2018 Year End Tax Considerations
2018—A Year in Wake of Big Reform
2018 was the first tax year after President Donald Trump signed into law the Tax Cuts and Jobs Act on December 22, 2017. This was the largest change to the United States tax system since the last tax reform was signed into law in 1986. Such broad changes to the tax code brought a lot of uncertainty to how individuals and businesses would be impacted alike. Even now, the dust around some of the biggest changes as they apply to individuals and businesses has yet to settle and likely won’t for a number of years. Hopefully, we can bring some clarity to the changes enacted as part of the Tax Cuts and Jobs Act, and how individuals and businesses alike are adopting to the new provisions—
Notable Changes on the Individual Level
Standard Deduction and Personal Exemption
As part of the recent reform, the standard deduction was almost doubled while personal exemptions were removed from the code. This was intended to simplify the tax code—Congress wanted to provide taxpayers with a large enough standard deduction so that taxpayers no longer have to run through a complex calculation of whether their standard deduction or itemized deductions would provide a greater benefit. While this change in the law should provide some taxpayers with less complexity, the full result of the change has yet to be seen. Additionally, taxpayers should not stop tracking their expenses that qualify for itemized deductions—some taxpayers will be in the unique position where their itemized deductions for the year will exceed their doubled standard deduction. Below are the updated standard deduction amounts—
FILING STATUS 2018 STANDARD DEDUCTION AMOUNT
Single/Married Filing Separately $12,000
Married Filing Jointly/Surviving Spouse $24,000
Head of Household $18,000
Changes to the Itemized Deduction
In addition to doubling the standard deduction, the Tax Cuts and Jobs Act also made sweeping changes to Itemized Deductions for individuals. These changes were made to further Congress’s intent to simply the tax code—Congress wanted to limit the possible itemized deductions available to taxpayers so that they would fall under the new, doubled standard deduction. The biggest changes to previously available itemized deductions are outlined below—
State and Local Real Estate Taxes: Prior to the recent tax reform, there was no limitation on the amount of state and local real estate that taxpayers could claim as an itemized deduction. This benefit has now been capped to an $10,000 itemized deduction for married filing jointly taxpayers, and $5,000 for those taxpayer filing single.
Primary Residence Mortgage Interest: Prior to the tax reform, taxpayers could deduct as an itemized deductions interest paid on primary residence mortgage debt equal to $1 million or less. However, this benefit was altered so that taxpayers can now only deduct interest on mortgage debt incurred after December 15, 2017 totaling $750,000 or less
Home Equity Loans Interest: Prior to the reform, homeowners were able to deduct interest paid on home equity loans equal to $100,000 or less. However, this deduction was completely eliminated under the recent reform.
Miscellaneous Itemized Deductions: Prior to the passage of the recent tax reform, taxpayers were able to take as itemized deductions investment expenses, professional service and tax preparation fees, as well as unreimbursed business expenses. However, the applicability of this provision was eliminated through the end of 2025.
Notable Changes on the Business Level
Interest Deduction Limitation
As part of the Tax Cuts and Jobs Act, Congress passed a provision that limits the deductibility of interest for those businesses in excess of average annual gross $25 million over the prior three years. Specifically, Congress limited the deductibility for such businesses to the business interest income of the taxpayer, plus 30% of the business’s earnings before income, taxes, depreciation and amortization (i.e. EBITDA). Any interest paid in excess of the limit described is carried forward to the next taxable year, where it can be deducted as long as the taxpayer is under the limit. Additionally, any disallowed interest can be carried forward indefinitely until either (1) it can be deducted by the taxpayer in a tax year or (2) until the sale of the business where all such carried forward interest expenses may be deducted.
For those businesses operating through a partnership or S corporation entity, the interest limitation is applied at the entity level and not at the ownership level. Additionally, any disallowed interest expense incurred at the entity level is allocated to the owners of the partnership or S corporation as excess business interest.
This interest expense limitation will have its biggest impact on those businesses which are highly leveraged—first it will increase a business’s taxable income and will secondarily increase the business’s cost of capital.
New Pass-through Deduction
Congress enacted a new deduction for the owners of pass-through entities—this provision provides a 20% deduction on the income passed through to an owner of certain qualifying businesses. This was a deduction that was provided in order to make the effective tax rate on income generated by pass-through entities competitive with the new, lower 21% corporate tax rate. If an owner is able to obtain the 20% deduction on all of the income passed through to them, the owner will pay an approximate ~27% effective tax rate on such income. However, this provision is highly complex and not all types of income is eligible for the deduction.
There are a lot of factors that determine how large the deduction will be on income passed through to an business owner—the type of business activity leading to the income, the amount of wages paid to employees, as well as the amount of qualifying business property owned. Without diving too deeply into all of the nuances and complexities present in this new deduction, only certain types of income qualify. The code section providing this new deduction expressly prohibits certain type of income from eligibility—this includes income generated by professionals in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, as narrowly defined in proposed regulations.
Meal and Entertainment Expenses
The recent tax reform made sweeping changes to the deductions previously allowed meal and entertainment expenses. The new tax legislation no longer allows deduction for (1) entertainment activities even if it is directly related to the conduct of the taxpayer’s business, (2) membership dues for any club organized for business, pleasure, or other social purposes, and (3) any deduction for facilities used in connection with the aforementioned purposes.
While the reform greatly limited the deductibility of entertainment expenses, a 50% deduction is still allowed for meals that are provided or consumed in connection with a taxpayer’s trade or business. This 50% deduction limitation is also now applicable to meals that used to be fully deductible under the tax code prior to the recent reform. Additionally, after 2025, these expenses incurred for these meals will no longer be deductible.
Year End Tax Planning Considerations
Even though there were a number of sweeping changes to the tax code, there are strategies that taxpayers should consider to lower their taxable income for 2018—
Maximizing Contributions to IRAs, 401(k) plans, 403(b) plans, SEP plans, etc.
Normal IRA, 401(k), 403(b), SEP and other qualifying plans enable taxpayers to receive a deduction for the portion of their earnings that the taxpayer contributes to such plans. These contributions allow a taxpayer to reduce their taxable income for the year, as well as increase the value of other deductions since they reduce a taxpayer’s adjusted gross income. Additionally, the contributions in these plans are allowed to grow tax-free until distributions are taken from them at a later date. The general limitations on the deduction provided for a taxpayer’s contribution to these qualifying plans are outlined below, however, there are a number of restrictions on the deductibility of these contributions so please consult your tax advisor before doing so.
Type of Plan 2018 Contribution Limits
401(k) and 403(b) Plans $18,500
SEP Plans $55,000
Engaging in Like Kind Exchanges
A taxpayer may defer capital gains realized on the sale of real-property if, within a set time limit, the investor reinvests those capital gains into another like-kind parcel of real property that is used in a trade or business. Prior to the recent reform, this deferral strategy was available for both personal and real property, however, the recent reform has limited this benefit to gains realized on the sale of real property.
Employing a strategy on the exchange of like-kind real property allows an owner of highly appreciated real property to indefinitely defer the gain that they would normally be required to recognize on the sale of real property. Theoretically, an owner of real property can continue to employ this strategy all the way through death—if done correctly, the taxpayer’s heirs will take the piece of real property with a stepped-up tax basis and will never be required to pay tax on the appreciation of the property. However, as a word of warning, this is a strategy that is easier said than done. There are many stringent requirements around completing a successful like-kind exchange.
Additionally, a taxpayer should not engage in a like-kind exchange of real property when its fair market value is less than the taxpayer’s tax basis in the property. In this scenario, the taxpayer should sell the property and recognize the loss. If a taxpayer decides to not sell the property in this scenario but rather engages in a like-kind exchange, the taxpayer does not get the benefit of the potential loss as it will be deferred.
Investing Capital Gains into Opportunity Zone Investments
Capital gains recognized by a taxpayer can be deferred though December 31, 2026 if they invest those capital gains into a qualified opportunity zone fund within 180-days of recognizing the gain. Additionally, the taxpayer who invests their capital gains into a qualified opportunity fund obtains incremental tax benefits determined by the number of years they hold their investment in the fund—
If an investor holds their capital gains in the qualifying fund for five years, then 10% of the original capital gain invested will not be subject to tax when the deferral period ends;
If an investor holds their capital gains in the qualifying fund for a total of seven years, then an additional 5% of the original capital gain will not be subject to tax when the deferral period ends; and
If an investor holds their capital gains in the qualifying fund for ten or more years, any appreciation on the capital gains invested in the fund when the taxpayer later sells their interest will not be subject to tax.
The benefits provided by this opportunity zone program are very unique as they also allows taxpayers to invest their capital gains into businesses who are located and operate in these designated zones and qualify for the benefits listed above. This is different from the like-kind exchange program discussed earlier as those capital gains only qualify for the like-kind exchange program if they arose from the sale of real property and are re-invested back into real property. Under the opportunity zone program, a taxpayer can take capital gains from the sale of any property (i.e. stocks, property held for investment such as an expensive painting, real property, etc.) and have them qualify for the benefits provided under the program whether or not they reinvest them back into like-kind property.
An issue many taxpayers face is that they do not know amount of capital gains they recognized throughout the year until they receive their K-1s from partnerships, or other funds or vehicles they are invested in. Additionally, many of these taxpayers find out about such capital gains only after the 180-day period to reinvest them into a qualified opportunity fund has passed. However, the government addressed this problem—in the recently released guidance on the opportunity zone legislation, the government is allowing taxpayers, who receive capital gains from pass-through entities, an 180-day reinvestment period beginning the day that the underlying pass-through entity’s tax year ends. For example, if a taxpayer is invested in a calendar year partnership that incurs capital gains for the year, and the taxpayer does not find out about these gains until after year end, the guidance allows the taxpayer 180-days beginning on January 1 of the next year to reinvest such gains into a qualified opportunity fund and qualify for all of the benefits provided.