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.”