By far the source of the greatest number of questions from my clients in the last two months center around one topic - tax reform. People want to know what is being proposed, the possibility of it passing, when it would take effect and, most importantly, how it would impact them.
First off, there is zero chance that anything passed in late 2017 would be effective retroactively to the beginning of 2017. One reason is practical - the IRS spends several months getting ready for a new filing season and all of the forms that have been finalized for the next filing season can not change this late in the process. The other reason is economic - any change to the tax code is ostensibly made to change individual and corporate behavior to achieve some desired outcome(s). Even with a month left in the year most of the decisions around investment, employment, etc. have already been made. A retroactive change would have no effect on behavior that has already taken place.
As a result, any new rules would go into effect starting in 2018. The House and the Senate are working on different versions of tax reform but both follow the same basic blueprint - cut corporate taxes permanently, lower the rate on LLC’s and S-Corps ("pass-thru" entities), repeal the gift and estate tax, repeal Alternative Minimum Tax, and pay for it by significantly increasing the national debt and raising individual taxes over time. As it relates to individual taxes, the general idea is to eliminate certain deductions and the personal exemption and offset that with an increase to the standard deduction and child tax credits. The biggest deductions that are on the chopping block are the mortgage interest deduction and the deduction for state and local income taxes (there are others but they impact fewer taxpayers and to a lesser degree like the deduction for educator expenses or for medical expenses). As that is the case there are certain things that taxpayers could potentially do in 2017 that would minimize overall taxes - either by moving deductible expenses from 2018 to 2017, deferring or recognizing income early, or vice versa (depending on the nature of the change to the tax code).
Mortgage Interest Deduction
Under the current rules an individual can deduct interest to acquire or improve their primary residence so long as the debt does not exceed $1M. The proposals that have currently been made public either eliminate this deduction altogether or limit the amount of qualified debt to $500K (with current mortgages being grandfathered). If the deduction were eliminated completely then taxpayers would benefit from making their January 2018 mortgage payment early as the interest related to that payment would not be deductible next year. If it is limited and one has either a purchase or refinance pending that is in excess of $500K and may or may not close in 2017 then it would be beneficial to close in 2017, to the extent that is possible, so that the loan is grandfathered with the $1M limit.
State and Local Income Taxes
Taxpayers in states with high income taxes like California, New York and New Jersey all benefit from deducting their state income taxes. Under both proposals that have been made public this deduction is eliminated. A self-employed individual who makes estimated quarterly payments or an individual who has income that is not subject to regular withholding (like capital gains, interest and dividends) would benefit from estimating their 2017 state tax liability and paying it off before December 31, 2017.
Likewise there has been discussion of eliminating or limiting (to $10K) the deduction for property taxes. In California most property taxes are due in December and April so taxpayers would benefit from making the April payment in 2017.
Alternative Minimum Tax
Taxpayers in California who own their own home are often subject to Alternative Minimum Tax because this “shadow” tax code already disallows the deductions for state and local income taxes. As a result many California homeowners end up owing more tax under this system because they have to have substantial income to live here but also get a substantial benefit from deducting state and local taxes. This has long been a source of frustration because AMT was originally designed to force a few hundred extremely wealthy individuals to pay at least some income taxes but over time more and more people have been caught in its net. Today millions of taxpayers pay AMT and their numbers also skew toward states with high local taxes where people have to earn over about $200K to live there.
Eliminating AMT would be a good thing overall as a means to simplify the tax code, however a taxpayer who is subject to AMT in 2017 would not benefit from early payment of state income tax or property tax as they are not getting the benefit of those deductions because they’re subject to AMT.
Reduction of the tax rate on LLC’s and S-Corps
Legal entities like LLC’s and S-Corps are known as “pass-thru” entities because they are not subject to tax at the corporate level, rather the earnings of the entity are passed to the individual owners and taxed at individual rates - up to 39.6% depending on the taxpayer’s total income. These entities have often been used as a proxy for “small business” in the press but in reality the limit on the entity is not its size in terms of revenue or number of employees but rather in the number of owners it can have.
Current proposals limit the rate on pass-thru income to either 20 or 25% but exclude individual “service providers” from being able to take advantage of this structure. Self-employed individuals who currently work under a sole proprietorship might be able to benefit from incorporating and electing to be taxed as an S-corp, but the ban on service providers may preclude them from doing this. Very little can be planned for with respect to this change until there is more clarity about what the rules will be.
All of this is conjecture because nothing has become law and there are still negotiations as to what would be in the final version of the bill. Also it is unclear whether any version of tax reform will pass this year though Congress does seem intent on doing so. However rules in the Senate that limit how much new legislation can add to the debt could ultimately prove unworkable. Also there are so-called “deficit hawks” who have vowed not to vote for any legislation that increases the deficit, and Republicans can only lose two votes in the senate and still pass a bill.
I’m currently telling clients to take a “wait and see” approach - even if legislation is passed in the final week of 2017 there would still be at least a few days to react by moving 2018 deductions to 2017 if the taxpayer could benefit from doing this. Longer-term planning can only take place once a final version of a bill is signed into law.