Small Business Taxes & ManagementTM--Copyright 2018, A/N Group, Inc.
If you haven't read the introduction to our first article on the new law, please go to Tax Cuts and Jobs Act--Part 1.
In this installment we'll be discussing individual itemized tax deductions that are taken on Schedule A. Everyone has been talking about the limit on state and local taxes, but there are additional cutbacks. As under prior law you want to take the larger of the standard deduction or your itemized deductions. Enter your itemized deductions and your tax software will automatically take the larger amount. The big increase in the standard deduction reduces your chances of your itemized deductions exceeding the standard. That's made even more difficult by the new restrictions on state and local taxes, mortgage interest, and the elimination of miscellaneous itemized deductions. (Note. There are sometimes reasons to itemize even when you'd come out ahead with the standard deduction.)
For example, Fred and Sue had state and local income taxes in 2017 $14,000; mortgage interest of $13,000 and charitable contributions of $1,000. Thus, instead of taking the standard deduction of $12,700 they itemized and deducted $28,000. Assuming the same expenses for 2018, because of the $10,000 limit on state and local taxes, their itemized deductions will only total $24,000, the same as the standard deduction.
Clearly, fewer taxpayers are likely to itemize for federal purposes. But that may prove disadvantageous for state purposes. For example, New York (and many other states) use your federal itemized deductions and disallow the deduction for state income taxes. If, in 2018, Fred and Sue lived in New York and had real estate taxes of $9,000, interest of $13,000 and $1,000 in charitable contributions they could take itemized deductions of $23,000 for state purposes. Their standard deduction for state purposes would be only $15,950, substantially less. They may have to compute their itemized deductions just for state purposes. But there's another hitch. Many states don't allow you to itemize for state purposes if you didn't itemize for federal. More than likely a number of states will revise their rules to accomodate the federal changes.
There is some offsetting good news. First, the new law removes the limitation on itemized deductions that's based on adjusted gross income (AGI). Under the old law taxpayers with AGI of more thant $320,000 (married, joint; $266,700 for single individuals) would see their itemized deductions phased out.
Second, state and local taxes, certain interest deductions, etc. were not deductible for alternative minimum tax purposes. So many higher-income taxpayers ended up receiving little or no benefit from some of their deductions. The changes in the alternative minimum tax make that much less likely.
State and Local Taxes
This change may be the most talked about one, and it's also one of the most straightforward. Your deduction for state and local income, property, and sales taxes (if you use that option), combined, is limited to $10,000 ($5,000 married filing separate). No deduction is allowed for foreign real property taxes paid in the years 2018 through 2025; foreign income taxes are still deductible, subject to the restrictions on all taxes. If you prepaid state and local income taxes for 2018 in 2017, they're not deductible until 2018. Real property taxes that are assessed in 2017 are deductible if paid in 2017, if you're allowed to do so under local law.
There is an exception for state and local real or personal property taxes paid or accrued in carrying on a trade or business or income-producing activity. For example, you have an auto repair business operated as a sole proprietorship. You own the building that is used by the business. The real property taxes would be fully deductible, but on Schedule C. Property taxes related to rental property should be taken on Schedule E as part of the rental expenses.
There are some issues here that will probably be addressed in guidance from the IRS.
If you have a vacation home that's not being used, you might consider renting it to secure a deduction on Schedule E. There are pros and cons. Talk to your tax advisor.
If you are self-employed and use a portion of your home for business, the business portion of the taxes (and other expenses) are entered on Form 8829 and deducted on Schedule C or Schedule F for farm income. For example, you use 20% of your home for business. Your real estate taxes are $10,000 for the year. Of the total $2,000 (20%) would be deductible on Schedule C, the remaining $8,000 would be deductible on Schedule A, subject to the overall$10,000 limit rule.
Home Mortgage Interest Deduction
This change, too, is pretty simple. Mortgage interest on acquisition indebtedness on a qualified residence incurred on or after December 15, 2017 is deductible, but only to the extent of the interest on the first $750,000 ($375,000 if married filing separate) of debt, not the $1 million limit under the old law. No deduction is allowed for home equity debt, regardless of when incurred.
A qualified residence is your principal residence plus one other residence. That includes a vacation home, or a boat or recreational vechicle with living accommodations. The old rules continue to apply as well to other definitions. For example, the debt must be secured by the residence and acquisition indebtedness includes refinanced debt not in excess of the original debt. Acquisition debt includes debt incurred in the purchase, construction, or substantial improvement of the residence. There are other rules with respect to refinanced debt including that the refinancing cannot extend the term of the original loan. The qualifying debt on a mortgage refinanced that was take out before December 15, 2017 can be as much as the old limitation, $1 million. Talk to your tax advisor on potential other restrictions.
The two changes here are the loss of a deduction for home equity interest and the lower maximum indebtedness. Like other provisions in the new law, both of these restrictions expire after 2025.
While there are no "loopholes" there are steps you can take to make sure you don't give away an interest deduction. For example, many taxpayers use their home equity line to add a room, redo a kitchen, finish the basement, etc. Under prior law the first $100,000 of home equity interest was deductible, so it really didn't make much difference if the amount was incurred for a addition to the home or a new foreign sports car. But for home improvements the home equity loan is really acquisition debt and the interest on the portion of the total debt used for these purposes should still be deductible, subject to the overall limits. Interest on home equity debt incurred to purchase a new car would not be. If you do use the home equity line for this purpose you need to keep accurate records of the date and amount spent and be able to tie it to the amount withdrawn from the home equity line. Talk to your tax advisor about the fine points of recordkeeping here.
Example--In 2017 Carol and Bill drew down $30,000 on a $100,000 home equity line to purchase a car. On July 1, 2018 they take $60,000 from their home equity line to pay for a new kitchen and an additional bathroom. The interest on the $60,000 home improvement debt would be deductible in 2018. But that amount was outstanding for only half the year. Carol and Bill would have to determine the amount of interest on that $60,000 for the last six months of 2018.
Business owners can encounter the situation where they borrow on their home to finance their business or for the purchase of a rental property. In both these situations the loan and the interest really belongs on the business or the rental property and should be deducted on that business. Debt related to these types of loans is not subject to the $750,000 restriction. For example, Sharon and Mark have a home worth $2.3 million. They borrow $1.25 million to finance their business. Interest on the entire debt would be deductible, but not as an itemized deduction on Schedule A. Again, talk to your tax advisor about the recordkeeping and mechanics, both of which can be critical.
Investors can still deduct investment interest. Amounts borrowed through a home equity line should be allocated to the investment interest deduction. See Form 4952 and the instructions.
While the interest isn't deductible, that doesn't mean taking out a home equity loan no longer makes sense. If you got into financial difficulty and ran up your credit cards, using a home equity loan at 4% or a similar interest rate to pay off 22% credit card balances makes sense. On the other hand, car loans currently carry a low rate. It may make more sense to finance a new car with an auto loan rather than use home equity money. A home equity line can still prove useful in many situations, but you shouldn't use it indiscriminately.
Medical Expense Deduction
This change is a positive one. Under prior law only unreimbursed medical expenses that exceed 10% of AGI were deductible for regular or AMT purposes. The new law lowers the percentage threshold to 7.5% for both regular and AMT purposes, but only for 2017 and 2018. (It had been 7.5% some years ago.) For example, under the 10% threshold a taxpayer with AGI of $50,000 would be able to deduct only the amount of unreimbursed medical expenses that exceed $5,000 (10% of $50,000). Under the new law that same taxpayer would get a deduction for expenses that exceeded $3,750 (7.5% of $50,000). Medical expenses includes health insurance, long-term care insurance (subject to restrictions), unreimbursed doctor and hospital bills, tests, prescriptions, etc.
There's another change to the law here. This change applies to tax years beginning after December 31, 2016. That means it applies to 2017 tax returns, one of the few changes that does.
There's a downside here. The lowered threshold only applies to tax years beginning before January 1, 2019. For almost all taxpayers that means it only applies to tax years 2017 and 2018.
Miscellaneous Itemized Deductions
These deductions include a broad range of expenditures from job hunting expenses, union dues, professional uniforms, an employee's home office, unreimbursed employee business expenses (e.g., travel, lodging, meals and entertainment), continuing education expenses, to professional subscriptions and dues. The expenses deductible under this category also include expenses for the production and collection of income such as the cost of preparing your tax return, investment advisory publications and advisory fees. They may also include attorney's fees for the collection of income a safety deposit box, and appraisal fees. Finally, expenses under Section 183 related to "hobby losses" are deductible here.
Many taxpayers don't break the 2% threshold required to deduct any of these expenses, or do so only sporadically, but the category is such a catchall that more than a few taxpayers, particularly professionals who are employees will feel the pinch on a regular basis.
Taxpayers who are self-employed (that includes partners in a partnership and LLC members) or do business through a regular or S corporation should be particularly careful who the expenses belong to and who pays them. For example, you may have been deducting unreimbursed business expenses on Schedule A where you could be deducting them on your S corporation. Talk to your tax advisor about the correct treatment.
Business owners may have to reconsider their reimbursement policies. If the business had a policy of not reimbursing employees for meals that were business related, the employee will now be forced to absorb the entire bill. In order to placate and retain employees you may have to start reimbursing for items you didn't in the past. Talk to your tax advisor.
Copyright 2018 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 01/09/18