Itemized Deductions and The Tax Cuts & Jobs Act
by Marcus A. Rogers, CPA, JD, LLM
Photo by EtiAmmos/iStock / Getty Images
Overview: The Tax Cuts and Jobs Act was passed by Congress on December 20, 2017 and signed into law by President Trump on December 22, 2017. The Tax Act is the most sweeping and impactful revision of the Internal Revenue Code since the Act of 1986. The Act institutes several changes to the Internal Revenue Code affecting all taxpayers including Individuals, pass-through entities and Corporations. A lot of attention has been paid to the newly revised tax brackets for individuals and Corporations. However there has been significant revisions to IRS Form 1040 Schedule A Itemized deductions. These changes are unprecedented and to a great extent may eliminate the need to file Schedule A itemized deductions for a large number of individuals.
The Tax Act has significant impacts on pass-through, corporations and individuals alike. The overwhelming amount of attention has been placed on the newly reduced tax rate structure for both individuals and corporations. However, high income individuals in the high tax states should not be so quick to applaud the passing of the Tax Act.
The Tax Act eliminates, modifies and limits many of the popular itemized deductions most taxpayers have come to rely on. The Tax Act eliminates the deduction for casualty and theft losses with a small exception for federal disaster areas. In taking a closer look, the new law repeals miscellaneous itemized deductions that are subject to the 2% floor. Hence investment interest expenses, unreimbursed employee business expenses and tax preparation fees are no-longer deductible. The average taxpayer may not be significantly impacted by the elimination of these two deductions primarily because the standard deduction for all filing status has been increased greatly. For example, the standard deduction for married filing joint has increased from 12k to 24K for tax year 2018.
Another limitation of which may not just affect High Net Worth Individuals but will have a negative effect on the housing industry relates to the scale down of interest deduction for home mortgage indebtedness. The new law will reduce the amount of acquisition indebtedness from 1M to 750K of which home mortgage interest may be deducted on. Further, the interest deduction attributable to home equity loans in the amount of 100K has been completed eliminated.
By far the most sweeping reduction/limitation affecting itemized deductions relates to the now limited deduction for State and Local Taxes (SALT). SALT are now limited or capped at a maximum of 10K per year for married filing joint and 5k for married filing separately. This limit on deduction encompasses not only state and local income taxes but also affects sales and property taxes. The cap on this deduction effective acts as a mechanism for double taxation for high income taxpayers. Prior to the new tax law, roughly about one-third of all us taxpayers claim a deduction related to SALT. It is quite evident that there will be some taxpayers more adversely affected by the cap on this deduction than others. High income taxpayers who live in high state tax jurisdictions like California (13.3%), New York (8.82), New Jersey (8.82), Minnesota (9.85%), Iowa (8.98), Vermont (8.95), and District of Columbia (8.95) will pay more in tax.
For example, assume a resident of California making 600K will pay on average $79,800 in state and local taxes. The effective tax benefit of the state and local tax deduction will be $22,344 assuming an effective tax rate of 28%. Under the new law the state and local tax deduction is reduced from $79,800 to $10,000. The effective tax benefit or increase in tax liability is over $19,000. (Note these amounts are averages only and do not consider offsetting items such as Alternative Minimum Tax).
While we do not expect a mass migration to the states that do not impose a state income tax such as Texas, Florida, Washington, Nevada, Wyoming, South Dakota and Arkansas. We expect taxpayers to become more sophisticated in utilizing tax planning and financial management strategies to mitigate and offset their overall increased tax liability. The SALT deduction has been in the Internal Revenue code since 1913 and is a major perk that will exist on a capped basis for tax year 2018. High Income individuals will pivot towards maximizing the remaining itemize deductions in the code. For instance, making a donation to a charitable organization under IRC Section 170 is unchanged from 2017 with the exception of an increased a rate of 60% on certain donations adjusted income. In previous years the deduction was limited to 50% of adjusted gross income.
One final note, for individuals whom have significant itemized deductions whether charitable, medical or SALT, the Pease limitation on itemized deductions has been eliminated. This limitation capped the amount of itemized deductions a person could take in a given year. What this means now is that a taxpayer can deduct all the itemized deductions without limit to the extent these deductions have neither been eliminated or limited.
