Home Tax Deductions: Overrated and Getting Worse

If you ask virtually anyone about the benefits of home ownership, you will probably hear the phrase “great tax deductions” within 20 seconds. However, the reality is that for many taxpayers, owning real estate is not much of a tax deduction at all. And under the Trump-proposed tax reform bill currently in Congress, the actual tax benefits homeowners achieve will shrink vastly.

The two main tax benefits of being a homeowner are the mortgage interest deduction and the property tax deduction. These are claimed under “itemized deductions”, which also include charitable donations, medical expenses (exceeding 7.5% or 10% of income), and miscellaneous deductions such as unreimbursed employee expenses.

You have your choice of taking whichever is higher: the standard deduction or your itemized deductions (Schedule A). The standard deduction for 2017 is $6,350 (single) or $12,700 (married filing jointly). So, the first thing to realize about home tax deductions is that you only are getting a benefit if they exceed $6,350/$12,700.

If you are married and your mortgage interest, property tax, and other deductions only total $11,000, you will take the standard deduction. All those house expenses did not get you a penny of additional tax benefits. If your itemized deductions total $13,000, you would take the itemized deductions, but are only getting a benefit of $300 – the amount by which you exceeded the standard deduction.

The greatest proportion of tax benefits for homeowners go to those with very expensive homes and large mortgages. People with more modest homes may be getting little or no benefit relative to the standard deduction. But wealthy taxpayers can have their itemized deductions reduced by up to 80% under the Pease Restrictions. So, I have also seen high earning families who don’t get to count their home expenses either, and have to take the Standard Deduction!

The proposal in Congress today via President Trump would make two significant changes to tax deductions for homeowners:

1. The bill would almost double the standard deduction from $6,350 (single) and $12,700 (married) today to $12,000 and $24,000. This would reduce taxes and eliminate the need for itemized deductions for many American families. If you are married and your current itemized deductions are under $24,000, you would no longer be getting a deduction for those expenses.

2. Trump also proposes eliminating the deduction for State and Local Taxes (the so-called SALT deductions), which includes property taxes. Removing the SALT deduction from Schedule A would be devastating for high tax states like California, New York, Connecticut, and New Jersey. But it would also harm many homeowners right here in Texas, where our property taxes can be a significant expense.

While the increase in the standard deduction would offset the loss of SALT deductions for many Americans, it is still an elimination of a key benefit of being a homeowner. The current tax reform bill has narrowly passed in the House of Representatives and will be taken up by the Senate after November 6, where it requires only a simple majority to pass under budget reconciliation rules.

The fact is that real estate tax deductions were already overstated when you recognize that you only benefit when you exceed the Standard Deduction. The first $12,700 in itemized deductions achieve no reduction in taxes whatsoever. Now, if Congress acts to increase the Standard Deduction and to eliminate the ability to deduct property taxes, most people will not be getting any tax break from being a homeowner.

Depending on your situation, your overall tax bill may still go down. The current proposal will simplify the tax brackets to just three levels: 12%, 25%, and 35%. Your taxes may also go down because of the increase in the Standard Deduction, provided the Standard Deduction is higher than your Schedule A.

Tax policy has a profound influence on public behavior. If you know that you are not getting any additional tax benefit from being a homeowner, you may prefer to rent. If you are retired and see your income taxes go up, you may decide to sell your home and downsize to save money. This change in policy may have the unintended consequence of hurting home values, too, because it certainly make being a homeowner less appealing.

Beware: 2017 Fund Capital Gains Distributions

We are starting to receive estimates for year-end 2017 Capital Gains distributions from Mutual Funds, and no surprise, many funds are having large distributions to their shareholders this year. As a refresher, when a mutual fund sells a stock within its portfolio, the gain on that sale is passed through to the fund owners at the end of the year as a taxable event.

When you invest in a 401(k), IRA, or other qualified account, these capital gains distributions don’t create any additional taxes for you. If you reinvest your distributions, your dollar value of the fund remains the same, and you are unaffected by the capital gain. However, if you are investing in a taxable account, these distributions will cost you money in the form of increased taxes.

A quick look at estimates from American FundsColumbia, and Franklin-Templeton shows that many equity funds are having capital gains distributions of 3-10% this year. A few are even higher, such as the Columbia Acorn (17-21%) and Acorn USA (23-28%). Imagine if you made a $100,000 investment at the beginning of the year, your fund is up 16% and then you get a distribution for $28,000 in capital gains! Yes, capital gains distributions can exceed what a fund made in a year, when the fund sells positions which it owned for longer.

Capital Gains Distributions create a number of problems:

  • Even if you are a long-term shareholder, when the fund distributes short-term gains, you are taxed at the higher short-term tax rate.
  • If you didn’t sell any of your shares, you will need to find other money to pay the tax bill, which can run into the thousands each year if you have even just a $50,000 taxable portfolio.
  • If you are thinking of buying mutual fund shares in Q4 of this year, you could end up buying into a big December tax bill and paying for gains the fund had 6-12 months ago.
  • In addition to paying capital gains on fund distributions, you will still have to pay tax when you sell your shares.
  • Capital gains distributions are in addition to any dividends and interest a fund pays. In general, we want dividends and interest income as additions to our total return. Capital gains distributions, however, do not increase our return and are an unwelcome tax liability.

If you have a taxable account, or both taxable and retirement accounts, we may be able to save you a substantial amount of money on taxes. We can use tax-efficient investments like Exchange Traded Funds (ETFs), which typically have little or ZERO capital gains distributions at the end of the year. This puts us in control of when you want to sell and harvest your gains. When you have multiple types of accounts, we can place the investments into the best account to minimize your tax bill.

If you do presently have mutual funds in a taxable account, it may be a good idea to take a look at your potential exposure before the end of the year so you are not surprised. If you sell before the distribution is paid, you can avoid that distribution. Now that will mean paying capital gains based on the profit you have when you sell. But you definitely want to be planning ahead. When you’re ready to create a tax-managed portfolio that looks at all your accounts together, we can help you do that.

Can You Reduce Required Minimum Distributions?

After age 70 1/2, owners of a retirement account like an IRA or 401(k) are required to withdraw a minimum percentage of their account every year. These Required Minimum Distributions (RMDs) are taxable as ordinary income, and we meet many investors who do not need to take these withdrawals and would prefer to leave their money in their account.

The questions many investors ask is Can I avoid having to take RMDs? And while the short answer is “no, they are required”, we do have several ways for reducing or delaying taxes from your retirement accounts.

1. Longevity Annuity. In 2014, the IRS created a new rule allowing investors to invest a portion of their IRA into a Qualified Longevity Annuity Contract (QLAC) and not have to pay any RMDs on that money. What the heck is a QLAC, you ask? A QLAC is a deferred annuity where you invest money today and later, you switch it over to a monthly income stream that is guaranteed for life. Previously, these types of deferred annuities didn’t work with IRAs, because you had to take RMDs. Luckily, the IRS saw that many retirees would benefit from this strategy and provided relief from RMDs.

Investors are now permitted to place up to 25% of their retirement portfolio, or $125,000 (whichever is less), into a QLAC and not have to pay any RMDs during the deferral period. Once you do start the income stream, the distributions will be taxable, of course.

For example, a 70 year old male could invest $125,000 into a QLAC and then at age 84, begin receiving $31,033 a year for life. If the owner passes away, any remaining principal will go to their heirs. (Source of quote: Barrons, June 26, 2017)

In retirement planning, we refer to possibility of outliving your money as “longevity risk”, and a QLAC is designed to address that risk by providing an additional income stream once you reach a target age. Payouts must begin by age 85. A QLAC is a great bet if you have high longevity factors: excellent health, family history of long lifespans, etc. If you are wondering if your money will still be around at age 92, then you’re a good candidate for a QLAC.

2. Put Bonds in your IRA. By placing your bond allocation into your IRA, you will save taxes several ways:

  • You won’t have to pay taxes annually on interest received from bonds.
  • Stocks, which can receive long-term capital gains rate of 15% in a taxable account, would be treated as ordinary income if in an IRA. Bonds pay the same tax rate in or out of an IRA, but stocks lose their lower tax rate inside an IRA. You have lower overall total taxes by allocating bonds to IRAs and long-term stocks to taxable accounts.
  • Your IRA will likely grow more slowly with bonds than stocks, meaning your principal and RMDs will be lower than if your IRA is invested for growth.

3. Roth Conversion. Converting your IRA to a Roth means paying the taxes in full today, which is the opposite of trying to defer taking RMDs. However, it may still make sense to do so in certain situations. Once in a Roth, your money will grow tax-free. There are no RMDs on a Roth account; the money grows tax-free for you or your heirs.

  • If you are already in the top tax bracket and will always be in the top tax bracket, doing a Roth Conversion allows you to “pre-pay” taxes today and then not pay any additional taxes on the future growth of those assets.
  • If not in the top bracket (39.6%), do a partial conversion that will keep you in your current tax bracket.
  • If there is another bear market like 2008-2009, and your IRA drops 30%, that would be a good time to convert your IRA and pay taxes on the smaller principal amount. Then any snap back in the market, or future growth, will be yours tax-free. And no more RMDs.
  • Trump had proposed simplifying the individual tax code to four tax brackets with a much lower top rate of 25%, plus eliminating the Medicare surtaxes. We are holding off on any Roth conversions to see what happens; if these low rates become a reality, that would be an opportune time to look at a Roth Conversion, especially if you believe that tax rates will go back up in the future.

4. Qualified Charitable Distribution. You may be able to use your RMD to fund a charitable donation, which generally eliminates the tax on the distribution. I wrote about this strategy in detail here.

5. Still Working. If you are over age 70 1/2 and still working, you may still be able to participate in your 401(k) at work and not have to take RMDs. The “still working exception” applies if you work the entire year, do not own 5% or more of the company, and the company plan allows you to delay RMDs. If you meet those criteria, you might want to roll old 401(k)s into your current, active 401(k) and not into an IRA. That’s because the “still working exception” only applies to your current employer and 401(k) plan; you still have to pay RMDs on any IRAs or old 401(k) accounts, even if you are still working.

We can help you manage your RMDs and optimize your tax situation. Remember that even if you do have to take an RMD, that doesn’t mean you are required to spend the money. You can always reinvest the proceeds back into an individual or joint account. If you’d like more information on the QLAC or other strategies mentioned here, please send me an email or give us a call.

Will Trump Lower Your Taxes?

Since the surprise victory of Donald Trump, the markets have rallied and the dollar has strengthened. This is in expectation of increased infrastructure spending, looser regulation of finance, healthcare, and other industries, and lower tax rates. What does this mean for your personal tax situation?

You can read Trump’s tax platform on his website here. He proposes to simplify individual taxes from seven brackets today to three: 12%, 25%, and 33%. For higher income taxpayers, this would be a reduction from 35% and 39.6%. He also proposes to eliminate the 3.8% Medicare Surtax on Investment Income (for taxpayers above $200,000 single and $250,000, married). And he wants to lower the corporate income tax rate from 35% to 15% to prevent companies from leaving the US and to encourage US corporations to repatriate profits from overseas subsidiaries.

Before we consider what planning strategies this suggests, I’d like to make two points.

1) What candidates propose during the campaign and what they can actually achieve are often very different. There’s no guarantee these plans will become law. In Trump’s favor, however, he has a Republican controlled House and Senate which should work with him. Under budget reconciliation rules, the Senate can pass tax changes with a simple majority, and need not have 60 votes.

2) Under Trump’s economic plan, the deficit will soar and the national debt will grow at an unprecedented rate. Not only is he kicking the can down the road by not addressing the deficit, he will massively increase our debt load. Eventually, the cost of our debt service will crowd out other spending and has the potential to become a significant problem for our children and grandchildren.

For individual taxpayers, Trump wants to increase the standard deduction to $15,000 single and $30,000 joint, but to cap itemized deductions to $100,000 single and $200,000 joint. While he would reduce taxes for many taxpayers, the largest savings will go to those in the top tax brackets who would pay 33% on income over $225,000 (joint), under the Trump plan.

If you are in the top tax bracket and believe that Trump’s plan will become a reality in 2017, you would see your marginal rate decrease from 43.4% (39.6% plus 3.8% Medicare) to 33% next year. In that scenario, you would want to defer receipt of income, as possible, from 2016 to 2017. And you would want to accelerate any tax deductions, business expenses, and short-term capital loss harvesting to take those reductions in 2016. For example, in December, you could pay your property taxes, make charitable gifts planned for 2017, and make purchases of office supplies or other business goods which can be expensed and not capitalized.

If you own a business, under Trump’s plan, it may become appealing to convert to a C-Corporation to take advantage of the 15% corporate tax rate, instead of remaining a sole proprietor or other pass-through tax structure. While a dollar of income would be taxed at the corporate level and again when passed through to the owner, the owner of a C-corporation has the opportunity to take a modest salary and receive the rest of the profits as a dividend, which would be taxed at 15-20%, and not require any payroll tax.

For current owners of a C-Corporation, you would want to reduce your 2016 income as much as possible if you anticipate a 20% tax reduction in 2017. This means deferring income until January (which involves different strategies depending whether you use the cash or accrual accounting method), and maximizing your 2016 deductions.

Last December, Congress made the Section 179 deduction permanent. As a business owner, you should know about Section 179, which allows you to immediately deduct qualifying business equipment purchases, rather than capitalizing the costs over the life of the equipment and taking an annual depreciation amount. The limit on Section 179 is $500,000 per year, and is phased out for businesses who have purchased more than $2 million in qualifying property.

Qualifying property eligible for the Section 179 deduction includes equipment/machines, computers, software, furniture, and business vehicles over 6,000 pounds GVWR (Gross Vehicle Weight Rating). The vehicle deduction is very popular with business owners, and may be applied for new or used vehicles. Please note that vehicles under 6,000 pounds GVWR do not qualify, and that for certain vehicles, the deduction may be capped to $25,000.

If you are expecting your corporate tax rate to fall in 2017, I’d look to maximize your Section 179 purchases in 2016 and make those purchases before the year’s end.

I’d prefer you keep your hard-earned money rather than give it to the government to spend, and I will suggest every legal opportunity to reduce the amount my clients pay to the IRS. Having said that, it seems unfair to ask future generations to pay for our profligate spending. Hopefully, our politicians will eventually think further out than just winning the next election, but I’m not going to hold my breath for that one.

Trump’s economic plan also means that inflation should start to pick up. We’ve already seen interest rates move up since the election, perhaps more than they should have, in expectation of Trump’s spending plans. Mortgage rates have started to rise, and I believe that real estate price increases will slow. Property reflation may be in the 8th or 9th inning in many parts of the country. Affordability is an issue in many cities, and higher mortgage rates will not support home prices continuing to increase by 5-7% or more per year.

No one knows what will unfold over the next four years under Trump but if tax rates decline, we will certainly welcome the savings. We will continue to look for ways to reduce taxes from your investment portfolio and be as tax efficient as possible.