Tom Ewell and Marilyn Monroe (the stars of the Seven Year Itch) are long gone, but Congress is alive and well in going through the exercise of revising the tax code. Since the enactment of the first version of the Internal Revenue Code in 1913, major overhauls have occurred at regular intervals ever since, the biggest being in 1933, 1954, and 1986.
A recap of the 1986 act is needed for some historical perspective. The theme of the Tax Reform Act of 1986 was a lowering of tax rates paid for by reducing deductions and expanding the tax base.
- Top individual income tax rates were lowered from 50% to 39.6%.
- To pay for the lowering of rates, certain deductions were curtailed.
Medical expenses only contributed to itemized deductions to the extent that they exceeded 7.5% of Adjusted Gross Income.
Miscellaneous itemized deductions (principally investment expenses and unreimbursed employee business expenses) only contributed to itemized deductions to the extent that they exceeded 2% of Adjusted Gross Income.
• Capital gains were taxed at regular tax rates.
For 1987 the maximum capital gains tax rate was actually increased. In years leading up to the Tax Reform Act of 1986 there was a 60% exclusion for long-term capital gains. When applied to a 50% maximum tax rate, the effective rate was 20%. In 1987 long-term gains were taxed aVt ordinary rates up to a maximum of 28%. In 1988 through 1990 capital gains were taxed at ordinary rates with no maximum tax rate.
• A parallel tax computation was devised to minimize the impact of tax avoidance strategies, principally oil and gas drilling deductions. Under the Alternative Minimum Tax, certain deductions that were available under the regular tax computation were not allowed under the AMT.
State and local taxes
Deductions for Intangible Drilling Costs.
Miscellaneous itemized deductions
Regular tax personal exemptions
After these adjustments, the greater of the regular tax or the AMT was paid.
The Alternative Minimum Tax and the Passive Activity Loss rules ended up being two of the most hideously complex corners of the Internal Revenue Code.
In particular, the AMT turned out to be highly irritating because it didn’t take any tax oriented investment activity to be snared by it. The AMT had its own personal exemption, but it was not indexed to inflation. 30 years of inflation raised state income taxes, real estate taxes, and regular tax personal exemptions, resulting in increases to the minimum tax that outstripped increases in the regular tax. Due to this the Alternative Minimum Tax became a great revenue source for the federal government.
The Tax Cuts and Jobs Act
The messy details have yet to be negotiated between the House of Representatives and the Senate in Conference Committee. Taking a top-down view, the act is actually quite simple.
- There are increased tax breaks being given to businesses and business owners.
- There is a systematic gutting of the economic value of itemized deduction to pay for the business tax breaks.
If you’re looking for some unified theory behind the changes, look elsewhere.
Repeal of the deduction for state and local income taxes
The act takes a meat axe to deductions common to many income tax returns, most notably the deduction for state and local taxes. This comes at a time of high stress for state budgets.
- States have been slow to curtail defined benefit pension plans, and many have funding ratios below 40%.
- Local units of government rely mainly on real estate taxes for funding operations. These include pensions and post-retirement medical benefits.
- 18 states took the bait and signed on to Medicaid expansion. They have since found out that the liabilities are open-ended.
The last item is emblematic of what happens when entitlement programs are enacted at the federal level, but the funding is delegated to the states. Think about the situation that California residents are facing. There is a 13.3% top end tax rate. This is reduced to 8% if the taxes can be deducted on the federal return.
Repeal of the state and local income tax deduction is not a done deal, despite its inclusion in both the House and Senate versions of the bill. If Congress backtracks on this, it will be difficult to come up with tax increases to offset the loss of revenue.
The tax benefit for charitable contributions for most taxpayers is being eliminated indirectly. Itemized deductions provide no tax benefit until they exceed the standard deduction. For years the key itemized deductions for individual without mortgages have been—
- State & local income taxes
- Residential real estate taxes
- Charitable contributions
If you knock out the income tax deduction, and limit deductible real estate taxes to $10,000, you need more than $14,000 of charitable just to get up to the standard deduction amount for a joint return.
Elimination of personal exemptions
Personal exemptions are eliminated starting in 2018. (The deduction is $4,050 per exemption for 2017). The party line of the Republicans is that the doubling of the standard deduction will more than offset the loss of personal exemptions. The following table throws cold water on this argument.
What this table shows is that any time filers have more than the minimum number of personal exemptions for a filing status, the effect is a net loss in deductions.
Elimination of itemized deductions and the repeal of the Alternative Minimum Tax
You can’t discuss one without talking about the other. The key things putting taxpayers into an AMT situation are deductions for the regular tax that are not deductible for AMT.
- Regular tax personal exemptions
- State & local taxes
- Miscellaneous itemized deductions (mainly investment expenses)
Eliminating these deductions would largely eliminate the AMT. So why didn’t Congress just eliminate the deductions and repeal the Alternative Minimum Tax at the same time?
Repeal will be debated in the conference committee. The House version of the bill repeals the AMT, while the Senate version keeps it, but increases the AMT exemption.
The problem with the Senate’s approach is that the AMT exemption will have to be goosed up more substantially to make up for the loss of the expanded regular tax standard deduction. (Spoiler alert: That $24,400 regular tax standard deduction is an AMT addback. The AMT has its own standard deduction.)
The problem with repealing the AMT is investment related tax shelter activity. This was restrained under the AMT, but could resurface quickly. With that in mind, the Senate version of the bill is better, keeping it in place, but limiting its effect on most taxpayers.
The problem with keeping the AMT is its complexity. Regular tax and AMT calculations must be done for each entity reporting taxable income, regardless of whether the eventual owner of the income will be in an AMT situation or not.
The debate on the repeal of the Alternative Minimum Tax is far from over.
- For individual age 701⁄2+, charitable giving will move off Schedule A to IRA accounts.
- Individuals may choose to bunch charitable giving in alternating tax years, itemizing in those year while taking the standard deduction in years when no charitable giving occurs.
- Taxpayers need to stay alert to developments in the conference committee. If the repeat of state and local income tax deductions occurs, there may be a tax benefit from paying the taxes in 2017. This requires making sure that you are not incurring the Alternative Minimum Tax in 2017.
- Small business should look to defer income into 2018 to potentially take advantage of more favorable treatment of the business income of passthrough entities. See our article “Republican Helicopter Money: The Senate’s Small Business Plan.”
- Real estate values will be under pressure because a loss of deductions. See our article “The Withdrawal of Tax Subsidies From Residential Real Estate.”
- It looks like there will be additional restrictions on interest deductions. See our article “Restrictions on the Deduction of Business Interest.”