It is November 8th, 2017 as this is written and there is no doubt that a lot will happen with the Tax Cuts and Jobs Act before the end of the year. The current bill is being marked up by the House Ways and Means Committee and the Senate is due to release its own version of tax reform in the coming hours or days. Lobbyists will fight tooth and nail over every word on every one of the bill’s 429 pages. In fact, there is a real possibility that nothing happens on the tax reform front and that we’re left with the same tax rules and brackets in 2018 as we have in 2017.
So with that in mind, the following strategies are not meant to be immediately implemented. Instead, these tax-saving tools use the current Tax Cuts and Jobs Act proposals with the caveat that the advice and strategies could reasonably change before year-end. Still, we think it helps to evaluate and get prepared to act on these strategies if the key components of the bill become law.
1) Make unusually large charitable contributions before year-end and consider establishing a donor advised fund with appreciated investments in 2017.
Approximately 1/3 of all taxpayers currently itemize deductions on their taxes rather than take the standard deduction. However, it is estimated that only 1/20 taxpayers will itemize if the proposed House tax reform becomes law. There are a few big reasons for this change – most notably:
- Elimination of the state tax deduction;
- Elimination of the medical expense deduction;
- Limitations on the mortgage interest deduction; and
- A near doubling of the standard deduction.
This will have a big impact on tax planning as it changes the economics on many decisions from the rent vs. buy decision to the choice of whether to aggressively prepay a mortgage or invest. One of the biggest impacts of the current tax proposal is that most taxpayers will no longer receive a tax benefit from charitable contributions after December 31st. Given that high income taxpayers currently receive an effective federal and state tax subsidy of approximately $40 – $50 for every $100 they give to charities, this lost deduction is a huge deal for both charities and taxpayers.
If you do not expect to exceed the itemized deduction hurdle in 2018 before considering charitable gifts (which for most married taxpayers means that mortgage interest plus property taxes are less than $24,400/year and for single filers, less than $12,200), the big tax-saving strategy is to accelerate charitable contributions before the end of 2017. This is perhaps the most valuable tax planning strategy that comes out of the proposed tax changes. One of the most efficient ways to exploit this strategy is via a donor advised fund where the tax deduction is immediate but the actual timing of the gifts to the targeted charities can be years in the future.
Short of funding a donor advised fund before year-end, the other technique that will likely be advantageous in future years is to lump several years of charitable contributions into a single calendar year. There will be a meaningful tax incentive for many, under the proposed tax bill, to give away $50,000 to charity in one calendar year rather than $10,000 per year for five years.
2) Pay all of your expected 2017 state income taxes before year-end.
If the state income tax deduction is eliminated as planned starting in 2018, it would be a real mistake to miss out on the 2017 deduction by underpaying your 2017 state income taxes before year-end. So make sure you’re fully deferred on state income taxes or send in additional 2017 state tax withholding before year-end if you expect to be light. This advice holds true even for taxpayers who expect to face alternative minimum tax in 2017.
3) Take advantage of the home office deduction, if you’re eligible and not already using.
For most small business owners, entrepreneurs, or employees who work from home and could qualify for the home office deduction, the value of the deduction would markedly increase in 2018. Presently, items related to the home office such as property taxes and mortgage interest are deductible as itemized deductions whether or not you utilize the home office deduction for tax purposes. Again, with the increased standard deduction starting in 2018, mortgage interest and property taxes may no longer provide any tax benefit or as much tax benefit going forward. However, qualifying a portion of your home as a home office enables the property taxes and mortgage interest attributable to that portion of your home to be deductible for tax purposes (in addition to other expenses such as utilities, maintenance, etc.) regardless of whether you use the standard deduction or not.
So while the home office deduction is valuable now, it becomes even more valuable starting in 2018 under proposed tax reform. This should inspire those eligible taxpayers who are not currently satisfying the requirements for the home office deduction (such as using a spare bedroom as both an office and an exercise room which disqualifies the home office deduction eligibility) to clean things up in order to qualify starting in 2018.
4) If you are at least 70.5 years old, utilize the qualified charitable distribution (QCD) starting in 2018 (or just start in 2017 and keep using in 2018).
The qualified charitable distribution (QCD) is an underutilized tax-saving tool that will see its benefit dramatically expand starting in 2018 under the proposed tax law. The biggest beneficiaries of the QCD now are those taxpayers who claim the standard deduction as they receive a tax benefit from charitable contributions that would otherwise provide no tax benefit. Given that the number of standard deduction filers will significantly increase (and likely approach 99% for retirees over age 70.5 as most will not have any mortgage interest), the tax benefit of the QCD expands to a much larger base and should be a tool that everyone over age 70.5 considers in 2018.
5) If you have a significantly appreciated residence on the market and it currently qualifies for the capital gain exclusion (owned and use the property as a primary residence for at least 2 of the last 5 years), there is an economic incentive to close the sale before 12/31/17.
Under the Tax Cuts and Jobs Act, there is a new income phase-out of the capital gain exclusion on the sale of a primary residence. For a high income family selling a property that has appreciated by more than $500,000 since it was purchased, the new tax rules would potentially mean additional taxes of more than $100,000 by selling the property after December 31, 2017. There is, resultantly, a significant tax incentive to get appreciated primary residence sales closed before year-end if the bill passes.
6) If you are considering the purchase of an electric vehicle, buy before year-end.
The $7,500 credit for electric vehicle purchases would be repealed at year-end, immediately making that Tesla $7,500 more expensive on January 1. Get your purchase done before year-end if you’re in the market for an electric vehicle.
7) High income married filers with taxable income between $260,000 and $416,700 or $1,200,000 and $1,614,000 and single taxpayers with income between $200,000 and $416,700 or $1,000,000 and $1,207,000 should consider the unusual strategy of deferring charitable contributions to 2018 and accelerating discretionary income into 2017.
Based on how the current and proposed brackets, taxpayers with incomes in these ranges would face a higher, not lower, marginal tax rate in 2018 (which does not necessarily mean a higher tax bill – just a higher rate on each additional dollar of income). A taxpayer in one of these income ranges who is considering the recognition of a gain, for example, may be best served to do so in 2017 rather than waiting until 2018.
8) Rent rather than own, especially with vacation property.
There’s no doubt that homebuilders were among the hardest hit sectors, if not the hardest hit, in the new tax legislation. Incentives for home ownership were slashed with the higher standard deduction, limits on the mortgage interest deduction, limits on the property tax deduction, and reductions in the primary residence gain exclusion. An advisor colleague remarked, “there’s now a strong financial incentive for me to sell my home to my brother, him to sell his home to me, and for us each to rent them back to each other.”
The elimination or reduction in many of the homeownership tax incentives changes the calculus on home ownership by making it more expensive to own a home going forward. This is especially true of vacation homes. Anyone considering the purchase of a new home or vacation home ought to reconsider the economic cost of ownership versus simply renting.
9) Consider paying down your mortgage more aggressively.
Some of the mortgage interest deductions will be “grandfathered” for current home owners but it is likely that most homeowners will still be impacted by the proposed tax reform. For example, any taxpayer who currently itemizes but will begin using the higher standard deduction under the new code will face a higher mortgage interest cost. Consider a high income family with a mortgage rate of 4.0% who uses the higher standard deduction starting in 2018. Their effective interest rate goes from less than 2.5% today (when factoring in the interest deduction) to the full 4.0% in 2018.
This higher effective interest rate dramatically changes the calculus of the “should I pay off my mortgage or invest” question. Depending on unique circumstances, it will be more advantageous for many individuals and families to more aggressively pay down mortgage debt relative to investing starting in 2018.
10) Prepay 2018 medical insurance premiums before the end of 2017.
With the medical expense deduction eliminated in the proposed tax bill, accelerating any medical expenses into 2017 while they’re still deductible is clearly advantageous. Notably, this deduction and strategy is limited in scope as it only applies to taxpayers where medical expenses (including insurance premiums) in 2017 exceed 10% of adjusted gross income.
If you fall into this segment of the population, one strategy is to schedule any elective medical procedures before year-end. Another strategy is to prepay 2018 private medical insurance premiums before year-end.
Importantly, there is a limit on how much premiums can be prepaid and still immediately deducted. The tax rule permits an immediate deduction provided that “the benefit of an expenditure does not extend beyond the earlier of 12 months after the first date on which the tax payer begins receiving benefit or the end of the taxable year following the year in which the payment is made.” Essentially, this means that you can wait until December 2017, prepay all (or some) of 2018 medical insurance premiums, and capture the deduction in 2017 that would be of no value if paid in 2018.
These ten strategies are not intended to be all-encompassing or to cover every unique situation. They are just 10 broadly applicable strategies that come to mind in light of the proposed tax reform. We welcome feedback if you think we have missed anything important or if you have questions about whether these strategies might be useful for your situation. Please feel free to email us or leave comments below if you have any questions, feedback, or additional thoughts.