It actually happened. With passage of the Tax Cuts and Jobs Act (renamed An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018), Congress has enacted the most significant changes to the federal income tax rules in three decades.
That’s the good news for those who stand to benefit.
The bad news? The late-December timing makes year-end tax planning more complicated than ever. And if you wait until January to think about taxes, your options will be much more limited.
In broad strokes, the Act makes the following changes affecting individuals and families:
reduces tax rates and changes the amounts subject to each tax bracket
eliminates many itemized deductions
reduces the impact of the alternative minimum tax (AMT)
changes the tax rules for sole-proprietorships and pass-through entities, such as partnerships, LLCs and S corporations
increases the estate tax exemption amount
So what should you do before year-end to minimize your tax liability?
The answer depends on your own tax situation, but strategies generally revolve around timing.
Timing Considerations for Income and Expenditures
If you’re like most people, you are a cash-basis taxpayer and that means you probably have at least some control over the tax year in which you recognize income and end-of-year expenditures.
To exert that control in a way to minimize your tax bill, start with an estimate of your income and expenditures for 2017 and 2018. At the very least, you’ll want to consider whether your taxable income is likely to increase or decrease over the next year — and whether you anticipate any large or unusual expenditures in the near future.
Armed with these estimates, you can consider strategies to reduce your overall federal income tax burden. These strategies typically include the following:
harvesting tax losses on investments
If you can defer income to 2018 and thus reduce taxable income for 2017, you will likely benefit from the reduced tax rates in the Act. The maximum individual income tax rate has been reduced from 39.6 percent to 37 percent — and rates for the lower brackets are also reduced.
As an employee, you typically don’t have control over payroll payment dates. But there may be other items of income you can control. For example, if you are receiving a bonus this year you might be able to ask your employer to defer payment until early in 2018.
If you’re self-employed and a cash-basis taxpayer, you may be able to time your billings to ensure that you receive the payments after the end of the year. The same may be true if you are a member, partner or shareholder in a pass-through entity.
If you are an accrual-basis taxpayer, your options are a bit more limited. But it may be possible to postpone product deliveries or completion of a job to ensure the income is reported in 2018.
If you intend to convert an existing IRA to a Roth IRA, you can defer recognizing the resulting income to 2018 by postponing the conversion until after the end of the year.
Alternatively, if you’ve already done so but would like to convert back to a traditional IRA based on tax rate changes, you must unwind the transaction this year. Under the Act, such recharacterizations are not allowed in future years.
The Act changes the tax rules for alimony. Under the new rules, alimony received is no longer included in income and alimony paid is no longer deductible. These rules only apply to divorce or separation agreements executed after December 31, 2018, so you have a bit more time with this one. But if you’re currently negotiating a divorce or separation, it’s an important consideration.
The applicable tax rates for both the earned and unearned income of a child are changed by the Act, beginning in 2018. As a result, it may be beneficial to defer income and accelerate deductions.
Harvesting Tax Losses on Investments
For tax purposes, investments held more than one year are considered long-term while investments held for a shorter period are short-term. Long-term capital gains are taxed at preferential rates while short-term gains are taxed as ordinary income. (The Act does not change these rules, with one exception: the holding period for carried interest is extended to three years.)
That means realizing losses on investments may reduce your taxable income. And if you have a net short-term gain for 2017 without offsetting losses, consider selling an investment that has declined in value and use the loss to offset the gain.
You can repurchase the sold investment at a later date if you want to retain it in your portfolio, but you must be careful to avoid wash sale rules. These rules preclude you from recognizing a loss for tax purposes if you reinvest in an identical security within a 61-day period, which includes 30 days before and thirty days after the date of the sale.
If you accelerate deductions into 2017, you reduce taxable income when taxes are likely to be higher. You may also benefit from deductions that are slated to expire.
In return for lower marginal tax rates, the Act roughly doubles the standard deduction while eliminating personal exemptions and many itemized deductions.
These changes, coupled with lower rates, mean that itemized deductions will be less valuable for many people beginning in 2018. If you can accelerate deductions into 2017, you may benefit.
If you use a credit card for these payments, the IRS allows you to deduct the expenditures when they are charged to your card, and not wait until you actually pay off your credit card balance. That means you can use your credit card to pay such expenses before year-end and then pay the credit card bill when it comes due in January.
That said, it’s important to do the math. Itemized deductions phase out for taxpayers with adjusted gross incomes that exceed a specified amount. That phase-out, coupled with the increase in the standard deduction, means that it is possible you will not benefit from additional deductions this year.
Another consideration: The overall limit on itemized deductions that applies in 2017 is eliminated beginning in 2018.
Deduction for Pass-Through Income
The Act changes the tax rules for pass-through income beginning in 2018 by creating a new deduction for members, partners or shareholders in pass-through entities, such as LLCs, partnerships and S corporations, as well as sole-proprietorships.
The calculation is a complicated one, but is generally equal to 20 percent of qualified business income (subject to wage limitations) plus 20 percent of REIT dividends and qualified publicly traded partnership income. Most professional service businesses are ineligible.
State and Local Taxes
The Act limits the deductibility of property taxes and state and local taxes by restricting the deduction to a combined total of $10,000. If you typically pay more than $10,000 each year, you may benefit from accelerating certain payments into 2017 to maximize deductions for both 2017 and 2018.
It is important to note that the Act specifically prohibits prepayment of state income taxes. States may also impose restrictions on prepayments. For example, Washington state residents cannot accelerate payment of property taxes outside of the year in which they are due.
For newly purchased homes, the Act limits the interest deduction to interest on the first $750,000 of mortgage debt, reduced from $1 million. Unfortunately, the effective date for this change was December 15, 2017.
However, if you are refinancing a mortgage taken out before December 15, 2017 the old rules continue to apply to the refinanced amount, excluding any additional debt involved.
Interest on Home Equity Debt
Beginning in 2018, you won’t be allowed a deduction for interest you pay on home equity debt. As a result, you may find it beneficial to pay the debt down or off after 2017.
Medical and Dental Expenses
Under the Act, you can deduct medical and dental expenses that exceed 7.5 percent of your adjusted gross income. This deduction applies to 2017 and 2018 only.
If you are near or over that threshold for 2017, you may want to accelerate payment of medical bills due early in 2018, or schedule your annual checkup for December rather than January.
Alternatively, if you won’t meet the threshold for 2017, you may want to delay payments or reschedule checkups or appointments to try to exceed the threshold for 2018.
Although the Act generally retains the existing rules for charitable deductions, the existing 50 percent limit for cash contributions to public charities and certain private foundations is increased to 60 percent beginning in 2018.
To accelerate deductions into 2017, you can prepay multi-year gifts this year and consider gifting larger amounts to private foundations, donor advised funds, charitable gift annuities and charitable lead and remainder trusts.
If you plan to make an additional charitable contribution before the end of the year and you have appreciated stock in your portfolio, you may be able to reduce your overall tax liability by gifting the appreciated stock.
Donate appreciated stock that you have held for at least one full year and you’ll avoid the capital gains tax on the appreciated value of your stock and the amount of your charitable deduction is equal to the stock’s market value on the day you make the donation, subject to a limit of 30 percent of your adjusted gross income for donating capital gain property.
Like-Kind Exchanges (1031 Exchanges)
Beginning in 2018, the Act restricts these exchanges to real property. If you are swapping or intend to swap personal property, you must either acquire the replacement property or dispose of the property you are relinquishing before January 1, 2018.
For 2017 you can deduct miscellaneous expenses that exceed 2 percent of your adjusted gross income, with certain exceptions. These expenses include unreimbursed employee business expenses, tax preparation fees, safe deposit box rent, investment fees, certain federal estate taxes, professional dues and memberships, certain casualty and theft losses, IRA trustee fees, and certain losses on IRA (or Roth IRA) distributions.
The Act eliminates these deductions for 2018.
100 Percent Expensing
The Act effectively increases bonus depreciation to 100 percent for qualified property acquired and placed in service after September 27, 2017. Given the earlier effective date, it isn’t necessary to delay asset purchases.
Other Items Eliminated Beginning in 2018
Deduction for casualty losses (other than federally-declared disasters)
Deduction for moving expenses (other than for certain members of the military)
Exclusion for moving expense reimbursements
Alternative Minimum Tax
If you anticipate you might be subject to the alternative minimum tax (AMT) in 2017 — perhaps because you were last year — you’ll want to ensure that your deductions this year aren’t too high relative to your income. That means you may need a different strategy — to accelerate income or delay deductions, rather than the reverse. It’s important to do the math.
The Act increases the exemption amounts beginning in 2018, meaning fewer people will be subject to AMT. As a result, you may be able to increase your deductions without becoming subject to AMT.
The Act doubles the estate and gift tax exemption and retains the step-up in basis so beneficiaries don’t pay capital gains tax on the assets. However, it does retain the estate tax for larger estates. And Washington state’s estate tax provides a much smaller exemption amount of $2.2 million.
As a result, year-end gifting can still be an important planning technique. When part of an overall family plan, gifting can also provide asset protection and, most importantly, shift wealth and the related income to succeeding generations.
For 2017 you can make tax-free year-end gifts of up to $14,000 per person to an unlimited number of persons.
Given the magnitude and complexity of the tax rule changes in the Act — and the various limitations, thresholds, phase-ins, phase-outs and other exceptions that cannot be fully described here — you will likely benefit from professional advice regarding the Act’s impact on your personal tax situation.
If you’d like to know more about how to implement your own year-end tax plan, give us a call.
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