Trump supporters welcomed the Republican-backed tax reform package that took effect just over a year ago—and expected that they would see reduced tax liability as a result. Now that the first tax filing season under the new tax changes is well underway, many taxpayers—especially those in higher income tax brackets living in high tax states—are shocked to find that the Trump tax “cuts” actually left them shouldering a higher tax burden for the 2018 tax year.
Many advisors now find themselves facing clients who are angry and wondering why their overall tax burden has increased—and now have the opportunity to add value by explaining the new rules and proposing possible solutions.
Post-Reform State of Deductions
The 2017 Tax Act limited the ability of taxpayers to deduct state and local taxes (including sales, income and property taxes, which were previously deductible from federal income taxes without limit). The new law now imposes a cap of $10,000 ($5,000 for married taxpayers filing separate returns) on this deduction. Foreign real property taxes can no longer be deducted. These rules apply for tax years beginning after December 31, 2017 and before January 1, 2026.
For high-income clients who live in high tax states (notably, most traditionally “blue” states, such as New York and California, have the highest state-level taxes), placing a $10,000 cap on the deductibility of state and local taxes can represent a significant tax increase. Additionally, many higher income clients who have bought a new home recently will find that their mortgage interest deduction is also limited—only interest on the first $750,000 of mortgage debt can be deducted post-reform. This $750,000 cap may seem generous, but higher income clients who live in high tax states often find themselves facing a real estate market where homes are significantly more expensive than in no or low-tax states.
Although the highest ordinary income tax rate was reduced from 39.6 percent to 37 percent, the standard deduction was doubled and the child tax credit was significantly expanded so that more high-income clients can now benefit, higher income clients are still learning that they will pay more in taxes in 2018 than they did under the old pre-2018 law.
Potential Planning Opportunities
Both the proposed and final Section 199A regulations upset some possible planning strategies by adding a new provision that requires aggregation of two or more trusts in certain circumstances. The aggregation rules apply in the Section 199A context and beyond—meaning that they are also relevant for those who had planned to use multiple non-grantor trusts to avoid the SALT cap.
Aggregation is now required if the trusts have substantially the same grantor or grantors, and substantially the same beneficiary or beneficiaries, if the principal purpose of forming the trust or contributing additional assets to the trust is the avoidance of income tax. This means that for income tax planning purposes, trusts can continue to add value for clients who have multiple natural beneficiaries, each of whom can be named beneficiary of a different trust, or for clients who can justifiably point to a significant non-tax reason for the trust formation.
For some clients, closely examining state tax law provisions can help reduce the SALT cap impact between now and 2026. For example, New York law provides an exclusion ($20,000 for those 59 1/2 and older, and $40,000 for married couples) from federal income for qualified pension and annuity income when residents calculate their New York taxable income. This means that these amounts will not be subject to state-level taxes.
Clients who have the choice between withdrawing funds from these types of accounts or other taxable accounts may benefit from choosing to use excluded funds during the years the SALT cap is in effect in order to reduce state and local taxes that may no longer be deductible at the federal level.
While most clients would not consider moving to avoid higher federal income taxes, some clients have considered relocating their “tax home” to a low or no-tax state—a strategy that may be particularly valuable for clients who are nearing retirement and have already acquired a “retirement” home in a low tax state, such as Florida.
The bottom line is that, under tax reform, many taxpayers actually will face a higher tax burden from now until 2026, when most of the individual tax reform provisions—including the SALT cap—are set to expire absent extension by Congress. Highly motivated clients can plan to reduce the sting, but also need to be advised that certain planning techniques are complex and can create cost of their own.
- Please read previous coverage of planning for expanded tax credit post-tax reform in Advisor’s Journal.
- For in-depth analysis of pre-reform rules governing income tax deductions, see Advisor’s Main Library.
- Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.