If you are a tax accountant, watching what is happening in Washington right now is the equivalent of watching game seven of the NBA Finals. Things are moving fast in the tax game (so to speak), and the group that stands to benefit the most is the tax oracle who can explain it all to you once it becomes law.
The three things we know for sure…
First, you will not be able to file your taxes on a postcard. The powers that be have suggested that you can file your taxes on a ½ page post card. Yes, it looks great for the media, but you will still need to fill out the forms, submit them to the IRS, and hope that you are not one of the unlucky ones that gets tagged for more information (i.e. a desktop audit).
Second, the House bill is more favorable than the Senate bill on personal income tax, if for no other reason than the Senate bill has seven tax brackets and the House bill has four.
Third, if you live in New York or California, you are going to get decimated if you make a medium to large income, because you can no longer deduct state income tax on your Federal return. These two states have some of the highest taxes in the union and there is zero chance they will go down (as Treasury Secretary Mnuchin suggested would be “the right thing for the states to do” at last week’s Economic Club of New York luncheon).
What this means in practicality is that if you are paying 7% state taxes and are in the 35% tax bracket, your take home pay will go down by 7% x 35% x taxable income-ish. We might also expect a tit-for-tat reaction from the states: if the federal government won’t give you a tax break on state taxes paid, the states in return can use this as an opportunity for more tax revenue by doing it right back in the other direction…
Now that we’ve scared the heck out of some of you, let’s discuss what is on offer by the Federal Government? You could very well come out ahead under the right circumstances.
There are two different versions of tax reform, one is put forward by the House of Representatives and the other by the Senate.
Here is a side by side comparison of what each is proposing. If we were betting on the outcome, it will fall somewhere in between.
|State and Local Tax Deduction||Gone||Gone|
|Mortgage Interest Deduction||$500k limit||$1m limit (no change)|
|Estate tax||Gone||$11m (no change)|
|Corporate tax rate @20%||2018||2019|
|Medical Tax Deduction||Gone||No change|
|Repeals estate tax||Yes||No|
|Repeals Alternative Minimum Tax||Yes||Yes|
|Property Tax Deduction||10,000||Gone|
Using the schedule above, here is an explanation of what each of these line items means…
Eliminate State and Local Tax Deduction (House and Senate)
If you live on the coasts of the United States (and a several states in the middle), this is a biggie. New York has a state tax rate of about 7%, California has a tax rate that varies between 1% and 12.3%. However, anything below about 6% in California is a head-fake because if you’re single and make $29.9k or more, you’ve already reached 6%. When you hit $41.6k you’ve reached 8%. This is a lot of extra revenue to the IRS, which means a lot less revenue for many tax payers. New York and California contain 48 million people, or about 15% of the population of the United States.
Add on States like Vermont, Maryland, Maine, and New Jersey – all of which are outsized east coast taxing states and the tax bill becomes quite large. Then remove deductibility of city taxes such as NYC (circa 3.5%) and the revenue to Uncle Sam becomes massive and the pain to middle class tax-payers becomes chronic…
Cap on Mortgage Interest Deduction (House)
The House version limits your deduction to the first $500k of mortgage. If you have a mortgage that is say, $600k at a mortgage interest rate of 3.5% this basically means that you will be able to deduct $21,000 x 5/6 or $17,500. The remaining $3500 is not deductible – except…. If you already have a mortgage in place. This means that most people won’t get hit with this change right away, but rather once they buy a new home or refinance their existing mortgage.
Eliminate Estate Tax (House)
The US is somewhat unique in that it will tax a person’s income over their life and then again when they die. Most countries do this once. The elimination of the estate tax provision is clearly aimed at protecting the wealthy, because the current threshold is $5.49 million of estate assets for an individual and $11 million for a married couple. 95%+ of the tax payers in this country do not have that much wealth when they die. Still it is a little unfair to tax someone twice on the same dollar earned, so we do feel for the wealthy on this one.
Corporate Tax Rate at 20% (House and Senate)
Both the House of Representatives and the Senate want to set the maximum tax rate for corporations to 20%. The rationale is to bring business back to the US, and create additional wealth for corporations to reinvest and grow. What this provision seems to leave behind are pass through corporations, such as LLCs and S corporations. These types of businesses are almost always micro-sized (one or two employees, usually owner-operated).
Here in lies the problem. The small business is already here, so there is no need to “entice” the shareholders (owners) to bring the business back to the US, so it theoretically penalizes the little-guy and makes him/her less competitive against the mega-corporation who gets the tax benefit. Still, the proposal is not finalized, so watch this space…
Eliminate Medical Tax Deduction (House)
Up until this point we understood the methodology of the tax plan. On the surface, it taxes the rich and gives benefits to the middle class and the poor, or it tries to bring back industry to the United States…But eliminating the medical tax deduction baffles us. Here is why: The current medical tax deduction allows a taxpayer to deduct their out of pocket medical costs if those costs exceed 7.5% of taxable income.
Now here comes the confusion…it is probably not too far-fetched to assume that the wealthy are more likely to have health insurance than the poor – so their out of pocket costs relate to deductibles, etc. It’s also not too far-fetched to assume that even if the wealthy were not insured, it would be far more difficult for them to spend 7.5% of their taxable income on medical bills, than it would be for the poor. In fact, the poor could reach 7.5% very quickly. Therefore, if the House plan is the final version ratified, then this is a penalty primarily against the poor.
Repeal the Alternative Minimum Tax (AMT) (House and Senate)
This is the something for everyone provision – basically to appease the wealthy. Repealing the AMT means that wealthy, tax-savvy taxpayers can construct their world in a way that maximizes the use of available tax exemptions and deductions, and the Federal Government does not have a way to claw it back if the basket of deductions, while legitimate, is “excessive.”
Reduce or Eliminate Property Tax Deduction (House and Senate)
Both the House version and the Senate version tamper with the taxpayer’s ability to deduct property taxes. The House version caps the deduction to $10,000 and the Senate version gets rid of it all together.
What does it all mean? It’s too early to tell. There is motivation in Washington to get something done ASAP. The House has already voted on and passed their proposal, but it is very unlikely the Senate will just drop their own version and go with the House’s recommendation. So we could be in for a long period of reconciliation, or even tax reform gridlock.
Tax reform will undoubtedly be the platform that the Republican party uses to fuel the mid-term election machine. Focusing in on bringing back jobs through a 20% corporate tax rate and lowering taxes for low to middle income citizens will capture a lot of votes, but be careful what you ask for because what is proposed now could be drastically different on the surface than what lies underneath.
But who knows for sure. We’re just a bunch of paranoid accountants, so it could be all good…