Adapting to the tax reform’s limits in the highest taxed states
One of the causes for worry around tax reform, particularly for residents who pay the highest state tax rates, is the $10,000 cap on state and local tax deductions, including real estate and personal property taxes. For the 30 percent of taxpayers who typically itemize, state and local taxes can make itemizing worthwhile. In 2015, 44.2 million taxpayers deducted $553 billion in state and local taxes. That’s more than $12,500 on average, meaning on average, taxpayers will lose $2,500 in itemized expenses starting with tax year 2018. Depending on which tax bracket the taxpayer falls in, deducting an additional $2,500 could be a tax benefit of $250 to $925. Conversely, losing that tax deduction could mean a tax increase of $250 to $925.
“Don’t panic,” said Gil Charney, director at The Tax Institute at H&R Block. “Even if you pay more than $10,000 in state and local taxes, it’s not a foregone conclusion that you will be worse off in 2018. You might benefit from lower tax rates, an increased child tax credit with a much higher income limitation and a higher standard deduction that might make your state and local taxes irrelevant to your overall outcome.”
Still, the limitation gives taxpayers another variable to factor in to their tax planning strategies. And the goal, Charney says, is to get the best tax outcome possible for their situation, not to resign themselves to paying more than what is necessary even if it compares favorably to prior years.
For how that’s possible, Charney gave a few tax planning strategies to adapt to the new $10,000 limit on state and local tax deductions and other ways to maximize tax savings under the new law.
Keep in mind the $10,000 cap only impacts individuals
While state and local tax deductions are limited to $10,000 on an individual return, any property or sales taxes paid for a business (such as a sole proprietorship, rental property or farm) would remain fully deductible against income from that business. So, if an individual owns a business that pays state and local taxes, there’s no change from previous law.
Don’t take the suggestion to move too seriously
To the suggestion that taxpayers move to a lower-tax state, Charney advises it’s no laughing matter.
“States without income tax may still have high property or sales taxes – after all, states need to fund their operations from some source of revenue. So, if it’s not an income tax, it’s something else,” he said. “Instead of trying to avoid living in these states, taxpayers may look for ways to mitigate the tax impact of living in a high-tax state.”
Spend less time working in a higher-tax state
Taxpayers who travel for work could try spending less time working in states with the highest state income tax rates. States generally offer resident taxpayers a nonrefundable credit for taxes paid to other states. If a taxpayer pays more to other states than their resident state tax liability, the credit would not cover the excess paid. The taxpayer can limit the excess by spending less time working in the higher tax states.
Invest in rental property for the pass-through deduction
Under tax reform, eligible businesses will get a 20 percent deduction off their net income if they meet certain rules around their income and type of business. They don’t have to spend money to get this deduction.
“Most deductions are based on what you spend, but this deduction is an extra 20 percent off your taxable income even after deducting all your business expenses,” said Charney. “If you own a profitable business, you may still get the benefit of this deduction.”
See if the alternative minimum tax (AMT) no longer applies
One big driver of the AMT was state and local taxes, but now with the $10,000 cap, taxpayers who might have had to pay AMT may no longer, especially since the tax reform law raises the exemption on AMT substantially.
“You win some, you lose some,” Charney said. “If the $10,000 cap on your state and local tax deductions means you don’t have to pay AMT, you may be better off than if you had to pay AMT.”
Think twice before deducting those prepaid state taxes
Some taxpayers prepaid their 2018 real estate tax liability before the end of 2017 in order to deduct the taxes on their 2017 return before the $10,000 cap went into place. Unfortunately, the IRS issued a notice stating that taxpayers can’t deduct pre-paid real estate taxes that had not yet been assessed by the end of 2017.
“If the state property tax was assessed in 2017 but due in 2018, it is deductible in the year it is paid, whether that is 2017 or 2018,” Charney said. “You’ll know if a tax was assessed or not because you will typically have a dated bill with an amount due, although the method of assessment depends on local law. But if you only estimated your state property taxes and paid them in 2017, they are probably not deductible in 2017.”
Take advantage of Pease limitation elimination
In the past, as income reached a certain level, the taxpayer could not get a 1-to-1 tax deduction for itemized expenses. The new law repeals income caps on itemizing, known as Pease limitations. This means high-income taxpayers can fully deduct their itemized expenses, except for the $10,000 cap that applies to all individual tax returns on state and local taxes.
“It’s possible that a taxpayer whose itemized deductions were limited in the past because of the Pease limit could actually see their itemized deductions increase even if they’re impacted by the $10,000 cap,” Charney said.
Give charitably, strategically
The limit on deducting charitable contributions increased from 50 percent to 60 percent of income. So, taxpayers have more room to make donations of stock and avoid any tax on the appreciated value.
Another strategy to make itemizing worthwhile now that the standard deduction is almost doubled is to use donor-advised funds. Donor-advised funds can be funded with large gifts upfront while delaying the actual distribution to a charity. Taxpayers can take a deduction when they contribute to the fund, not when the fund disburses money to the charity.
Reevaluate business structure
Though many individuals would benefit from a lower tax rate if it their income were taxed as a pass-through rather than wages from an employer, there are many factors that the Department of Labor and the IRS use to determine if a worker is properly classified as an independent contractor or an employee.
“Chasing a tax rate should not be the only basis for the decision to change the type of business entity or an employment relationship, but if it makes sense holistically, then the individual should do that,” Charney said.
Pass-through businesses, such as sole proprietors, partners and S corporation shareholders, could benefit from the new 20 percent deduction off their net income. There are limitations on service providers in health, law, accounting, consulting, performing arts, athletics, financial or brokerage industries, as well as on businesses with more than a certain amount of income: $157,500 if single and $315,000 if married filing jointly.
Instead, businesses should evaluate their eligibility for the 20 percent deduction. Some may consider converting to a C corporation, which has a 21 percent tax rate.
“These strategies are a good starting point for talking to your own tax professional about your specific circumstances,” Charney said. “Tax reform impacts virtually everyone, but it impacts everyone differently. It’s important to look at your unique situation.”
Learn more about the latest guidance and regulations on the updated 20% deduction that tax reform gives some business owners and independent contractors.
Learn whether tax reform will mean a larger or smaller tax refund this year with H&R Block’s tax refund and tax reform calculator.
Learn how H&R Block’s free tax reform checkup can help taxpayers prepare for tax reform impact now before it’s time to file and too late to change anything.
Learn about the TCJA impact on taxpayers this year. H&R Block explains why some people had smaller refunds although their taxes went down and the importance of W-4 help.