The Key Tax Reform Changes that Will Impact You
As you may have heard, America's tax reform is currently underway. We're still pretty far away from knowing where we'll end up in terms of the final tax code, but now that the House and Senate have each defined their own tax plans, we at least have some idea of where things are headed.
Before we dive in, I want to first identify the parties involved and briefly explain the process of passing tax reform:
1) The House of Representatives ("the House") writes their own version of the tax plan. Their tax plan was voted on and passed by the House on 11/16/17.
2) The Senate Finance Committee ("the Senate") writes their own version of the tax plan as well. The Senate plan was voted on and passed on 12/2/17.
3) The two tax plans will go to the Joint Congressional Conference for reconciliation (which means they would have to work out their differences and come to a consensus) and be voted on.
UPDATE: Final version of tax bill was passed on 12/15/17.
4) Once the bill is voted through, the new tax reform bill will then get signed into law by the President.
UPDATE: The President signed the Tax Cuts and Jobs Act ("TCJA") into law on 12/22/17.
Since the House and Senate will need to come to a consensus on the tax plan (you'll see how different they are below), the final plan could ultimately end up being different from either of their currently proposed plans, but we'll likely see parts of each plan passing.
Below, you'll see how the final Tax Cuts and Jobs Act ("TCJA") differed (or remained the same) from the House and Senate plans. The final changes are indicated in red and labeled "TCJA UPDATE". The "Bottom Line" has also been updated based on the final changes.
While there are many changes to the tax code, I wanted to focus this post on the major changes that matter to you individually:
Marginal Tax Rates Shakeup
We currently have 7 tax brackets, the House bill would reduce the number of brackets to 4 while the Senate would keep 7, but both proposals change the marginal rates and shift the income thresholds of each bracket.
Below is a chart showing a comparison of tax brackets for taxpayers under the current tax law vs. the new plans under the House and the Senate:
Below are the final tax brackets and rates that will go into effect for 2018 through 2025. After 2025, the new tax brackets and rates including many of the below tax changes will revert back to the previous laws, unless they vote to extend the provisions at that time:
Note: Our tax system is a marginal tax bracket system which means that you don't have just one "tax bracket" – you pay all of the tax rates from the first tax bracket up to the tax bracket in which you earned your last dollar (your marginal rate). Thus, your effective tax rate (the total tax you’re actually paying) is generally lower than your marginal rate.
Bottom Line (Updated): While the marginal rates at any given level of income generally go down, some do go up (e.g. the marginal rate for single taxpayers with income roughly between $200,000 and $400,000 increases from 33% to 35%). Based on the new brackets alone, everyone's total tax rates would decrease; however, without the deductions which are now disallowed under the new rules, some might not actually experience an overall tax cut. (Deductions are items that reduce your taxable income. The more deductions you have, the lower your taxable income... keep reading below.)
Mortgage Interest Deduction Reduction
Currently, interest paid on mortgage loans (including $100k of home equity loan) up to a maximum of $1.1M is deductible (interest paid on the portion above $1.1M is not deductible if the loan exceeds $1.1M). The House plan would greatly reduce this mortgage interest deduction threshold, to $500K, while the Senate plan would slightly reduce this threshold, to $1M (removes deductibility of interest on $100k in home equity loan).
The House and Senate split their differences so that the maximum loan amount eligible for mortgage interest deduction is $750,000.
Bottom Line (Updated): New mortgages issued after 12/14/17 would be impacted by this new tax rule, but mortgages issued prior to that date will be grandfathered in under the prior tax rules and therefore be unaffected. So unfortunately if you acquire a new home with a mortgage above $750,000 you'll receive less tax benefit from your mortgage interest payments than what previous homeowners receive.
Gain Exclusion on Principal Residence
Currently, you can exclude up to $500,000 in gains on the sale of your principal residence if you owned and lived in the property for 2 out of the last 5 years. The new House and Senate plans will require you to live in the property for 5 out of the last 8 years to qualify. The House plan additionally phases out the gain exclusion when income is greater than $500,000 ($250,000 for single taxpayers).
Neither of the proposals made by the House or Senate made it into the final tax bill. No changes were made to the existing home gain exclusion rules.
Bottom Line (Updated): You can continue to exclude up to $500,000 in gains on the sale of your principal residence if you live in the property for 2 out of the last 5 years.
Other Personal Deductions
Currently, the standard deduction is $6,350 ($12,700 for married filing joint) and the personal exemption deduction is $4,050. If you itemize deductions, the amounts you pay for property tax, state income tax, and medical expenses (if they exceed 10% of your income) are deductible under current law. The House and Senate plans both double the standard deduction to about 12,000 ($24,000 for married filing joint), but place a limit of $10,000 on property tax deductions, and eliminate the personal exemption and state income tax deductions. The House plan eliminates the medical expense deduction whereas the Senate retains the deduction and lowers the requirements for deductibility (medical expenses will be deductible if they exceed 7.5% of your income).
As consistent with the House and Senate proposals, the final version of the bill doubled the standard deduction, placed a $10,000 combined limit on state and property tax deductions, and eliminated personal exemptions. The Senate plan won out in regards to the medical expense deduction, lowering the income threshold for claiming it from 10% to 7.5%.
Bottom Line (Updated): If you previously itemize deductions, you would no longer be able to deduct many those expenses (with the exception of the enhanced medical expense deduction), which means your taxable income would be higher than under previous law. If you previously took the standard deduction, you would get a higher deduction amount which means a lower taxable income; however, note that the net benefit wouldn't be nearly as much as it might seem since the personal exemption deduction was eliminated.
Alternative Minimum Tax (AMT)
Under current laws, certain people are subject to AMT, an "alternative" tax calculation which applies to higher income taxpayers with large amounts of itemized deductions, and most notably residents of California, New York, and New Jersey due to their high state income taxes. The House plan repeals the AMT completely. The Senate retains AMT but increases the income threshold where people are exempt from the tax. Both plans would decrease taxes for these higher income taxpayers.
In line with the Senate's proposal, the finalized TCJA retains the AMT but increases both the "AMT exemption" amount and the income level at which the AMT exemption phases out (i.e. more taxpayers receive benefit from the AMT exemption).
If you're wondering if you've been subject to AMT tax in the past, check line 45 of your Form 1040 tax return for 2016 – if there’s a number there, you were "in AMT".
Bottom Line (Updated): With the increase in the AMT exemption and phase out amounts, people who were previously subject to AMT may no longer be - which means taxpayers may see some benefit from being able to take the $10,000 in state and property tax deductions compared to previous years where they were subject to AMT and the entire deduction was disallowed. The changes to AMT would also present more opportunities for certain taxpayers to be strategic (e.g. those who hold incentive stock stock options).
The proposed changes to our tax code will most likely affect taxes starting in 2018, but your taxes for this upcoming tax season (April 2018) are still based on our current tax laws, so it's important that you're working with a tax adviser to take advantage of any tax planning opportunities before the end of the year.