Year-end Tax Legislation Update
As of the date of writing (12/18/19), the House of Representatives has added tax extenders as part of their overall budget bill to fund the government through fiscal year-end. The bill has passed the House and now moving onto the Senate for final confirmation. According to various reporting agencies, it will pass and the President will sign by December 20th.
Below is a brief overview of what is part of the “Taxpayer Certainty and Disaster Tax Relief Act of 2019.”
THE FOLLOWING TAX BENEFITS THAT HAD EXPIRED OR WERE EXPIRING, MAY BE EXTENDED AS PART OF THE LEGISLATION:
- Tuition and fees deduction (EXPIRED AS OF 12/31/17, BUT COULD BE EXTENDED THROUGH 2020)
- Exclusion of discharged principal residence indebtedness (EXPIRED AS OF 1/1/2018, BUT COULD BE EXTENDED THROUGH 2020)
- Mortgage premium insurance deduction (EXPIRED AS OF 12/31/2017, BUT COULD BE EXTENDED THROUGH 2020)
- Credit for residential energy-efficient property (EXPIRED AS OF 12/31/2017, BUT COULD BE EXTENDED THROUGH 2020)
- Credit for construction of energy-efficient homes (EXPIRED AS OF 12/31/2017, BUT COULD BE EXTENDED THROUGH 2020)
- Several other alternative fuel and energy credits
- The Work Opportunity Credit and the Employer Credit for Paid Family and Medical Leave were set to expire 12/31/19. The new legislation extends these credit until 12/31/2020.
THE SECURE ACT IS ATTACHED TO THE BUDGET BILL.
The Setting Every Community Up for Retirement Enhancement, or otherwise known as the “Secure Act,” passed the House in May of this year. The bill was overwhelmingly supported by the House, and the final vote was 417-3 in favor for the legislation. The Senate’s version of the bill was never voted on, and the legislation had stagnated since the House’s passing. With the Secure Act attached to the spending bill, it is now likely provisions of the act will be passed, and the retirement landscape will be permanently changed. If passed, the following changes will go into effect starting Jan. 1, 2020:
- The required minimum distribution age will increase to age 72 from 70 ½. For individuals that turned 70 ½ prior to 1/1/2020 and have not reached the age of 72, you are out of luck. You will not be grandfathered, and distributions will continue to be required. For those that turn 70 ½ after 1/1/2020, you will enjoy another year and a half of tax free growth without required distributions.
- Eliminates the stretch IRA for inherited IRAs. Previously, beneficiaries receiving an inherited IRA could “stretch” the distributions of the IRA according to their life expectancy. Younger recipients of an inherited IRA could theoretically stretch out required distributions from the IRA for decades and enjoy tax free growth. Under the Secure Act, the maximum deferral period for required distributions is 10 years after the account owner passes away. This provision will crush family wealth generation.
- Traditional IRA contributions can continue after age 70 ½. Under current law, working individuals with earned income aged 70 ½ or older are prohibited from contributing to a traditional IRA.
- Part-time workers can participate in 401(k) plans. Individuals who work part-time and want to participate in an employer plan will now have the ability to fund up 401(k) accounts if they have worked for at least 1,000 hours during the year, or three consecutive years of at least 500 hours.
- Annuities may now be included as an option for 401(k) plans.
If passed, we recommend you review retirement plan/account options and discuss with your financial advisor regarding planning opportunities. Tax projections should also be updated.
For those turning 70 ½ after 1/1/2020, speak with your custodian about delaying required distributions until you turn 72.
Special Issues Requiring Action in 2019
The Tax Cuts and Jobs Act (TCJA) eliminated many long-standing tax benefits taxpayers relied upon, and some of the more traditional year-end tactics no longer apply. That being said, we still recommend re-visiting your tax estimate if you haven’t done so already. If an update is needed, let us know so we can properly advise you on specific actions that should be taken by year-end.
A. THE VALUE OF ITEMIZED DEDUCTIONS HAS BEEN DIMINISHED.
One of the biggest components of the TCJA was the change to the standard deduction figure. The standard deduction per filing status for 2019 is:
- Single & Married Filing Separately: $12,200
- Head of Household:$18,350
- Married Filing Jointly:$24,400
In addition to the standard deduction increases, the following items changed as part of the TCJA:
- Deductible state and local taxes (SALT) are now capped at $10,000.
- Miscellaneous itemized deductions subject to the 2% floor of Adjusted Gross Income were eliminated.
- The floor for claiming medical expenses is 7.5% for ALL taxpayers (not just those 65 or older). This was set to expire and revert back to a 10% floor, but was extended by the “Taxpayer Certainty and Disaster Tax Relief Act of 2019.”
- Home Equity Loan indebtedness is no longer deductible if not related to the improvement, construction, or refinance of your primary residence.
- Deductible mortgage interest limited to $750,000 of qualifying acquisition debt. Homes that had a mortgage contract before December 17, 2017 and closed by April 1, 2018 will still have the grandfathered limit of $1,000,000 of acquisition debt.
- Casualty and theft losses are now limited to only federally-declared disaster areas.
B. REVIEW YOUR CHARITABLE GIVING
While the TCJA did increase the deduction limit of charitable gifts from 50% to 60% of Adjusted Gross Income, the deduction itself was unaffected by the act. However, due to the SALT limitation and the expanded standard deduction, charitable giving may now be an afterthought to many taxpayers.
- Review your tax estimate to see if you are able to itemize before you make year-end gifts.
- If you cannot itemize, see if bringing forward gifts from 2020 could put you into a situation where you could itemize (assuming cash flow permits this). This is a lumping strategy, where two years’ worth of contributions are combined into one year to take advantage of the deduction. This strategy also assumes that in the year you do not make contributions you will take the standard deduction.
- Consider making a large contribution to a donor advised fund. You’ll take the deduction in the year the gift was made, but distributions out of the fund will not be tax deductible. This strategy allows for your favorite charities to receive contributions in a more consistent manner.
- Consider making charitable gifts from your IRA if you are over the age of 70 1/2. The Qualified Charitable Distribution was made permanent by the PATH Act in 2015. These contributions qualify against Minimum Required Distributions. There is a $100,000 per Individual limit.
C. YEAR-END TAX SELLING
The TCJA created separate tax brackets for long-term capital gains. They are no longer tied to the ordinary tax rate schedules. Gains are taxed at:
- 0% if taxable income is less than $39,375 for single filers and $78,750 for joint filers,
- 15% if taxable income is less than $434,550 for single filers and $488,850 for joint filers, and
- 20% if taxable income exceeds $434,550 for single filers and $488,850 for joint filers.
A 3.8% surtax on investment income is levied on gains that are part of modified adjusted gross Income is excess of $200,000 for a single filer, and $250,000 for joint filers. Considering state income taxes, the tax on capital gains can exceed 30%.
A situation you want to avoid is paying tax on capital gains in 2019, but having non-deductible losses in 2020 because total losses exceed total gains and the allowable $3,000 capital loss deduction. Taking capital losses to offset capital gains can also avoid the surtax on investment income.
- Review portfolios before year-end for tax selling opportunities.
- If your year-to-date realized losses exceed realized gains, you may want to realize additional gains to the extent of losses. Remember that there is a netting process for gains:
- Short-term losses are netted against short-term gains,
- Long-term losses are netted against long-term gains,
- If either of the preceding two steps is a net gain and the other a net loss, you are required to net those.
- If your year-to-date realized gains exceed realized losses, you may want to realize additional losses to reduce your overall gain.
- Look into spreading gains over two years to avoid the maximum 20% rate and 3.8% surtax.
- Realize long-term gains if you are in the 0% tax bracket.
D. QUALIFIED OPPORTUNITY FUNDS – POTENTIAL GAIN DEFERRAL
One of the lesser talked about components of the Tax Cuts and Jobs Act was the creation of two code sections that were designed to encourage investment in certain low-income communities. Section 1400Z-1 created roughly 8,700 qualified opportunity zones that were designated as low-income communities. Section 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a Qualified Opportunity Fund (QOF):
- Temporary deferral of capital gains, to the extent the gains are reinvested into a “Qualified Opportunity Fund” or QOF;
- Partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and
- A permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.
First, taxpayers must elect to defer recognition of capital gain from certain sales or exchanges of capital assets by investing the capital gain in a QOF if the gain is invested during the 180-day period beginning on the date of the sale or exchange. Unlike 1031 exchanges, an individual just has to invest the gain component from the sale, not the adjusted basis. So theoretically, an individual can exclude the gain and take some cash off the table depending on the basis of the property sold.
Second, up to 15% of the deferred capital gain may be permanently sheltered from tax if the QOF investment is held long enough. If the investment is held for five years, 10% of the deferred gain is sheltered; if the investment is held for seven years, an additional 5% of the deferred gain is sheltered from taxation. The remaining 85% of the deferred capital gain remains subject to tax and is taken into income when the investment is sold or on December 31, 2026, whichever comes first.
Third, if the QOF investment appreciates in value, tax on that appreciation may be avoided altogether if the taxpayer holds the investment for 10 years and makes an appropriate election.
While this sounds well and good, the problem is the code sections are temporary, and the benefit expires at the end of 2028. And as soon as 2020 a portion of the potential tax benefit is gone forever (i.e. the 15% permanent gain exclusion from the original deferred gain). Timing is an issue if this is something you want to consider.
A taxpayer that wishes to defer gain must acquire an equity interest in a QOF.
- Stock in a corporation, or
- A partnership interest in a partnership with special allocations.
- An eligible interest DOES NOT include debt instruments.
The nature of the gain deferred remains the same at the time you recognize it for tax purposes.
- Example: You defer a short-term gain in year 20xx. You elect to defer the gain into a QOF. You are long in the QOF investment and continue to hold it beyond Dec. 31st, 2026. You will be required to report the deferred short-term gain in 2026. If you met the 5 or 7 year holding period requirements you would be eligible to exclude up to 10 or 15 percent of the original deferred gain. These exclusions, if met, are additions to basis of the QOF investment.
Eligible gains for deferral are:
- Treated as capital for federal tax purposes;
- Would be recognized for federal income tax purposes before Jan. 1, 2027; and
- Do not arise from a sale or exchange with a related party.
- The deferral period for gains from partnerships that are not deferred at the partnership level begins 180 days from the date the partnership’s tax year ends (typically 12/31/xx). This means you have until midway through the following year to defer any gains IF you get the K-1 in time.
- To achieve the 15% permanent gain exclusion you’d have to defer gains from 2019 or earlier. The clock is ticking here
- An individual doesn’t need to defer gain amounts to invest in a QOF. If cash and gain are invested, two separate investments are deemed to be made.
- If the investment in the QOF (not the original deferred gain) is held for more than 10 years, and the investment was made before 2028, any gain will be excluded from income if sold before Jan. 1, 2048.
The number one consideration for investing in a QOF will be whether or not it will be profitable. While some of the designated areas are already considered up and coming, remaining “zones” may need significant investment before turning around. Some will not be profitable. Remember that while deferring a gain into a QOF provides temporary tax relief (or a permanent exlcusion up to 15%), if the QOF loses money you will still have to pay the tax on the includable deferred gain.
2019 Year End Items of Note
1. RESTRUCTURE YOUR DEBTS WHERE POSSIBLE TO ENSURE DEDUCTIBILITY AND REDUCE FINANCIAL RISK.
- Pay down nondeductible debt first.
- Consider paying down debt that produces deductions that are part of blocked passive activity losses.
- Lock in fixed rates.
- Caution: When refinancing grandfathered acquisition debt, you must meet several limitations if you want to stay above the new $750,000 debt limit. Grandfathered debt will not be recognized if a refinancing:
- Exceeds the principal of the previous loan balance;
- Is extended after the original term completed,
- Has principal that is not amortized over its term, and
- Is extended longer than the current term remaining of the original long with a maximum of 30 years (i.e. If 25 years remain on a 30 year mortgage, the refinance cannot exceed 25 years. In the event you have a balance with a term longer than 30 years you cannot extend beyond 30 years to meet the requirements for refinancing grandfathered debt).
2. REVIEW YOUR GIFTING OPPORTUNITIES:
- The present interest annual exclusion gift: $15,000 per donee for 2019. According to Rev. Proc. 2019-44, the annual exclusion for 2020 will also remain at $15,000.
- Unlimited transfers directly to educational institutions for tuition: These amounts are not considered taxable gifts. If amounts are not paid directly to the educational institution they are considered gifts.
- Unlimited transfers directly to medical care providers for medical expenditures: These amounts are not considered taxable gifts. If amounts are not paid directly to the medical care provider they are considered gifts.
- Gifts to 529 plans: These are considered gifts that reduce your annual exclusion ($15,000 max per donee in 2019 & 2020). However, there is an exception that allows 5 years of gifts in 1 year – a maximum of $75,000 in 2019 & 2020.
2019 Year End Tax Planning: Routine Follow-ups
1. REVIEW YOUR 2019 TAX ESTIMATES.
Update what 2019 will look like, and do the following:
- Estimate your marginal tax rates (income tax rate on the next dollar of income).
- Determine whether your wage or self-employment income will be above the FICA limit ($132,900 for 2019).
- Determine whether you are eligible for the pass-through deduction under IRC Section 199A. Qualifying taxpayers are eligible for a deduction equal to 20% of Qualified Business Income. Taxpayers who are close should determine what additional steps should be taken at year end to qualify for this tax break.
2. DEVELOP STRATEGIES FOR TAKING 2019 DEDUCTIONS.
Know where additional deductions will produce little or no tax benefit.
- If your childcare expenses are already above the tax credit or salary reduction limits.
- If your rental losses are already blocked by the passive loss rules.
- If your losses or deductions will throw you into a 0%, 10%, or 12% tax bracket.
- If you won’t have enough deductions to itemize and instead will use the standard deduction (Single/Married Filing Separate = $12,200; Head of Household = $18,350; Married Filing Jointly = $24,400).
- Think about your charitable giving strategy. It may make more sense to lump two years’ worth of charitable contributions into one year to take advantage of itemizing.
If any of these situations exist, it may be preferable to delay taking the deduction until 2020.
3. LOOK FOR SITUATIONS WHERE TAKING INCOME IN 2019 WILL RESULT IN NO ADDITIONAL TAX BEING DUE.
- Realizing capital gains where you will have excess (non-deductible) capital losses.
- Realizing passive income where you have blocked passive activity losses.
- Realizing investment income where you have blocked investment interest deductions.
- Where you are in a zero or low (10% or 12%) income tax bracket.
- Making a Roth IRA conversion.
4. MAKE SURE THAT YOU ARE MAKING MAXIMUM USE OF THE FOLLOWING TAX BENEFITS:
- $3,000/year capital loss deduction allowance.
- $25,000 rental loss allowance for owners with active participation in the ownership and management of rental real estate. (Warning: This benefit is phased out as Adjusted Gross Income increases from $100,000 to $150,000.)
- The $2,000 per individual child (must be under the age of 17) tax credit, and $500 for other dependents (not children under age 17). Phase out begins at $400,000 of modified adjusted gross income for married filing joint filers ($200,000 for all other filers).
- $5,000 per year dependent care exclusion ($2,500 for single filers).
Deductible IRA contributions (Maximum $6,000 per individual). Individuals over age 50 are able to make an additional “catch-up” contribution of $1,000. Non-working spouses may have deductible IRA’s available if AGI tests are met.
Note that deduction phase-out ranges are increased annually for individuals who have pension coverage. The phase-out point begins for individuals with pension coverage at $64,000 of AGI for single and head of household filers, and $103,000 of AGI for joint filers with pension coverage. Individuals are completely phased out at AGI levels of $74,000 for single and head of household filers, and $123,000 for joint filers. The phase-out point for spouses without pension coverage starts at $193,000 of AGI when the other spouse has pension coverage.
- $100,000 per year exclusion of charitable distributions from IRA accounts by individuals aged 70 ½ or older.
Review whether 100% bonus depreciation or IRC section 179 expensing is more beneficial for property used in a trade or business. To qualify for bonus depreciation the property categorization must meet the MACRS recovery period of 20 years or less.
The maximum deduction under Section 179 expensing is $1,020,000 and the phase-out-threshold begins at $2,550,000 million of asset additions. The expense allowance is completely phased out if $3,550,000 of purchases are made.
- The optional standard mileage reimbursement rate for 2019 is 58 cents per mile.
5. INDIVIDUALS SHOULD MAKE SURE THAT TAX DEPOSITS ARE ADEQUATE.
- To avoid underpayment penalties, your total withholding plus estimated tax deposits must exceed the lesser of: (a) 2018’s tax or (b) 90% of your eventual 2019 tax.
- If your prior year Adjusted Gross Income was above $150,000, you will avoid underpayment penalties if you deposit 110% of 2018’s tax. Taxpayers with incomes up to $150,000 can avoid penalties by depositing 100% of the prior year’s tax as noted above.
- Don’t forget to review estimated taxes for your children. The kiddie tax is now based on trust tax rates, and income is subject to higher tax rates at lower income levels.
6. REVIEW YOUR TAX BASIS IN PARTNERSHIPS AND S-CORPORATIONS.6. REVIEW YOUR TAX BASIS IN PARTNERSHIPS AND S-CORPORATIONS.
- Losses from S-corporations can be non-deductible if a shareholder does not have tax basis in either the stock or debt of the company. Partnership losses can be limited if losses allocated exceed the taxpayer’s basis in the partnership.
- Partners and shareholders of these entities that are projected to have pass-through losses should review their basis in the investment to make sure that the desired amount of loss will, in fact, be deductible. Making additional investments before year-end to increase basis may be necessary to make this happen.
7. PAY ATTENTION TO FINANCIAL HOUSEKEEPING.
- If you are married to a foreign national, make sure your spouse has an ITIN (Individual Tax Identification Number). E-filing is not allowed without one.
- Apply for Social Security numbers for dependents.
- Change Social Security name records for name changes due to marriage or divorce. (Note: Names used on tax returns must agree exactly to the spelling used by the Social Security Administration, including the use of abbreviations and initials.)
- Obtain documentation for charitable contributions. Gifts of $250 or more must be substantiated by a written acknowledgment from the donee organization.
- Obtain appraisals for non-cash contributions exceeding $5,000.
- Get auto usage records compiled. Businesses should make sure that the personal use value of company autos is included in the employee’s W-2.
Make sure that documentation for meal expenses is adequate to withstand an IRS audit.
Do not dispose of the year’s appointment book if you intend to rely on it to support business deductions. Entertainment expenses are no longer deductible.
Make sure that documentation for meal expenses is adequate to withstand an IRS audit.
Do not dispose of the year’s appointment book if you intend to rely on it to support business deductions. Entertainment expenses are no longer deductible.
8. REVIEW 2020 BENEFIT PLAN OPTIONS WITH YOUR EMPLOYER.
- 401(k) plan contribution rate and investment choices. (Don’t forget to elect the bonus contributions if you’re 50 or older.) The maximum elective deferral for 2020 is $19,500. The catch-up contribution for individuals 50 years or older is $6,500.
- Non-qualified deferred compensation plan elections.
- Dependent care assistance salary reductions.
- Compensation paid in the form of mass transit passes. (The Tax Cuts and Jobs Act eliminated the deduction for employers, but retained the pre-tax benefit for employees.)
- Health savings account contributions
- Flex spending account contributions
Having health insurance coverage with a high deductible policy entitles you to make contributions to a Health Savings Account (HSA). Minimum qualifying policy deductibles are $1,400 for single coverage or $2,800 for family coverage. The maximum HSA contribution for 2020 is $3,550 for single coverage or $7,100 for family coverage. Bonus contributions of $1,000 will be allowed for those individuals age 55 or more. Individuals eligible for Medicare cannot make HSA contributions.
The maximum annual contribution limit for a flex spending account for 2019 is $2,700. Participants can carry over up to $500 in unspent contributions if the plan has not adopted the 2 ½ month grace period rule. (This allows 2 ½ months after year-end to spend unused funds.) The $500 carryover will not reduce the current year’s FSA contribution. Caution: Taking advantage of the carryover rule will prevent HSA contributions.
If you plan on making HSA contributions for 2020, clear out the flex spending account before year-end.
9. DISCUSS CHANGES TO TAX TREATEMENT OF UNREIMBURSED BUSINESS EXPENSES WITH YOUR EMPLOYER BEFORE YEAR-END.
- The TCJA eliminated miscellaneous itemized deductions subject to a 2% of Adjusted Gross Income floor. Employees who incurred business expenses that were not reimbursed under an accountable plan are no longer able to deduct these as an itemized deduction. See whether or not these can be reimbursed under an accountable plan with your employer moving forward.
10. ZERO OUT PERSONAL SERVICE CORPORATION INCOME WITH EXPENSE PAYMENTS AND BONUSES AT YEAR END.
- When taxable income is retained in a Personal Service Corporation (PSC), it is subject to a 21% income tax. Corporations that have not elected S status must zero out income to avoid eventual double tax when corporate earnings are distributed.
11. S-CORPORATION OWNER/EMPLOYEES SHOULD REVIEW THEIR COMPENSATION.
- S-Corporations shareholders who are also employees are required to declare reasonable compensation from the business. The IRS has not defined what is reasonable, but recent court cases show the service applies a facts and circumstances calculation based on the trade or business and location of the entity. The formalities of setting reasonable salary levels should be strictly observed to avoid potential distribution reclassification as wages by the IRS.
13. MAKE SURE THAT ALL INVESTMENT ACCOUNTS HAVE A PROPER SOCIAL SECURITY NUMBER AND ARE NOT SUBJECT TO BACKUP WITHHOLDING.
- The backup withholding rate is 28%. The existence of backup withholding can cause the filing of a child’s individual return that may not be required.
14. C-CORPORATIONS THAT PLAN TO RETAIN EARNINGS SHOULD MAKE ESTIMATED TAX DEPOSITS EVEN IF NO TAX WAS INCURRED IN 2018.
- Underpayment penalties are usually avoided if a taxpayer at least matches the prior year’s tax with estimated tax payments. This penalty exception does not apply if a corporation has no tax liability in the prior year.
15. IF YOU MAINTAIN AN IRREVOCABLE LIFE INSURANCE TRUST, MAKE SURE THAT CRUMMEY POWER DOCUMENTATION IS KEPT IN YOUR FILE AND IS UP TO DATE.
- In the absence of this documentation, the IRS can apply the transfer of funds to the trust against your unified estate and gift tax credit.
16. REPORTING FOREIGN BANK ACCOUNTS
A U.S. person may be required to file with the U.S. Treasury a report disclosing foreign bank account information.
The foreign bank account reporting (FBAR) is required if:
- A taxpayer has a financial interest in, or signature authority over, at least one financial account located outside the United States, and
- The taxpayer has financial foreign accounts with an aggregate value which exceeds $10,000 at any time during the calendar year.
Looking to 2020 and beyond
Traditional tax planning includes looking ahead to assess and plan for future tax liabilities. With 2020 being an election year, we believe there is a low probability of any significant tax legislation being enacted.
We believe there will be more activity at the state level, specifically the state of Illinois. If the state’s proposed “Fair Tax” receives 60% or more of the vote next November, the state’s constitution will be changed to mandate a graduated income tax rate and repeal the current flat-rate income tax.