On Dec. 22, 2017, President Trump signed into law H.R. 1, or The Tax Cuts and Jobs Act (TCJA) — the first major tax reform since 1986. With 2017's tax season wrapping up, now is a good time for Americans to see how the TCJA will affect their tax situation going forward.
The Impact of Increasing the Standard Deduction – The Diminishing Value of Itemized Deductions
Craig and Mary Smith
- Married with no children
- Live in Columbia, Missouri
- Household income of $115,000
- Own a home with a $200,000 mortgage and pay about $7,500 per year in interest
- They make deductible annual contributions to a local charity of $2,000 a year
| Header Cell - Column 0 | 2017 | 2018 |
|---|---|---|
| Wages/ Adjusted Gross Income | $115,000 | $115,000 |
| Deduction | $16,479 (Itemized) | $24,000 (Standard) |
| Personal Exemptions | $8,100 (2x) | N/A |
| Taxable Income | $90,421 | $91,000 |
| Row 4 - Cell 0 | Row 4 - Cell 1 | Row 4 - Cell 2 |
| Federal Tax | $14,084 | $11,899 |
| State Tax (MO) | $4,579 | $5,059 |
| Marginal Tax Bracket (Federal/State) | 25%/6% | 22%/6% |
Bottom line: Due to the substantial increase of Standard Deductions, Craig and Mary will not be able to itemize deductions, which they previously used for the 2017 tax year, reducing the value of these deductions.
The Diminishing Value of Itemized Deductions
In 2017, the Smiths itemized their deductions because they exceeded the standard deduction amount available in 2017, which was $12,700. The Smiths’ itemized deductions consisted of the following:
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| Itemized Deductions | Header Cell - Column 1 |
|---|---|
| State Income Taxes (Wages) | $4,579 |
| Mortgage Interest | $7,500 |
| Property Taxes | $2,400 |
| Charitable Contributions | $2,000 |
| Total | $16,479 |
Due to the increase of the standard deduction to $24,000 for those who are married and file jointly, the Smiths will use the standard deduction amount, since it is greater than the their total itemized deductions. As a result, the deductions they received for items such as mortgage interest and property taxes will not be as valuable for the Smiths. Finally, would the Smiths still make charitable contributions, considering there is no tax benefit for them?
Summary
This example reflects the concerns that real estate professionals and charities have about the new tax act. If fewer people itemize their deductions, which will likely be the case with the increase of the standard deduction, will individuals still purchase homes or give to charities, since there may no longer be a tax incentive to do so?
High-Income Married Couple – Impact of State and Local Income Tax Limitation
Richard and Karen Douglas
- Married with two dependent children
- Live in San Francisco, California
- Their adjusted gross income is $1 million
- They pay $40,000 annually in mortgage interest and $20,000 in property taxes
- They also make annual charitable contributions of $30,000 per year
| Header Cell - Column 0 | 2017 | 2018 |
|---|---|---|
| Wages/ Adjusted Gross Income | $1,000,000 | $1,000,000 |
| Deduction (Itemized) | $159,066 | $80,000 |
| Personal Exemptions | $0 | N/A |
| Taxable Income | $840,934 | $920,000 |
| Row 4 - Cell 0 | Row 4 - Cell 1 | Row 4 - Cell 2 |
| Federal Tax | $277,791 | $279,329 |
| State Tax (CA) | $89,652 | $89,253 |
| Marginal Tax Bracket (Federal/State) | 39.6%/11.3% | 37%/11.3% |
| Effective Marginal Tax Rate on next $1000 (Fed/St) | 41.7%/12% | 37.9%/12% |
Bottom line: Even with the loss of over $79,066 in itemized deductions in 2018 due in part to the capping of state and local income tax deductions to $10,000 under the new law, the Douglases’ federal taxes increase only slightly, by about $1,538. This may be surprising given the amount of deductions lost but this is balanced out by the other favorable aspects of the law (including the lower tax rates)
Overview of 2017 Taxes – Non- capping of State and Local Income Taxes (SALT) & Phase Out of Personal Exemptions
For 2017, the Douglases’ itemized deductions would be $159,066 and are broken down as follows:
| Itemized Deductions | Header Cell - Column 1 |
|---|---|
| State Income Taxes (Wages) | $89,652 |
| Mortgage Interest | $40,000 |
| Property Taxes | $20,000 |
| Charitable Contributions | $30,000 |
| Total | $179,652 |
| Deduction Available (Pease Limitation) | $159,066 |
Under the previous law, the Douglases would be able to apply the full amount that they paid for state and local income taxes, including property taxes, to determine their itemized deduction amounts. In 2017, if taxpayers’ adjusted gross income exceeds certain levels ($261,500 for single filers and $313,800 for those who are married and filing jointly) the total amount of itemized deductions that can be used is reduced, also known as the Pease Limitation. Therefore, even though the Douglases’ total itemized deductions are $179,652, their total eligible deduction due to the Pease limitation is capped at $159,066.
The personal exemptions in place for 2017 also phase out at adjusted gross income levels similar to the itemized deduction phase-out, but unlike itemized deductions, personal deductions completely phase out when taxpayers exceed certain adjusted gross income thresholds ($436,300 for those married filing jointly). The Douglases’ adjusted gross income exceeds this amount, and therefore they will not be able to take any personal exemption deductions in 2017. In this case, the Douglases are not negatively impacted by the repeal of the personal exemption under the TCJA since they were not able to utilize personal exemption deductions in the previous year.
Overview of 2018 Taxes – Impact on the Capping of SALT Deductions
One of the major modifications under the TCJA for itemized deductions is the capping of state and local tax (SALT) deductions to $10,000. Since most of the Douglases’ deductions consist of SALT deductions, the amount of itemized deductions they can take for 2018 is significantly decreased, resulting in losing $79,066 in deductions for 2018 tax year.
Even though they lose a large portion of their itemized deductions, the Douglases’ federal tax still goes down slightly due to the lower marginal and effective tax rate for 2018 (37% and 37.9%) vs. 2017 (39.6% and 41.7%).
Summary
The capping of SALT will impact taxpayers in states with high income tax rates, such as California and New York, resulting in those taxpayers losing significant deductions that they were able to take previously. Even though their federal income taxes will generally not change significantly from previous years, they will not receive the same level of savings on their federal taxes than high-income taxpayers who live in states with lower income tax rates will.
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