The details of the tax bill have yet to be fully explored and the impact of these changes may not be fully apparent for some time. But now that the bill has passed, it is important to understand how the new tax laws might affect you. Our team at Whitnell has spent the last several days reading and analyzing the proposed tax changes. This analysis has helped us draw several conclusions.
My counsel is to view these six ideas as either a win or a tie. Many long-standing tax deductions may be partially or completely eliminated very soon. These may include deductions for local real estate taxes, state income taxes, housing mortgage interest payments, investment advisory and accounting fees and possibly other deductions.
It appears that most changes to the tax laws will likely be effective going forward, but there are some with effective dates in 2017. Since substantial deductions will be partially or completely wiped out starting next year, it is wise to consider how to take advantage of current tax law to reduce future taxes. Here are six ideas to help you win or tie against pending tax changes.
Win Or Tie – That’s The Goal
Here are six ideas I recommend that you review with your advisors to see if they might help reduce future tax debt:
- Pay all of your 2017 state income taxes now
- Pre-pay state and local real estate taxes now and state income tax
- Pay your tax advisor and financial planner any fees owed to them before year end
- Beware of changes in mortgage interest deductions
- Leverage charitable deductions despite standard deduction eliminations
- Beware of potential divorce changes
Let’s explore these a bit.
What About The AMT – Alternative Minimum Tax?
Before we look at these ideas, I want to address the topic of the AMT. As I read the literature advising people what to do prior to the end of 2017, I see that most authors are saying that prepaying taxes and fees would be ineffective if you are in the alternative minimum tax. I tested that advice with a number of my clients and found that some of them were able to save significant taxes in 2017, despite being in the alternative minimum tax.
The rate of savings was about 15%. Although the rate is not great, these same deductions next year would save 0%. Simple math says that 15% savings is better than zero. I encourage you to ask your advisors to actually run an estimate of tax that shows the impact of prepaying when you are in the minimum tax.
They (and you) may find that it actually works for you. It was interesting that the same people who got the 15% benefit from prepaying taxes also got a 43% tax savings for prepaying charitable gifts. That is particularly interesting since the highest marginal tax bracket is 39.6%. Will this apply to your situation? The only way to know is to explore the options with your tax advisor.
Pay Your Estimated State Income Taxes Now
Let’s start with a fairly simple opportunity that may help you. The tax code revisions will partly eliminate the federal tax deduction for state income tax payments. Many people make quarterly estimated tax payments with the 4th quarter payment being due January 15th of the next year.
Also, with the strong equity market, many stock funds have been paying huge capital gain distributions this year, which will cause many people to have large balances due in April for their state income tax. If, however, you prepay your 4th quarter state income tax this year, before December is over, you may be able to deduct it against your 2017 federal income taxes.
Likewise, if you are expecting to owe a large balance to your state for your capital gains and other investment income, you could also pay that in December. If you pay the taxes in January or April, when you normally would have done so, you may get no deduction.
Pay or Pre-Pay SALT (State and Local Real Estate) Taxes Now
The state and local property tax deduction has long been a benefit for property owners. In some states, depending on the county, you can prepay your real estate taxes before December 2017 is over and receive the full deduction before it is reduced or eliminated.
In Illinois, Cook County residents can prepay 50% of their 2017 real estate taxes this year, and if you live in DuPage or Lake County, you can prepay 100% of 2017 real estate taxes this year. This is possible, in part, because in Illinois you pay real estate taxes in arrears, that is, your 2017 taxes aren’t billed until 2018. But the taxes relate to 2017 ownership.
Some states will give you a choice between paying these real estate taxes either in December of the year they are due or in January of the next year. Because of tax law changes, you may want to pay them now, before December 31.
Some real estate tax authorities will allow you to pre-pay if you request to do so—even if a tax bill has not yet been issued and is technically not yet due. In Cook County, for example, you can prepay your taxes online. Certainly, it’s worth making the inquiry of local authorities, or having your professional tax advisor or financial advisor do so on your behalf.
Since neither real estate tax nor state income tax is deductible against the alternative minimum tax, you should consult with your tax advisor to determine whether prepaying some or all of these taxes would trigger the alternative minimum tax for you. The Senate-House compromise for 2018 allows people to deduct only $10,000 of real estate tax and state income tax combined.
Pay Your Financial Advisor and Tax Preparation Fees This Year
Asset management fees, financial advisory fees, and tax preparation fees will not be allowable as deductions under the new tax laws. In the past, these fees were deductible as a miscellaneous itemized deduction to the extent that they exceeded 2% of your adjusted gross income.
If your financial planner, your tax accountant or your investment advisor generally bills you after the end of the year for work done in the prior year, it would be worthwhile to pay them for the work they have done in 2017 before the end of the year.
As is the case with state income and real estate taxes, these deductions are not allowable against the alternative minimum tax. So prepaying them may not help in reducing your tax burden. However, the calculation is tricky. Some people who are subject to the alternative minimum tax may still get a benefit by prepaying these expenses in 2017 but no benefit from waiting until next year. As always, consult with your tax advisor for details regarding your situation.
Beware of Changes in Mortgage Interest Deductions
It appears that the mortgage interest deduction, long a backbone of financial planning and home ownership, will be substantially reduced. Under current law, until the end of 2017, you can deduct interest on loans up to $1,000,000 for traditional mortgages and up to $100,000 on home equity loans. These amounts can also be split between a first home and an additional vacation home.
Under the new law, it appears that the total amount that is deductible for mortgage interest will go down substantially. It also appears that the deductibility of interest on home equity loans may be eliminated altogether, even for existing loans. While there may be no simple fix for this, here are a couple of ideas to consider.
First, let’s suppose you have a home equity line of credit for $100,000. Next year the interest on that loan may be non-deductible. If your financial situation allows, you should pay all the interest you owe on this loan before the end of the year to get the deduction in 2017.
If you need to free up capital to do this, you might consider liquidating some investments. How advisable is this? That depends on the interest rate you are paying on the loan versus the safety and reliability of keeping the capital invested. This might create a change in your overall financial plan, so be sure to closely consult with your financial planner about this.
Second, let’s assume you have non-qualified assets (i.e., not qualified retirement accounts like IRAs or 401(k)s) which you convert to cash to pay off the line of credit. Later, you can go back to the bank and replace that line of credit for $100,000 or even more, using your home or second home as collateral. Let’s assume that you invest that money in stocks, taxable bonds, treasuries, or any other taxable investments. Now the investment interest expense you incur will be deductible against your investment income.
The law focuses on where the money goes and how it is used. So, even though you received a loan with your home as security—technically, still a mortgage—you may nonetheless deduct the interest on the loan as an offset to your investment income. Again, depending on your tax bracket and your mortgage interest rate, this may or may not make sense. So you should consult closely with your financial and tax professionals.
Leverage Charitable Deductions Despite Standard Deduction Eliminations
The new tax laws may likely eliminate several long-time deductions while raising the standard deduction for married couples to $24,000. The idea here seems to be to cajole as many people as possible into taking the standard deduction.
Let’s assume a married couple has been giving $20,000 a year to their favorite charity or church, knowing that they could make this amount part of their standardized deductions. Under the new tax laws, this couple may be limited to a $10,000 deduction for taxes together with their $20,000 deduction for the charitable donation. Together they have $30,000 of deductions.
However, since the new standard deduction is $24,000, their $20,000 charitable gift only gave rise to an increase of $6000 above the standard deduction. In effect, $14,000 of the donation would save no tax. So what should they do? This couple should consider prepaying the $20,000 this year to get the full benefit of the deduction.
Another option for leveraging charitable contributions concerns using an IRA distribution. Those who are 70.5 or older are required to make minimum distributions from their IRAs. This strategy involves making a “qualifying charitable contribution” from your IRA to a charity, which amount will come directly off of your gross income, thereby reducing your tax burden.
Gifts from IRA accounts up to $100,000 can be considered a “qualifying charitable distribution.” Contributions up to that amount will come directly off your gross income. The distribution has to come from a traditional IRA and has to go directly from the IRA custodian to the charitable organization, with no intervening possession by the owner of the IRA. In this way, the couple could make a $20,000 charitable contribution and still take the likely $24,000 standard deduction.
Similarly, people who are 5 years away from being required to take IRA distributions can put $100,000 of appreciated stock into a charitable gift fund before the end of this December. For the next 5 years, the charitable fund could distribute $20,000 a year to a charity. They will get the $100,000 deduction this year and after five years they can use their IRA account to further leverage their charitable contributions.
Beware of Potential Divorce Changes
The new tax laws radically change the treatment of alimony payments. If you are considering a divorce, be aware that going forward, the alimony deduction will be eliminated. I was glad to hear that the joint committee delayed the effective date of this change to divorce settlements until after December 31 of 2018. People who have been spending their money on legal fees will not have to go back to renegotiate the arrangement or try to get it completed prior to the end of 2017 (the original proposed effective date).
The way it currently works is that alimony payments are tax deductible and alimony income is taxed. In the new model, alimony payments will not be deductible and alimony income will not be taxed. This means that in most cases, the higher-earning and higher tax-bracket individual in a divorce would no longer be able to deduct alimony payments, and the lower-earning individual would no longer have to pay taxes on alimony payments.
This change is prospective and not retroactive. This means that for divorces happening next year there will be considerable pressure to complete the process by year end to avoid losing the deductibility of paying alimony. This is likely to have a dynamic impact on divorce negotiations. Even though this proposal is not retroactive, it may impact current divorce agreements where one party wants to renegotiate the settlement.
Your situation is unique and you should always make any significant tax-related decisions in conjunction with advice from your financial advisor as well as your tax advisor. In this case, because the laws are so new and the strategies to respond to these laws are emerging quickly, you should run the ideas in this article by your professional advisors as soon as possible.
There may be things you can do right now. But time is fleeting and some of the opportunities you have right now may be lost forever in the next several days. If you need more information or have specific questions, let’s set up a time to talk.
The information contained in this article is provided for informational purposes only. No illustration or content in it should be construed as a substitute for informed professional tax, legal, and or/financial advice.