The New Tax Law and its Impact on Itemized DeductionsDecember 16, 2019
For many taxpayers the changes to itemized deductions above may not be as bad as they sound.
*Editor’s Note: This blog was originally posted January 29, 2018 but has been updated as of December 16, 2019 for accuracy and comprehensiveness.
Though enacted two years ago, taxpayers are still feeling the impact of The Tax Cuts and Jobs Act (TCJA). From the new tax brackets, to the changes of many itemized deductions, the new tax laws have many people trying to figure out how they will be impacted. One area that is being scrutinized is itemized deductions.
Prior tax law allowed taxpayers, if they qualified, to reduce their taxable income by claiming a certain variety of personal deductions. These deductions have included mortgage interest, state and local income or sales taxes, property taxes on their homes and cars, charitable contributions, and certain miscellaneous deductions. Under the new tax law, the standard deduction nearly doubles for taxpayers, thus making itemizing less likely for a large number of taxpayers.
What itemized deductions have been affected under the TCJA?
- Limit on the state and local tax deductions: Under the new legislation, the deduction for all state and local taxes (SALT) combined cannot exceed $10,000. These taxes include state and local income, sales, real estate, or property taxes. Taxpayers in high-tax states may see much of their SALT deduction reduced, and limiting this one deduction could mean itemizing won’t make sense for many taxpayers.
- Medical deductions: Although for 2017 and 2018 the threshold amount for itemized medical expense deductions was lowered to 7.5% of adjusted gross income (AGI), for 2019, the threshold returns to 10% (amount prior to TCJA).
- Mortgage and home equity loan interest: The cost of buying or owning a home has traditionally been made more affordable by the deductibility of mortgage interest and real estate taxes. Although real estate taxes are included in the $10,000 limit for all state and local taxes, mortgage interest remains deductible – with two important changes.
For mortgages taken out after December 14, 2017, only the interest on the first $750,000 of mortgage debt is deductible. This may not be a factor where housing prices are relatively low and mortgages are below this limit. Also, interest on home equity loans are no longer deductible as of 2017. This affects interest on all home equity loans used for purposes other than to improve the current home, even if the loan was taken out before December 15, 2017.
- Charitable contributions are growing: The TCJA enhanced the deduction for charitable contributions by raising the limit that can be contributed in any one year. The limit is now 60% of adjusted gross income, up from 50%. So, if you still itemize, you can continue to deduct charitable contributions, but it only reduces your taxes if all your itemized deductions exceed the newly raised standard deduction amounts of $12,400 for individuals, $18,650 for heads of household, and $24,800 for married couples filing jointly and surviving spouses. Some taxpayers who have lost the value of some deductions (such as the state and local tax deduction) may make up the difference by contributing more to their favorite charity so they can continue itemizing.
- Other itemized deductions: SALT, mortgage interest, and charitable contributions are the most widely claimed deductions, but the list of deductions that were allowable before 2018 was much more extensive. Eliminated in 2018 are deductions for unreimbursed employee expenses, tax preparation fees, investment management fees, safe deposit box fees, and other miscellaneous deductions. Under the old law the 2% floor on miscellaneous itemized deductions was likely not having much of an impact and eliminating tax preparation fees, investment fees, safe deposit box fees will not have much of an impact as the 2% floor was subject to alternative minimum tax limits (AMT).
With all of these changes what does this really mean to taxpayers?
For many taxpayers the changes outlined above may not be as bad as they sound. There are several reasons why a significant number of taxpayers were not really receiving a tax benefit from these deductions on their income tax returns.
- Alternative Minimum Tax – The tax law contains an alternative tax system known as the “AMT.” The AMT calculates your taxes without the benefit of SALT, or miscellaneous itemized deductions, and generally results in a higher overall tax than with these deductions taken into account. The TCJA made some minor changes to the AMT, but it is likely that those individuals with large SALT and miscellaneous itemized deductions such as tax preparation and investment management fees will still be subject to the AMT.
- 2% Floor for Miscellaneous Itemized Deductions – If you were lucky enough to not be affected by the AMT, the “2% Floor” probably eliminated the benefit of your tax preparation, investment management fees, and other miscellaneous itemized deductions. The prior tax law contained a provision that you could only deduct these expenses to the extent they exceeded 2% of your adjusted gross income.
- Production of Income Principle– There is a tax principle that applies to certain otherwise allowable deductions and that is if the deduction is not related to the production of income, then you are not allowed to take a deduction for those expenses. For example, you are not allowed to deduct investment management fees for retirement accounts and investment accounts that are invested in tax-exempt bonds.
Therefore, most taxpayers were likely not really benefiting under the old tax laws due to these limits.
Please contact KLR Wealth Management to discuss your specific financial planning needs.
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