On December 22, 2017, the President signed the Tax Cuts and Jobs Act into law. The enactment marks the largest reform to the U.S. tax system since 1986.
The Tax Cuts and Jobs Act has a wide-ranging impact on both individuals and businesses, as well as international tax law. Below is an outline of some of the major provisions that are meaningful to high net worth (HNW) individuals in particular. Unless otherwise noted, these changes take effect as of the 2018 tax year and are scheduled to “sunset,” or expire, for tax years after 2025. “Sunset” means that beginning with tax year 2026, provisions will revert to the 2017 law.
Income Tax Rates
- Capital gains rates remain unchanged, but the highest individual ordinary income tax rate has dropped from 39.6% to 37.0%. Because of lower rates, many tax preparers encouraged their clients to accelerate deductions into 2017 and defer income to 2018, wherever possible.
- The estate tax exemption doubles from $5.6 million to $11.2 million beginning in 2018. The exemption will be increased annually for inflation until 2026, when it reverts to the 2017 level. Thus, a significant drop in the number of taxable estates is expected over the next few years. This increased threshold could also reduce the incentive for HNW individuals to transfer wealth to future generations during their lifetimes.
- The highest estate tax rate remains at 40%.
Changes for Homeowners
Real estate taxes:
- Deductible real estate taxes are significantly limited for wealthy homeowners. The new law caps the total of deductible state and local income tax (or sales tax if higher, which is rare in the case of HNW individuals) plus real estate taxes, at $10,000.
- Shortly after the passage of the Tax Cuts and Jobs Act, the IRS heavily scrutinized the prepayment of real estate taxes for future years. Many HNW taxpayers were motivated to prepay as much of their real estate tax as possible prior to December 31, 2017, in order to take advantage of deductions before the 2018 limits went into effect. The IRS warned that some deductions for prepayment of real estate tax might be disallowed. Generally, the IRS advised that prepayments of 2018 real estate taxes before January 1, 2018 would be deductible only if the municipality had actually assessed the taxes before the end of 2017. In other words, taxpayers would not be able to pay an indefinite amount toward real estate tax for future years and receive the full deduction. Many state officials, particularly the governors of New York and New Jersey, issued executive orders to require municipalities in those states to accept prepayments toward 2018 real estate taxes. It remains to be seen how closely the IRS actually examines this area once 2017 tax returns are filed.
- An interesting development is the concern of localities losing wealthy taxpayers, given the reduced tax benefit of state and local income and real estate tax payments. Certain municipalities are setting up programs as qualified charities to which a local taxpayer can donate and receive a credit to his or her state income or property taxes. As a result, the taxpayer could still benefit from a full deduction of the payment by classifying it as a charitable contribution rather than a state tax payment (which would be limited under the new law). You should consider contacting your local assessor to see if they have any such programs established in your area. These programs are an early development as localities continue to work through the impact of the tax law changes.
Exclusion of gain on sale of primary residence:
- The Tax Cuts and Jobs Act maintains the current provision. In order to exclude up to $250,000 in capital gains ($500,000 for joint filers) on the sale of a primary residence, the taxpayer needs to have lived in the home two of the previous five years. Earlier versions of this proposal contained more restrictive measures.
- The Tax Cuts and Jobs Act eliminates the overall limitation on itemized deductions for high-income taxpayers.
- Mortgage interest deduction:
- For new mortgages after December 15, 2017, deductible interest is capped at $750,000 of debt (in total, for up to two homes). Current mortgages are unaffected, with existing debt subject to the previous $1,000,000 limit being “grandfathered” in.
- Alternative minimum tax (AMT). The AMT limits the extent to which high-income taxpayers can take advantage of certain tax benefits. For instance, many itemized deductions are added back to calculate tax liability.
- The new law provides for a 30% increase to the AMT exemption (i.e., income threshold), to $70,300 for single taxpayers and $109,400 for married taxpayers filing jointly. Because this is a relatively incremental change for high-income taxpayers, the impact to HNW individuals will be minimal.
- Sales of securities:
- The current law remains intact, where individuals can specifically identify securities they wish to sell, thus allowing for more flexibility in cost basis and capital gains. This is significant because the Senate’s version of the original bill proposed a required FIFO (first-in, first-out) method of selling stock.
- Carried interest in private equity/venture capital/hedge funds:
- The required holding period has been increased from one year to three years in order to qualify for the long-term capital gains rate. This provision does not sunset after 2025.
Because our clients’ individual situations are complex and have many moving parts, there is no one-size-fits-all solution when it comes to tax planning. It is imperative to work with qualified advisors to evaluate and develop an appropriate strategy in this new tax landscape. Please contact me or a member of your JDJ team for assistance.