How to Pay Zero Taxes on Interest, Dividends, and Capital Gains

How would you like to pay zero taxes on your investment income, including interest, dividends, and capital gains? The only downside is that you have to live in a beautiful warm beach town, where the high is usually 82 degrees and the low in the winter is around 65.

If this sounds appealing to you, you should learn more about the unique tax laws of Puerto Rico. As a US territory, any US citizen can relocate to Puerto Rico, and if you make that your home, you will be subject to Puerto Rico taxes and may no longer have to pay US Federal Income Taxes. You can still collect your Social Security, use Medicare, and retain your US citizenship. (But not vote for President or be represented in Congress!) 

Citizens of Puerto Rico generally do not have to pay US Federal Income Taxes, unless they are a Federal Employee, or have earned income from the mainland US. This means that if you move to PR, your PR-sourced income would be subject to PR tax laws. In 2012, PR passed Act 22, to encourage Individual Investors to relocate to PR. Here are a few highlights:

  • Once you establish as a “bona fide resident”, you will pay zero percent tax on interest and dividends going forward.
  • You will pay zero percent on capital gains that accrue after you establish residency.
  • For capital gains that occurred before you move to PR, that portion of the gain would be taxed at 10%, (reduced to 5% after you have been in PR for 10 years). So if you had enormous long-term capital gains and were facing US taxes of 20% plus the 3.8% medicare surtax, you could move to PR and sell those items later this year and pay only 10% rather than 23.8%.
  • The application for Act 22 benefits costs $750 and if approved, the certificate has a filing fee of $5,000. The program sunsets after 2036. This program is to attract high net worth individuals to Puerto Rico, those who have hundreds of thousands or millions in investment income and gains. If your goal is to retire on $1,500 a month from Social Security, you aren’t going to need these tax breaks.

To establish yourself as a “bona fide resident”, you would need to spend a majority of each calendar year in Puerto Rico, meaning at least 183 days. The IRS is cracking down on fraudulent PR residency, so be prepared to document this and retain proof of travel. Additionally, PR now also requires you to purchase a home in PR and to open a local bank account to prove residency. (Don’t worry, PR banks are covered by FDIC insurance just like mainland banks). Details here on the Act 22 Requirements.

Note that Social Security and distributions from a Traditional IRA or Pension are considered ordinary income and subject to Puerto Rico personal income taxes, which reach a 33% maximum at an even lower level than US Federal Income tax rates. So, Act 22 is a huge incentive if you have a lot of investment income or unrealized capital gains, but otherwise, PR is not offering much tax incentives if your retirement income is ordinary income. 

If you are a business owner, however, and want to relocate your eligible business to Puerto Rico, there are also great tax breaks under Act 20. These include: a 4% corporate tax rate, 100% exemption for five years on property taxes, and then a 90% exemption after 5 years. If your business is a pass-through entity, like an LLC, you may be eligible to pay only 4% taxes on your earnings. If you are in the US, you could be paying as much as 37% income tax on your LLC earnings. Some requirements for Act 20 include being based in PR, opening a local bank account, and hiring local employees.

For self-employed people in a service industry, PR is creating (new for 2019) very low tax rates based on your gross income, of just 6% on the first $100,000, and a maximum of 20% on the income over $500,000. Click here for a chart of the PR personal tax rates and the new Service Tax.
A comparison of Act 20 and Act 22 Benefits are available at  Puerto Rico Business Link

When most people talk about tax havens, they would have to renounce their US citizenship (and pay 23.8% in capital gains to leave), or they’re thinking of an illegal scheme of trying hide assets offshore. If you have really large investment tax liabilities or have a business that you could locate anywhere, take a look at Puerto Rico. Besides the tax benefits, you’ve got great weather, year round golfing, US stores like Home Depot, Starbucks, and Walgreens, and direct daily flights to most US hubs, including DFW, Houston, Miami, Atlanta, New York, and other cities. 

Puerto Rico is still looking to rebuild after the hurricane and it’s probably not the best place to be a middle class worker, but for a wealthy retiree, it might be worth a look. Christopher Columbus arrived in Puerto Rico in 1493 and the cities have Spanish architecture from the seventeenth century. I’ve never been to Puerto Rico, but would love to visit sometime in 2019 or 2020. If you’d care to join me for a research trip, let me know!

(Please consult your tax expert for details and to discuss your eligibility. This article should not be construed as individual tax advice.)

The New 2018 Kiddie Tax

Last year’s Tax Cuts and Jobs Act (TCJA) significantly changed the way your dependent children are taxed. Previously, they used to be taxed at their parent’s tax rate, but starting this year, their income could be taxed at the egregious “Trust and Estate” rate of 37% with as little as $12,501 in taxable income. With higher deductions, other children will pay less tax in 2018. Both changes give rise to additional planning strategies that parents will want to know before potentially getting a nasty surprise next April when they file their next tax return.

First, let’s define dependent child for IRS purposes. A dependent child includes any child under 18, an 18 year old who does not provide more than 50% of their own support from earned income, or a full-time student who is under age 24 and also does not not provide more than 50% of their own support from earned income. A child’s age for the tax year is the age they are on December 31.

There are different tax methodologies for earned income (wages, salary, tips, etc.) versus unearned income (interest, dividends, capital gains, etc.) under the Kiddie Tax.

First, some good news, for Earned Income, the standard deduction has been increased to $12,000 for 2018, which greatly increases the amount of income a child can earn income tax-free. Of course, they will still be subject to payroll taxes (Social Security and Medicare) on these earnings.

Strategy 1. For Self-Employed Parents: did you know that when you hire your dependent children, you do not have to pay or withhold payroll taxes (Social Security and Medicare) on their income. If you hire them, and have legitimate work for them to do, you could shift $12,000 from your high tax rate to their 0% tax rate. If they open a Traditional IRA and contribute $5,500, they could earn $17,500 tax-free. Just be aware that the IRS scrutinizes these arrangements, so be prepared to demonstrate that the work was done and the pay was “reasonable”. (Paying your kids $500 an hour to mow the lawn might be considered excessive.)

For Unearned Income, the Kiddie Tax is more complicated. The standard deduction for unearned income is only $1,050 (or their earned income plus $350 up to the $12,000 maximum). Above this amount, the next $2,100 is taxed at the child’s rate, and then any unearned income above this level is now taxed at the Trust and Estates rate. If a child has a significant UTMA, inherited IRA, or other investment account, this is where their taxes could soar in 2018, especially if they used to be taxed at their parent’s rate, say, of 22%. If their parents were in the highest tax bracket, there would be no change, but for middle class kids with investment income, they now could be taxed at a much higher rate than their parents!

Here are the 2018 Trust and Estates Tax Marginal Rates, which now apply to the Kiddie Tax:
10% on income from $0 to $2,550
24% from $2,551 to $9,150
35% from $9,151 to $12,500
37% over $12,501

Long-Term Capital Gains and Qualified Dividends will be taxed at:
0% if from $0 to $2,600
15% if from $2,601 to $12,700
20% if over $12,701

2. Children with under $1,050 in income do not need to file a tax return.

3. The first $4,700 in long-term capital gains are at the 0% rate (a $2,100 deduction followed by $2,600 at the zero rate). This is an opportunity to gift appreciated shares to a child and then they will not owe any tax on the first $4,700 in capital gains. If you are planning to support your kids and set up a fund for them, or pay for college, why should you pay these taxes if they can be avoided? We can establish a program to make use of this annual 0% exclusion.

4. If a child’s investment income is subject to the Kiddie Tax, and the portfolio is going to be used for college education, a 529 Plan can offer tax-free growth and withdrawals for qualified higher educational expenses. In these cases, 529 Plans have just become more valuable for their tax savings.

5. For some college aged kids, it may be better for the parents to stop listing them as a dependent if eligible. In the past, parents received a personal exemption for each child ($4,050 in 2017), but this was eliminated by the TCJA. It was replaced with an expanded child tax credit of $2,000 in 2018. However, the tax credit only applies to children under 17. Unless you are able to claim a college tax credit, it is possible you are not getting any tax benefits for your college kids over 17. In this case, not claiming them as a dependent, and having your child file their own tax return, may allow them to receive the full standard deduction, save them from the Kiddie Tax, and may even allow them to qualify for the college credit. You would need to verify with your tax professional that your child did in fact have enough earned income to be considered independent.

College financial aid doesn’t exactly follow the IRS guidelines for dependency, and they don’t even ask if a parent lists a child as a dependent or not. Instead, the Free Application for Federal Student Aid (FAFSA), has its own form, Am I Dependent or Independent?, which looks at factors including age, degree program, military service, and marital status.

If you’ve got questions on how to best address the Kiddie Tax for your family, let’s talk.

What Are Quarterly Tax Payments?

The IRS requires that tax payers make timely tax payments, which for many self-employed people means having to make quarterly estimated tax payments throughout the year. Otherwise, you could be subject to penalties for the underpayment of taxes, even if you pay the whole sum in April. The rules for underpayment apply to all taxpayers, but if you are a W-2 employee, you could just adjust your payroll withholding and not need to make quarterly payments.

If your tax liability is more than $1,000 for the year, the IRS will consider you to have underpaid if the taxes withheld during the year are less than the smaller of:

1. 90% of your total taxes dues (including self-employment taxes, capital gains, etc.)
2. 100% of the previous year’s taxes paid.

However, for high income earners – those making over $150,000 (or $75,000 if married filing separately) – the threshold for #2 is 110% of the previous year’s taxes. Additionally, the IRS considers this on a quarterly basis: 22.5% per quarter for #1, and 25% per quarter for #2, or 27.5% if your income exceeds $150,000.

Many taxpayers will find it sufficient to make four equal payments throughout the year. If that’s the case, your deadlines are generally April 15, June 15, September 15, and January 15. However, if your income varies substantially from quarter to quarter, or if your actual income ends up being lower than the previous year, you may want to adjust your quarterly estimated payments to reflect these changes.

You can estimate your quarterly tax payments using IRS form 1040-ES. Of course, your CPA or tax software should automatically be letting you know if you need to make estimated tax payments for the following year. You can mail in a check each quarter, or you may find it more convenient to make the payment electronically, via IRS.gov/payments.  For full information on quarterly estimated payments, see IRS Publication 505 Tax Withholding and Estimated Tax.

Please note that the estimated payments will fulfill the requirement of 100% of last years payment, or 90% of this year’s payment if that figure is lower. However, it is not required that you pay 100% of the current tax bill, so if your income is significantly higher this year, you could still owe a lot of taxes in April even after making quarterly estimated payments.

If you’re self-employed, you don’t need to be a tax expert, but you do need to understand some basics and to make sure you are getting correct advice. When you aren’t being paid as a W-2 employee, it is up to you to make sure you are setting money aside and making those tax payments throughout the year, so that next April you aren’t facing penalties on top of having a large, unexpected tax bill.

Roth Conversions Under the New Tax Law

The Tax Cuts and Jobs Act (TCJA) will impact Roth Conversions in 2018 and beyond in a number of significant ways for investors. Since I can hear the yawns already through my laptop, here’s why you should care: wouldn’t it be great to have your investment account growing tax-free? Once you are retired, which would you prefer: an account with $100,000 which you could access tax-free or one which will cost you $22,000 or more in taxes to use  your money? Taxes can take a huge bite out of your investment returns.

Quick refresher: A Roth IRA holds after-tax money and grows tax-free. A Conversion is when you take a Traditional IRA, 401(k), or similar account, pay the taxes on it today, and transfer it to your Roth IRA. While that does mean paying taxes now, any future growth in the account would be tax-free. When you withdraw the money from a Roth IRA in retirement, you pay no taxes.

The TCJA has both positive and negative impacts on doing a Roth Conversion:

1. Lower tax rates. Under the TCJA, most people will receive a 1-4% reduction in their marginal tax bracket. For example, the top bracket was 39.6% in 2017 and will be 37% in 2018. If you are in the top bracket, a Roth Conversion is cheaper by 2.6% today.

For a married couple, if your taxable income is under $77,400 you are now in the 12% tax bracket. Paying 12% to convert an IRA to a Roth would be a bargain, but the Conversion plus your taxable income would need to stay under $77,400 to remain in the 12% rate. With a $24,000 standard deduction, a married couple could make as much as $101,400 and be in the 12% bracket.

To add a sense of urgency, don’t forget that the new lower tax rates are only temporary. In 2026, the top rate goes back to 39.6%. I suppose Congress could extend the tax cuts, but no one knows what will happen in eight years. What we do know is that deficits will rise dramatically, which suggests to me the need to have higher taxes in the future.

2. Beneficiary’s Tax Rate. If your beneficiaries – children, grandchildren, or anyone – are in higher tax bracket than you, the tax bill may be lower for you to convert your IRA to a Roth than for the beneficiaries to inherit the IRA. With a Conversion, your heirs inherit your Roth IRA tax-free. Also, converting to a Roth means you do not have to pay any Required Minimum Distributions (RMDs) starting at age 70 1/2, allowing your account to grow.

If you were planning to leave your Traditional IRA, perhaps in trust, to your young grandchildren, the TCJA will change how they are taxed. For children under age 18, or under age 24 if full-time students, they used to be taxed at their parent’s tax rate. Now for 2018, the “Kiddie Tax” will increase the tax on unearned income, such as IRA distributions, to the much worse tax rate of trusts, a 37% tax rate on income above $12,500.

3. The TCJA eliminated Recharacterizations. Previously, you could undo a Roth Conversion through a process called a Recharacterization. Why would you want to do that? Let’s say you converted $10,000 of a mutual fund from a Traditional to a Roth IRA in January; you would pay taxes on the $10,000 as income. Now, imagine that the account went down and was worth only $8,000 by November. You’d be pretty mad to pay taxes on $10,000 when your account was then only worth $8,000.

The Recharacterization would let you cancel your Roth Conversion if you didn’t like the outcome within that tax year. You could get a “Do-Over”. The TCJA eliminated Recharacterizations, so now if you do a Roth Conversion, you are stuck with it!

4. Back-Door Roth. Since 2010, there has been a type of Roth Conversion called a Back-Door Roth IRA. It allows high income investors who did not have any IRAs to fund a non-deductible Traditional IRA and then convert it to a Roth. It was a “Back Door” way to fund a Roth IRA if you made too much to qualify under the regular rules. There was discussion in Congress to eliminate the Back Door Roth IRA (as there has been for years), but in the final version of the TCJA, it is still allowed…for now.

So, should you convert your IRA to a Roth? If you are in a low tax bracket, 10% or 12% in 2018, I think it is worth consideration. If you are in a low tax bracket this year and anticipate your income rising substantially in future years, this would be a good year for a Conversion. You don’t have to convert your entire IRA. You could just convert a portion that would stay within your existing tax bracket. I suggest you use outside funds to pay the taxes, rather than the proceeds of the conversion.

If you are planning to leave your IRA to a charity, they can receive the funds without paying any income taxes and you should not do a Roth Conversion. In fact, if your estate plan includes donations to charity, the most tax-efficient solution is to make those donations from your Traditional IRA. Instead, leave your heirs money from taxable investment accounts; they can receive a step-up in cost basis and potentially owe little or no income taxes or capital gains.

If your IRA is invested in equities, converting when the market is at an all-time high is a risk. With the elimination of Recharacterizations, you don’t get a do-over if the stock market tanks after you do a conversion. It would be preferable to do a conversion is when your account is at a low point, such as in a Bear Market. Educate yourself now, and then in the future, if the market does go down by 25% or 30%, that would be an advantageous time to convert your investments to a tax-free Roth to enjoy the likely subsequent rebound.

In the mean time, if you have questions about Roth Conversions, or just choosing a Roth versus Traditional account for your 401(k), please send me a note. A Roth Conversion could possibly save you tens of thousands of dollars in retirement, which would definitely help elevate your lifestyle. It’s a big decision – often costing thousands of dollars in taxes today – so we have to make sure we are making a well-informed choice and have a thorough understanding of the costs and benefits.

FAQs: New 20% Pass Through Tax Deduction

You’ve probably heard about the new 20% tax deduction for “Pass Through” entities under the  Tax Cuts and Jobs Act (TCJA), and have wondered if you qualify. For those who are self-employed, here are the five FAQs:

1. Do I have to form a corporation in order to qualify for this benefit?
No. The good news is that you simply need to have Schedule C income, whether you are a sole proprietor (including 1099 independent contractor for someone else), or an LLC, Partnership, or S-Corporation.

2. How does it work?
If you report on Schedule C, your Qualified Business Income (QBI) may be eligible for this deduction of 20%, meaning that only 80% of your net income will be taxable. Only business income – and not investment income – will qualify for the deduction. Although we call this a deduction, please note that you do not have to “itemize”, the QBI deduction is a new type of below the line deduction to your taxable income. The deduction starts in the 2018 tax year; 2017 is under the old rules.

There are some restrictions on the deduction. For example, your deduction is limited to 20% of QBI or 20% of your household’s taxable ordinary income (i.e. after standard/itemized deductions and excluding capital gains), whichever is less. If 100% of your taxable income was considered QBI, your deduction might be for less than 20% of QBI. If you are owner of a S-corp, you will be expected to pay yourself an appropriate salary, and that income will not be eligible for the QBI. If you have guaranteed draws as an LLC, that income would also be excluded from the QBI deduction.

3. What is the Service business restriction?
In order to prevent a lot of doctors, lawyers, and other high earners from quitting as employees and coming back as contractors to claim the deduction, Congress excluded from this deduction “specified service businesses”, including those in health, law, accounting, performing arts, financial services, athletics, consulting, or any business which relies primarily on the “reputation or skill of 1 or more employees”. Vague enough for you? High earning self-employed people in one of these “specified service businesses” are not eligible for the 20% deduction.

4. Who is considered a high earner under the Specified Service restrictions?
If you are in a Specified Service business and your taxable income is below $157,500 single or $315,000 married, you are eligible for the full 20% deduction. The QBI deduction will then phaseout for income above this level over the next $50,000 single or $100,000 married. Professionals in a Specified Service making above $207,500 single or $415,000 married are excluded completely from the 20% QBI deduction.

5. Should I try to change my W-2 job into a 1099 job?
First of all, that may be impossible. Each employer is charged with correctly determining your status as an employee or independent contractor. These are not simply interchangeable categories. The IRS has a list of characteristics for being an employee versus an independent contractor. Primarily, if a company is able to dictate how you do your work, then you are an employee. It would not be appropriate for an employer to list one person as a W-2 and someone else doing the same work as a 1099.

Additionally, as a W-2 employee, you have many benefits. Your employer pays half of your Social Security and Medicare payroll tax (half is 7.65%). As an employee you may be eligible for benefits including health insurance, vacation, unemployment benefits, workers comp for injuries, and the right to unionize. You would have a lot to lose by not being an employee.

Even still, I expect we are going to see a lot of creative accounting in the years ahead for people trying to reclassify their employment from W-2 to pass-through status. Additionally, businesses which are going to be under the dreaded “specified services” list will be looking for ways to change their industry classification. We will continue to study this area looking for ways for our clients to take advantage of every benefit you can legally obtain.

This information is for educational purposes only and is not to be construed as individual financial advice. Contact your CPA or tax consultant for details on how the new law will impact your specific situation.

9 Ways to Reduce Taxes Without Itemizing

If you used to itemize your tax deductions, chances are you will not be able to do so in 2018 under the new Tax Cuts and Jobs Act (TCJA). While it sounds good that the standard deduction has been increased to $12,000 single and $24,000 married, many tax payers are lamenting that they no longer can deduct certain expenses from their taxes.

As of January 1, we’ve lost these deductions:

  • Miscellaneous Itemized Deductions, including all unreimbursed employee expenses, tax preparation fees, moving expenses for work, and investment management fees.
  • Interest payments on a Home Equity Loan
  • Property Tax and other state and local taxes are now capped at $10,000 towards your itemized deductions.

For a married couple, even if you have the full $10,000 in property tax expenses, you will need another $14,000 in mortgage interest and/or charitable donations before you reach the $24,000 standard deduction amount. Even if you do have $25,000 in deductible expenses, you would effectively be getting only $1,000 more in deductions than someone who spent zero.

Under the new law, people are no longer going to be able to say “it’s a great tax deduction” when buying an expensive home. When you take the standard deduction, you’re not getting any tax benefit from being a homeowner or having a mortgage.

So if you’ve lost your itemized tax deductions for 2018, can you you do anything to reduce your taxes? Thankfully, the answer is yes. I’m going to share with you 9 “above the line deductions” and Tax Credits you can use to lower your tax bill going forward.

Above The Line Deductions reduce your taxable income without having to itemize on Schedule A. All of these savings can be taken in addition to the standard deduction.

1. Increase your contributions to your 401(k) or employer retirement plan. For 2018, the contribution limits are increased to $18,500 and for those over age 50, $24,500. What a great way to build your net worth and make automatic investments towards your future.

2. Many people who think they are maximizing their 401(k) contributions don’t realize they or their spouse may be eligible for other retirement contributions. If you have any 1099 or self-employment income, you may be eligible to fund a SEP-IRA in addition to a 401(k) at your W-2 job. Spouses can be eligible for their own IRA contribution, even if they do not work outside of the home.

3. Health Savings Accounts are unique as the only account type where you make a pre-tax contribution and also get a tax-free withdrawal for qualified expenses. You can contribute to an HSA if you are enrolled in an eligible High Deductible Health Plan. There are no income restrictions on an HSA. For 2018, singles can contribute $3,450 to an HSA and those with a family plan can contribute $6,900. If you are 55 and over, you can make an additional $1,000 catch-up contribution.

4. Flexible Spending Accounts (FSAs) or “cafeteria plans” can be used for expenses such as child care, medical expenses, or commuting. These are often use it or lose it benefits, unlike an HSA, so plan ahead carefully. If your employer offers an FSA, participating will lower your taxable income.

5. The Student Loan Interest deduction remains an above-the-line deduction. This offers up to a $2,500 deduction for qualifying student loan interest payments, for those with an AGI below $65,000 single or $130,000 married filing jointly. This was removed from early versions of the TCJA but made it back into the final version.

Tax deductions reduce your taxable income, but Tax Credits are better because they reduce the amount of tax you owe. For example, if you are in the 24% tax bracket, a $1,000 deduction and a $240 Tax Credit would both reduce your taxes by $240.

Tax Credits should be automatically applied by your CPA or tax software. For example, if you have children, you should get the Child Tax Credit, if eligible. (Since it’s only February, there is still time to make a child for a 2018 tax credit!) If you are low income, still file a return, because you might qualify for the Earned Income Tax Credit. But there are other tax credits where you might be eligible based on your actions during the year. Here are four Tax Credits:

6. The Saver’s Tax Credit helps lower income workers fund a retirement account such as an IRA. For 2018, the Savers Tax Credit is available to singles with income below $31,500 and married couples under $63,000. The credit ranges from 10% to 50% of your retirement contribution of up to $2,000. Note for married couples, if you qualify for the credit, it would be better to put $2,000 in both of your IRAs, and receive two credits, versus putting $4,000 in one IRA and only getting one credit. If you have a child over 18, who is not a dependent and not a full-time student, maybe you can help them fund a Roth IRA and they can get this Tax Credit. Read the details in my article The Saver’s Tax Credit.

7. Originally cut out of the House bill, the $7,500 Tax Credit for the purchase of an electric or plug-in hybrid vehicle was reinstated in the final version of the TCJA signed into law. The credit is phased out after each manufacturer hits 200,000 vehicles sold, so if you were planning to add your name to the 450,000 people on the waitlist for a Tesla Model 3, forget about the Tax Credit. But there are many other cars and SUVs eligible for the credit which you can buy right now. There are no income limits on this credit, but please note that this one is not refundable. That means it can reduce your tax liability to zero, but you will not get a refund beyond zero. For example, if your total taxes owed is $5,200, you could get back $5,200, but not the full $7,500.

8. Child and Dependent Care Tax Credit. To help parents who work pay for daycare for a child under 13, you can claim a credit based on expenses of $3,000 (one child) or $6,000 (two or more children). Depending on your income, this is either a 20% or 35% credit, but there is no income cap.

9. New for 2018: The $500 Non-Child Dependent Tax Credit. If you have a dependent who does not qualify for the Child Tax Credit, such as an elderly parent or disabled adult child, you are now eligible for a $500 credit from 2018 through 2025.

Even with the loss of many itemized deductions, you can reduce your tax bill with these nine above the line deductions and Tax Credits. We are focused on how we can help you achieve Financial Security, whether that is through long-term, diversified investment strategies, by helping you save on taxes, or making sure you have enough money for as long as you live. Thanks for reading!

Are Your Tax-Deductions Going Away?

Last week, we discussed the current tax reform proposal in Washington and discussed how it would reduce incentives for homeowners two ways: by increasing the standard deduction and by eliminating the deduction for state and local taxes, including the deduction for property taxes. Recall that itemized deductions only are a benefit if they exceed the amount of the standard deduction, currently $6,350 single or $12,700 married.

While the legislation has yet to be finalized, it appears increasingly likely that we are on the eve of the most significant tax changes in 30 years. The proposals are slated to take effect in 2018, which means that if they are approved, there is still several weeks in 2017 to make use of the old rules.

For many Americans, your taxes will be lower under the current proposal. The biggest tax cuts, however, would go to corporations, with a proposed reduction from 35% to a maximum of 20%. That’s the proposal, but the final version may be different. The advice below is based on the current GOP plan; we would not advocate taking any steps until the reforms are in their final version and passed.

1. Itemized Deductions. The proposal would increase the standard deduction from $6,350 (single) and $12,700 (married) to $12,000 and $24,000. As a result, it is believed that instead of 33%, the number of taxpayers who itemize will fall to only 10%. If you have itemized deductions below $12,000/$24,000, you will no longer receive any benefit from those expenses in 2018.

  • Consider accelerating any tax deductions into 2017, such as property taxes, charitable donations, or unreimbursed employee expenses.
  • Itemized deductions for casualty losses, gambling losses/expenses, and medical expenses will be repealed.
  • Many miscellaneous deductions will disappear, including: tax preparation fees, moving for work (over 50 miles), and unreimbursed employee expenses.
  • Investment advisory fees, such as those I charge to clients, will still be tax deductible. However, these miscellaneous deductions only count when they exceed 2% of AGI, which will be more difficult to achieve with so many other deductions disappearing.
  • The $7,500 tax credit for the purchase of a plug-in electric vehicle will be abolished. If you were thinking of buying a Chevy Bolt or Nissan Leaf, better do so now! If you are on the wait list for a Tesla Model 3, you probably will not receive one before the credit disappears. Read more: “Is Your Car Eligible for a $7,500 Tax Credit?”

2. Real Estate. The Senate version we discussed last week had completely eliminated the deduction for property taxes and state/local taxed paid. Luckily, this has been softened to a cap of $10,000 for property taxes.

  • If your property taxes exceed $10,000, you might want to pay those taxes in December as part of your 2017 tax year. If you pay in January 2018, you would not receive the full deduction.
  • The proposal also caps the mortgage interest deduction to $500,000, and for your primary residence only. This is a substantial reduction. Currently, you can deduct interest on a mortgage up to $1 million, and you can also deduct mortgage interest on a second home, including, in some cases, an RV or yacht.
  • Many owners of second homes will likely try to treat these as investment properties, if they are willing to rent them out. As a rental, you can deduct taxes and other costs as a business expense. See my article: “Can You Afford a Second Home?”

3. Tax Brackets. The proposal reduces the tax brackets to four levels: 12%, 25%, 35%, and 39.6% (the current top bracket remains). These brackets are shifted to slightly higher income levels, so many taxpayers will be in a lower bracket than today or pay less tax. Those in the top bracket, 39.6%, who also make over $1 million, will have their income in the 12% range boosted to the 39.6% level. So don’t think this proposal is excessively generous to high earners – many will see higher taxes.

The Alternative Minimum Tax (AMT) will be abolished, so if you have any Minimum Tax Credit carryforwards, those credits will be released. The 3.8% Medicare Surtax will unfortunately remain in place, even though Trump has previously promised to repeal it. Capital Gains rates will remain at 0%, 15%, and 20% depending on your tax bracket, and curiously, these rates will be tied to the old income levels, and not to the new tax brackets.

If passed, the tax reform bill will substantially change how we deduct expenses from our taxes. Those with simple returns may find that their tax bill is lower, but for many investors with more complicated tax situations, the proposed changes may require that you rethink how you approach your taxes.

We will keep you posted of how this unfolds and will especially be looking for potential ways it may impact our financial plans. It has often been said that the definition of a “loophole” is a tax benefit that someone else gets. Unfortunately, simplifying the tax code and closing these deductions is bound to upset many people who will see their favorite tax benefits reduced or removed entirely.

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.

Tracking Your Home Improvements

When you eventually sell your home, it may be helpful to have a record of your home improvement expenses. Because people often own their homes for decades, this is an area where a lot of records and receipts are lost. Here is what you need to know.

At the time of a home sale, the difference between your purchase price and your sale price is a taxable capital gain. Luckily for most people, there is a significant capital gains exclusion from the IRS: $250,000 (single) or $500,000 (married), for your primary residence. If your gain falls below this amount, you will not owe any taxes. In order to qualify, the property must have been your primary residence for at least two of the previous five years, and you must not have taken this exclusion for another property for two years.

If you make a capital improvement (described below), that expense increases your cost basis in the home. But because of the large exclusion ($250,000 or $500,000), many people don’t even bother to keep track of their home improvement expenses. That may be a mistake. Here are a number of scenarios which could be a problem:

  • If you get divorced or your spouse passes away, your exclusion will decrease from $500,000 to $250,000.
  • If you make another property your primary residence for four years, you will lose the tax exclusion on the previous property.
  • If you own your property for the next 30 years, it is possible your capital gain ends up being higher than the $250/$500k limits. These amounts are not indexed for inflation.
  • Congress could reduce this tax break, although it would be very unpopular to do so. They are not likely to change the definition of cost basis and capital gains.

What constitutes a Capital Improvement which would increase your cost basis? In general, the improvement must be permanent (lasting more than one year), attached to the property (not removable or decorative), and add to the value, use, or function of the property. Maintenance and repairs are generally not capital improvements unless they prolong your home’s useful life. The IRS provides the following specific examples of expenses that are Capital Improvements:

  • Additions, such as a new bathroom, bedroom, deck, garage, porch, or patio.
  • Permanent outdoor improvements, including paved driveways, fences, retaining walls, landscaping, or a swimming pool.
  • Exterior features, such as new windows, doors, siding, or a roof.
  • Insulation for your attic, walls, floors, or plumbing.
  • Home systems, including heat/central air, wiring, sprinkler, or alarm systems.
  • Plumbing upgrades such as septic systems, hot water heaters, filtration systems, etc.
  • Interior improvements, including built-in appliances, flooring, carpet, kitchen remodeling, or a new fireplace.

While there are many expenses which count as improvements, repairs and upkeep do not. Painting, replacing broken fixtures, patching a roof, or fixing plumbing leaks are not improvements. Also, if you install something and later remove it, that expense may not be counted. For example, if you install new carpet and then later replace the carpet with wood floors, you cannot include the carpet expense in your cost basis.

For full information on calculating your gain or loss on a home, see IRS Publication 523. While most homeowners are focused on mitigating taxable gains, I should add that if your capital improvements are significant enough to make your home sale into a loss, that loss would be a valuable tax benefit as it could offset other income. Here’s an example:

Purchase Price: $240,000
Capital Improvements: $37,400
Cost Basis: $277,400

Sale Price: $279,000
Minus 6% Realtor Commission: -$16,740
Closing Costs: -$1,250
Net Proceeds: $261,010

LOSS = $16,390

If you just looked at your purchase price and sales price, you might think that you would have a small gain (under the exclusion amount), and there was no need to keep track of your improvements. However, in this example, you do indeed end up with a loss, which would be valuable to your taxes. As a reminder: capital losses can offset any capital gains. Additionally, you can use $3,000 a year of losses to offset ordinary income. Unused capital losses carry forward into future years indefinitely, until they are used up.

Unlike other receipts, which you only need to keep for seven years, you do need to keep records of your capital improvements for as long as you own the home, and then seven years after you file your tax return after the sale. Even if you think you are going to be under the $500,000 tax exclusion, I’d highly recommend you keep track of these capital improvements which increase your cost basis.

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.