Because more than 90% of taxpayers are expected to claim the standard deduction under the new tax cut law, “very few taxpayers will receive a tax benefit from incurring deductible expenses,” ushering in a “new paradigm” that offers an opportunity for tax planning, according to Andy Friedman of The Washington Update.
In his newly released white paper, former tax attorney Friedman addresses the interplay of the tax law’s new rules for tax deductions, and offers a framework to help taxpayers determine whether to incur deductible expenses as well as planning opportunities to maximize the tax benefits these deductions can provide.
Taxpayers, Friedman writes, “might wish to reconsider whether it makes sense to incur deductible expenses, or to shift such expenses to other years, to minimize the taxes they pay under the new regime. Because individual circumstances differ, investors should discuss these techniques with their tax advisors before taking any action.”
Under the new tax law, the standard deduction is “roughly doubled” to $24,000 for joint filers and $12,000 for single filers, a simplification measure intended to free more people from the chore of recording and reporting their itemized expenses, Friedman said.
“The tax writers estimate that this increase in the standard deduction will reduce the number of taxpayers who itemize from roughly one-third to fewer than 10%.”
The new tax law will result in some taxpayers choosing to forego making expenditures, Friedman opines, “while others may move the outlays to different years to maximize their tax benefit.”
Friedman set out the following “planning opportunities” that are available as they relate to the new rules for itemized deductions.
1. State and local taxes
The new tax law allows taxpayers to deduct state and local taxes only up to $10,000 annually. Any state and local tax, including state income and property tax, may be included in this calculation, but the aggregate deduction may not exceed $10,000.
The limit applies only to state and local taxes imposed on individuals, not businesses, Friedman explains, so taxpayers “should scrutinize their state and local tax payments to determine if any might be regarded as business-related.”
Affluent taxpayers living in most states are likely to find that their individual state tax payments significantly exceed $10,000. “Of course, these taxpayers receive no tax benefit from incurring state tax payments in excess of this limitation.”
2. Mortgage interest
A homeowner can deduct interest paid on aggregate mortgage principal up to $750,000, down from $1 million under prior law. As under former law, the mortgages may be held on one or two residences, provided the total amount does not exceed this limitation, with existing home mortgages being grandfathered.
The Act also eliminates the deduction for interest paid on home equity lines of credit (HELOCs), including interest paid on existing line-of-credit borrowings. The IRS recognizes an exception to this new disallowance where HELOC proceeds are used to buy, build or substantially improve the taxpayer’s home that secures the loan.
Thus, for example, interest on home equity loan proceeds used to build an addition to that home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debt or college tuition, is not.
While interest incurred on mortgage debt in excess of $750,000 produces no tax benefit (absent grandfather protection), for “the projected 90% of taxpayers who do not itemize, interest on a lower loan amount also produces no tax benefit.”
3. Charitable contributions
The new tax law does not impose more restrictive rules on charitable contribution deductions, but actually increases the percentage of current-year income from which charitable contributions may be deducted from 50% to 60%.
However, Friedman explains, “the doubling of the standard deduction will limit the tax benefit of charitable contributions made by most filers.”
With the new tax law, “once again conventional wisdom is reversed. Taxpayers were encouraged to make charitable donations because the government would pay part of the outlay. Now almost all taxpayers will bear the full cost of their donations, and thus have no tax reason to make them. Only taxpayers who itemize will get a tax benefit from their contributions.”
With some planning, however, Friedman said that taxpayers under the following two scenarios may be able to claim a tax benefit from charitable contributions that otherwise would not yield one.
Bundling contributions with donor-advised funds: Taxpayers who otherwise take the standard deduction could consider “bundling” a number of years’ charitable contributions into a single year, so as to exceed the standard deduction in that year and receive a tax benefit.
Taxpayers considering this “bundling” might not want their charities to receive five years’ contributions at once, or they might wish to change the charitable recipients in future years.
To address these concerns, the taxpayer could consider establishing a donor-advised fund. Contributions to a DAF are deductible when made, but the DAF is not required to distribute the proceeds to charities immediately. Instead, the DAF could dole out the funds in succeeding years.
IRA/charitable contribution rollover: Non-itemizers who are receiving required minimum distributions from their IRAs have another way to benefit from charitable contributions. Under legislation enacted prior to the Act (and still in effect), an individual over the age of 70-1/2 may transfer up to $100,000 from an IRA to a charity and avoid tax on the IRA distribution.
Moreover, the distribution to the charity counts toward satisfying the individual’s RMD obligation. Even a taxpayer who claims the standard deduction can avoid taxes using this method. Thus, taxpayers over age 70-1/2 are well-advised to use IRA funds first to make their charitable contributions.
“To qualify under the IRA/charitable contribution rule, IRA assets must be transferred directly to a charity,” Friedman said. “Transfers to a DAF do not qualify. Thus, these two ideas may not be combined.”
4. Medical expenses
Medical expenses incurred in 2017 and 2018 (and not reimbursed by insurance) qualify as itemized deductions to the extent they exceed in the aggregate 7.5% of the taxpayer’s adjusted gross income.
Beginning in 2019, these expenses are deductible only to the extent they exceed 10% of adjusted gross income.
“Taxpayers who are contemplating medical procedures not covered by insurance might want to consider incurring the associated expense before 2020,” Friedman said. “If incurring the medical expense pushes the taxpayer’s total itemized deductions over the standard deduction amount, it might make sense for the taxpayer to increase charitable contributions in that year as well, taking advantage of the year in which they itemize.”
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