If you’re trying to figure out whether you will benefit or lose under the new tax bill, check out the summary below.
We’ve all heard plenty about the tax changes coming our way under the new administration. They are contemplating some of the largest changes to the tax code in decades, which is a pretty big deal. So far I’ve maintained a wait and see approach to the issue, given how back and forth other issues have gone (i.e. healthcare) without creating concrete change. Well, legislators have released the first draft of the proposed tax bill, and that means it’s time to start figuring out the lay of the land.
For others who are interested, here are the major highlights. Most Americans care about three things below, which is where we’ll focus:
- Tax rates on wage income
- Deductions they will get vs the old plan
- Tax rates on investments – particularly a main residence and capital gains for stocks
Keep in mind the bill is still in draft form and a lot could change as Congress tries to cobble together the votes needed to pass their bill.
Ordinary Income Taxes
Ahhh, the major highlight. Talk was that Republicans would simplify all these confusing brackets. Indeed, they’ve brought the count down from seven income brackets to four (arguably five given a special phase-out affecting the super-rich). Here’s how they compare. Green areas show who will benefit under the new plan, red areas show who will be paying more.
Chart by Michael Kitces
Almost every individual making $200k or less, or any married couple making approximately $260k or less, will see neutral or positive changes in their tax rates under the new plan. If you’re an individual roughly making between $200k-$425k, or a couple who are approximately making between $250k-$425k, these income tax changes will likely hurt you. It will also hurt folks who make more than a million dollars a year; but if you make more than a million dollars a year, I’m sorry but I can’t summon giant alligator tears for your plight.
Deductions, Deductions, Deductions
But wait, there’s more. What matters is not simply what tax brackets you will fall into, but also what income you get to deduct before applying those brackets.
Let’s do some quick consolidation of how that looks.
The current standard deduction (which is $6,350 for individuals and $12,700 for couples) and the personal exemption (which is $4,050 per person) are combined in the new bill into one consolidated standard deduction of $12k for individuals and $24k for married couples. So far that looks net positive for all taxpayers, to the tune of several thousand dollars more per year being deductible from your tax calculation.
Now let’s start factoring all the major deductions which will go away.
Goodbye To Your Favorite Itemized Deductions
Many of the most commonly used itemized deductions will be eliminated or sharply curtailed, making it less likely you will choose to itemize, and more likely that you will take the standard deduction if you don’t already.
No State and Local Tax Deduction
If you have previously itemized your deductions because of a large state and local tax bill (Hello, Californians!), this is a very sad day for you. Because you choose between a standard deduction amount ($6,350 for individuals and $12,700 for couples under the current regime) and itemized deductions, the way to think about this is if your state and local taxes and other itemized deductions exceed $6,350 for an individual or $12,700 as as an individual, you lose out by the difference.
New Cap and Restrictions on Property Taxes
While there was chatter that the entire property tax deduction would be eliminated, the actual draft allows for up to $10k of property taxes to be deducted. It specifies that this must be property tax on real estate. There are other property taxes such as on automobiles which will not qualify.
If you currently pay more than $10k a year in property taxes, you lose out by the difference between what you currently pay and the $10k cap. If you don’t, this is neutral to you.
Capped Mortgage Interest Deduction
The current regime allows homeowners to deduct interest paid on mortgage indebtedness of up to $1M. The new plan would lower that to a deduction on interest on the first $500k of mortgage indebtedness. Furthermore, it restricts this deduction to a primary home purchase and limits the deduction to only “acquisition indebtedness” which is defined as debt taken on in order to acquire, build, or improve the home. If you want to take out a home loan to use to start a business or any other purpose, you no longer get to deduct your interest payments. Note that existing home loans will be grandfathered in, so this provision relates to new mortgages.
To find out how much you lose because of this new provision, simply figure out how much debt (and accompanying interest you pay on that debt) you would take on above this lowered $500k cap.
Examples: How Reduced Itemized Deductions Hurt
Example 1: Still Choosing To Itemize
Mary and Joe are a married couple who used to itemize under the current tax plan solely for the three major categories above. This year they paid the following:
- $22,000 in state and local taxes
- $12,000 in property taxes on their primary home
- $28,000 in mortgage interest per year on a new $700,000 mortgage for a primary home
Under the new plan, here’s what the itemized deductions would look like:
- $0 of deductions for state and local taxes. Loss: $22,000
- $10,000 of deductions in property tax (the maximum now allowed). Loss: $2,000
- $20,000 in mortgage interest per year (only interest on first $500k of mortgage is deductible). Loss: $8,000
- Total Deduction Losses Under New Plan: $30,000
Note that their total deductions if itemized are $30,000 which exceeds the standard deduction for married couples. So they will still itemize under the new plan, but they will shelter a lot less of their money through deductions than before. Assuming their tax bracket is 35%, these changes will cost them $30,000 * 35% tax = $10,500 more out of their pocket in taxes per year!
Example 2: Switching to a Standard Deduction
Ben is a single guy who used to itemize under the current plan. He rents, so the changes to property tax and mortgage interest deductions don’t affect him. This year under the current plan he paid the following:
- $15,000 in state and local taxes
Under the new plan, he would lose total deductions worth $15k. However, assuming there are no major expenses that cause him to choose to itemize, all is not lost.
Seeing that he gains no benefit from itemizing, Ben now chooses to take the individual standard deduction of $12,000 which in previous years he had eschewed in favor of itemizing. His total loss under the new system is not $15k of deductions, but rather $15k-$12k=$3k. Assuming a tax bracket of 35%, that’s $3k *.35 = $1,050 out of his pocket more per year, probably less punitive than you might have thought.
Tax Treatment of Investments
Let’s turn to the final major category that affects most individuals – tax treatment of investments.
Capital gains bracket rates and thresholds remain unchanged. That means even if your ordinary income tax brackets have moved around, your cap gains rate on your investments given your current level of income will be exactly the same as under the current regime. 0% capital gains rate will still apply up to $77,200 for married couples or $51,700 for individuals (don’t forget your deductions which boost the actual effective threshold higher), the 15% capital gains rate will apply up to $425,800 for individuals and $479,000 for married couples, and the 20% capital gains rate will apply to anyone who has earned more.
Chart by Michael Kitces
Capital Gains on Primary Residence
The current plan allows for capital gains earned on the sale of one’s primary residence to be exempt from taxes: up to $250k of gains for an individual and $500kof gains for a couple. The current requirement is that you live in the residence 2 of the last 5 years. In order to crack down on flippers who “abuse” this provision, the new plan requires that you live in the residence for 5 years, and says you may only use the exemption once every 5 years.
Additionally, this exemption on the gains from a primary residence must now run through an income test. If your Adjusted Gross Income (AGI) exceeds $250k for an individual or $500k for a couple, your exemption is phased out $1 for every $2 you made above the AGI threshold. For example, say you are an individual who made $300k, $50k above the AGI threshold. You sell your primary residence that year. Your maximum cap gains exemption on your home will be $25k below the usual exemption – $225k instead of the usual $250k for an individual.
No More AMT!
I wanted to end the post on a positive note, so I’ve saved a bit of bright news for last. No more AMT! If passed, the new plan will eliminate the need for all of us taxpayers to run a parallel AMT calculation before submitting our taxes. If this sounds unfamiliar to you, know that you’ve been doing it all along. Tax preparation software (or your tax preparer) run this for you in the background.
It’s such a psychologically draining experience to calculate all these fancy deductions you are eligible for…then be required to add them back for the AMT calculation and get told you that whoops, you actually don’t “really” get them because you’ll have to pay more through the AMT calculation. I like the simplicity of knowing you are eligible for a deduction or you’re not, without this phantom process that gets run at the end of the year. For those who were subject to AMT in past years who itemized, the changes in deductions are probably less punitive than the examples illustrate, because AMT would have required them to add back things like state and local taxes and property taxes to calculate a parallel AMT tax burden anyway. At least in this new system it will be clearer for future planning purposes.
There’s still a lot that could change about the bill before a new tax plan goes into effect, but hopefully this gives you an update on where things currently stand. For those interested in an even deeper dive on provisions which affect individual tax payers, I highly recommend Michael Kitces’ tear-down. For those interested in a broader summary – including proposed changes to businesses’ tax treatment – I like Bloomberg’s summary. Other than that, there’s nothing else to do now but grab a bag of popcorn and settle in to wait and see.
Are you worried about the new tax plan? Any thoughts, positive or negative, on the issue?