbing a little SALT in your wound, as the excess is not deductible.

Mortgage Interest. Next, mortgage interest incurred on home acquisition debt in excess of $750,000 will not be deductible. Further, interest on home equity loans will, in most cases, no longer be deductible depending on the amount of the loan and the use of the proceeds.

Charitable Contributions. Back to where we started. Charitable contributions are still deductible and were not eliminated by tax reform. In fact, there was a limitation of 50% of AGI on total contributions, and this has been expanded to 60% for 2018.

Standard Deduction. Last, the standard deduction was significantly increased for all taxpayers. For married taxpayers, the standard deduction is now $24,000 in 2018. If the total of all deductible itemized deductions, after new limitations are applied, is more than $24,000, then taxpayers will realize some tax savings from their expenses. For most taxpayers, the lion’s share of itemized deductions consists of state and local taxes, charitable contributions, and mortgage interest. Some taxpayers have medical expenses that exceed a threshold allowing some of these to be deductible, and there was no change to the deductibility of medical expenses. This increase in the standard deduction will cause some taxpayers to use it, because the total itemized deductions will be less than the standard deduction threshold. One other tax saving idea to consider with the higher standard deduction is to bunch your itemized deductions and use your actual itemized deductions in one year, then claim the standard deduction in the following year. Your Sikich tax advisor can help walk you through the bunching strategy. Because of all these changes with itemized deductions, many believe they have lost out on deductions and their taxes will rise, but this is not necessarily the case. It depends on your particular situation.

Lost Exemptions, but Enhanced Tax Credits

The personal exemption is gone. A family consisting of husband and wife and two children would have claimed four total exemptions and received a $16,200 deduction for exemptions in 2017. In 2018, however, the exemption is repealed, and there is no deduction.

On the other hand, for taxpayers with dependent children under the age of 17, there is a $2,000 per child credit; up from $1,000 in 2017. In addition, the income phase-out for this child tax credit was significantly expanded in 2018, thus making it more likely that taxpayers will utilize this higher credit. For other children not entitled to the $2,000 credit, a smaller $500 credit might be available.

Business Owners

For taxpayers who own a business or rental property, or perhaps own investments in REITs or Publicly Traded Partnerships (PTP), there is a new deduction in 2018. This 20% deduction applies for “qualified business income” that comes from pass-through businesses that is reported on Form 1040. The rules are very complex and tax practitioners are focused on maximizing this deduction for their clients. The first question is whether the pass-through entity qualifies as a “trade or business.” Then the taxable income of the business owner must be determined. Next, there are limitations based on whether the business is a service business or not, as defined by the IRS. Finally, a computation of the amount of pass through deduction is done and then reported at the entity level. It is then reported and eventually deducted at the individual taxpayer level, subject to yes, some additional limitations.

There are several other notable changes that will impact business returns in 2018, and thus their owners. These changes involve several accounting method changes that offer opportunities, but also more complexity. Further, there is a new overall limitation on excess losses that establishes more compliance and complexity, but with little IRS guidance to date. Congress also repealed the deduction for entertainment expenses, but maintained the write-off for meals at 50%. Last, perhaps the most complex change involves new limitations on the deductibility of interest expense, including a maze of new rules, reporting, and restrictions especially with interest incurred by pass-through entities.

These tax changes, especially from pass-through entities, will create complicated reporting and frustrations this year. Changes made as part of tax reform flow from Congress to taxpayers and their businesses, then proceed over to their tax practitioners, and finally back to the IRS for tax processing. Implementation of these changes will impact nearly every business tax return and create additional compliance costs this filing season.

Alternative Minimum Tax (AMT)

AMT had been the government’s ATM machine for years, but for most individual taxpayers, AMT will be greatly reduced in 2018 due to changes made through tax reform. The expected drop in AMT exposure this year is mainly due to: changes in allowed itemized deductions; elimination of the personal exemption; increase in the AMT exemption; and finally, from raising the phase-out point for this exemption. AMT is curbed, but not forgotten. The AMT forms must still be completed, but less AMT will be collected this year.

Timing

Due to the complexity added to business tax returns as well as certain investments in REITS and PTPs, expect some delay in getting Schedule K-1s this year. Additional delays could be caused by the current government shutdown and impact to IRS operations this filing season. The delay could be exacerbated this year given the comprehensive tax law changes, and its many complexities and uncertainties.

Summary

The new tax law creates new opportunities for all taxpayers. Interpreting new laws in each taxpayer’s situation can at times be inconclusive and uncertain. But, it can also be rewarding when tax benefits are identified. There will be many challenges and even risks this year for tax professionals as they untangle the new law. Evaluating how to best find these opportunities is left to tax professionals. Industry experts predict these complexities and related opportunities will cause tax practitioners to invest more time for impacted tax returns this year; both business and individual. Additional time will lead to higher tax return compliance costs, a serious time crunch to file timely, but likely lower overall tax. A competent and experienced tax professional should help guide you through this year’s tax filing challenges. Please contact your Sikich tax advisor with any questions, or for any assistance.