Let the debate begin!! Last week the House released details of the Tax Reform plan to elaborate on the one-pager released by the White House earlier this year. Rest assured this bill will not be passed without some changes, but I thought it might be useful to know some highlights of where its starting.
This is the first of several updates I will do – in what, I hope – is a concise summary of important points. I will focus on what may impact my client-base and do not make any assertions this is a comprehensive list of everything being proposed in the bill!
I know this may be elementary to some but for those of you who don’t do hundreds of tax returns a year, I thought a simple tax refresher on the current state may help. I KNOW you review every line of the tax return I prepare for you but, just in case you forgot this year, or the last few years…
Your tax return is prepared each year to determine how much you owe the IRS by taking the following into account:
All sources of income are listed on your tax return in categories: wages, self-employment income, rental income, investment income, pension income, withdrawals from retirement accounts, etc. Not all income is created equally but we will get to that later.
Certain items can be subtracted from your income, such as, teacher’s supplies, student loan interest, health insurance, retirement contributions, employment taxes, etc. Not all adjustments are available to all taxpayers depending on differing factors.
Itemized or Standard Deduction. Which deduction you take is determined by whichever amount is higher. The standard deduction is a flat amount based on your filing status and age. When you itemize deductions you add medical expenses, state taxes paid, mortgage interest paid, charity, and other miscellaneous items. Deductions are subject to floors and can be impacted by AMT (the alternative minimum tax) in some cases.
– Personal Exemptions
This is a flat $4,050 per person you claim on your tax return but can be eliminated at higher incomes.
The combination of these items equals “taxable income” which is used to calculate the tax due based on they type of income, where you fall in the income ranges, your filing status, and the associated rate.
There are many different types of tax:
Income tax – this is simply the % tax you owe based on your taxable income, however, it is gradual so a portion of your income is at the lower rate, when you reach the next bracket the next amount is taxed at a higher rate, and so on. This tax is applied to each type of income except investment income which is treated differently.
Investment income tax – this is the tax you pay on investment income: dividends, interest, and capital gains at 0%, 15%, 20%, 23.8%, 25%, 28% depending on type of investment and total income. Net capital losses are limited to a maximum of $3k annually.
AMT – Alternative Minimum Tax, this is a flat tax on a different set of rules to derive income and adjustments that trumps the regular income tax in certain situations.
Self-employment tax – this is Social Security and Medicare tax calculated on self-employment income for business owners who do not or should not maintain payroll.
There are many different types of tax credits and tax penalties that are dollar for dollar reductions or additions to tax owed. Examples include:
-Child related credits for college, daycare, and/or simply having a child.
-Program initiative credits such as energy-efficient investments (i.e. solar panels)
-Social assistance credits such as the Earned Income Tax Credit or the Premium Tax Credit
-Early withdrawal tax penalty for retirement fund distributions before 59 ½
After calculating the tax and taking away the credits, you finally compare that to what you’ve paid the government throughout the year with what you owe and you either pay or get a refund.
Simple Stuff, right?!
This is far from major tax reform that simplifies the tax code because all the inherent complex nuances of income types, adjustments, credits, deductions, and varying tax rates and brackets still exist and can be changed again in the future – this is primarily a tax cut for businesses.
The basics of what is included in income doesn’t get impacted, however, how self-employment income is taxed will be impacted based on the proposal. There is a desire to equalize treatment across legal structures of a small businesses – as well as to – lower the tax rate for pass-thru entities: sole-proprietorships, partnerships, LLC’s, S-Corporations, etc. The bill, as drafted, proposes allowing a certain percentage of income, in certain industries, to be taxed at a preferential tax rate of 25%. There are also proposals for allowing capital expenditures to be expensed rather than depreciated over time, which would simplify tax accounting to an extent.
The standard deduction is raised to the levels listed above under the 0% (Standard Deduction) column in the tax table below. The itemized deductions are proposed to change in the following manner:
Eliminated deductions:medical, state income tax, alimony, business expenses, casualty loss, moving expenses, and tax preparation fees.
Changes are proposed for mortgage interest and property taxes to cap the interest on mortgage debt of $500k and only allow $10k of property taxes as a deduction. Charitable deductions would remain but some limitations would be implemented.
Personal Exemptions – Eliminated completely.
AMT is eliminated! I am VERY exited about this part of the bill.
Only 4 Tax Rates:
SD (0%) = Standard Deduction for each type of filer
There are more brackets for children with unearned income and trusts/estates
The bill proposes three rates based on income thresholds:
An education credit will exist as a single credit on $2000 of eligible expenses plus an additional 25% credit on the next $2,500. No adjustment will be allowed for student loan interest but 529 distributions will become permitted for elementary and secondary tuition to a limited extent. Child credits will increase to help working families, however, phase outs still exist.
Many credits are proposed to be eliminated including the adoption credit and the credit for electric vehicles.
Primary Residence Gain Exclusion Change
The gain on a sale of your primary residence will be eligible for an exclusion if you’ve lived in the house for at least five of the last eight years (from 2 of the last 5 as it currently stands). The exemption will phase out at income levels above $250k (single/MFJ) and $500k (MFJ).
As you can see, there’s a lot that is proposed to be changed yet somehow things remain almost the same. It certainly is a step in the right direction but we’ll need to see what comes to pass.