The Senate finance committee passed the “Tax Cuts and Jobs Act” and the Senate is due to vote on it after Thanksgiving (2017). This bill is packed with a lot of changes. So, if you’re a physician family and/or a high earner, what’s in it for you?
Tax brackets (House version)
- For simplification purposes, let’s compare MFJ (Married Filing Joint) taxpayers.
- The standard deduction is raised from $12,700 to $24,000 (+$11,300).
- Personal exemptions ($4,050/person in 2017) are eliminated. Since personal exemptions already phase out (decrease to zero) for MFJ taxpayers at $436,300 of taxable income, this reduction will not affect the top brackets.
- At this time, it appears the 0.9% Medicare tax on high earners and the 3.8% Net Investment Income Tax (NIIT) will remain in effect.
- In summary, your tax rates will change as follows:
If you don’t itemize and none of the below revisions are applicable to you, your tax bill will be reduced.
Sale of your primary residence
- You can currently exclude gain on the sale of your house of up to $250k per spouse if it has been your primary residence for two of the last five years.
- For houses sold after 12/31/17, the holding period will increase to five of the last eight years.
- In the Senate version, the amount you can exclude will be reduced dollar-for-dollar for taxpayers with over $500k in AGI (the last number on page one of your 1040).
Example: If your family’s AGI is $600k, you can exclude only $400k of gain (MFJ) and only if it has been your primary home for five of the last eight years if you sell it after 12/31/17.
Purchase of your primary residence
- You could previously deduct interest on “acquisition indebtedness” (i.e. a mortgage) of up to $1M on your primary home, along with $100k of home equity debt.
- As of 11/2/17, you will now be limited to a deduction of interest paid on only the first $500k mortgage on your primary and a secondary home ($500k total, not $500k per home).
- This limitation takes effect for new mortgages taken out after 11/2/17.
- Post 11/2/17 refinancing of pre-11/3/17 mortgages will retain the character of the original mortgage.
- You also will be no longer able to deduct interest paid on home equity debt for debt incurred after 11/2/17.
Example: If you take out a 3.5% mortgage for $200k on your primary home and a 4.5% mortgage of $400k on your vacation home on 11/15/17, you can deduct interest on schedule A on a combination of $500k of that debt. We don’t yet know if you can choose which debt to use to calculate (i.e. can you use $400k from your vacation home and $100k from your residence? Or do you have to exhaust the residence debt first before using the vacation home debt?) If this debt happens to be from two different banks, the onus will be on you (or your CPA) to figure all of this out.
- Expect to receive mortgage interest statements later than usual this filing season because lending institutions will need to split information between interest paid on pre-11/3 mortgages from interest on post-11/2 mortgages. Tax preparers must be prepared to split mortgages among homes for the $500k limit.
SALT (State and Local Taxes) as an Itemized Deduction
- Currently, you can deduct 100% of all taxes assessed based upon the value of a property.
- You will no longer be able to deduct state/local income or sales taxes. You will be able to deduct taxes on personal real estate up to $10k/year (House version).
- The Senate wants to make all personal real estate taxes nondeductible.
- This provision takes effect 1/1/18 (you’ll still get to deduct 100% of real estate taxes in 2017).
- Because some states also impose property taxes, typically on vehicles, in addition to taxes on real estate, we don’t yet know if those taxes are nondeductible or are included in the $10k limit.
#1 You pay your 2017 property taxes of $15k in 2018, along with 2018 property taxes of $15k at the end of 2018. You will deduct $10k in 2018 and lose the remaining $20k deduction.
#2 You pay your 2017 property taxes of $15k in 2017 and prepay your 2018 property taxes of $15k at the end of 2017. You will be able to deduct $30k of property taxes in 2017.
#3 You pay your 2017 property taxes of $15k in 2017 and pay your 2018 property taxes of $15k in 2018. You’ll get a tax deduction of $15k in 2017 and $10k in 2018.
Suggestion: If you will owe over $10k in property taxes in 2018, prepay at least part of them in 2017. (The IRS will not let you deduct prepaid expenses more than one year ahead.) First, see the suggestion at the end of this post.
AMT (Alternative Minimum Taxes)
- AMT is an “equalizer” tax that was put into the tax code in 1969 to prevent high income taxpayers from exploiting tax loopholes. Currently, taxpayers must compute their income for purposes of both the regular income tax and the alternative minimum tax (AMT) and pay the higher amount. Because the exemption amounts were not set to increase with inflation, the number of taxpayers paying AMT has grown each year.
- AMT is repealed for tax years beginning 1/1/18. Practically speaking, the tax bill takes away many of the AMT add-backs, so AMT was already on life support.
- Close to 50% of our physician clients pay AMT, but it’s too early to tell at this point what the overall effect is because of changes to other tax deductions.
- Under current law, corporations pay a tax rate of 34% on earnings between $75k and $10M. Safe to say, the taxable income of most physicians is in this range.
- The corporate tax rate will be reduced from 35% to 20% for standard (“C) corporations and to 25% for PSC’s (Personal Service Corporations). A physician corporation, by default, must file as a PSC unless it elects to be taxed as an S-corporation.
- A top tax rate of 25% could affect the way PSCs manage their payouts to owners.
- In the past, profits not paid by the PSC to owners as salaries and wages were taxed at a top rate of 35% but for all practical purposes, the rate for physicians is 34%. In other words, the goal of the owners at the end of each year was to file a “break even” tax return (no profit or loss). Otherwise, the corporation would pay 34% tax on profits kept inside the business.
- Now, the business will pay lower taxes than the owners on profits of the business. This could motivate PSC owners to expand operations by leaving money inside the business for future expenses. At a minimum, it will allow owners breathing space to plan ahead rather than emptying the till at the end of each year.
Pass-through business taxes
- Currently, profits from pass-through entities are taxed at the business owners’ highest marginal tax rates rather than separately at the entity (LLC, partnership, corporate) level.
- Pass-through businesses with the exception of certain personal services businesses are eligible for a top tax rate of 25%. This rate will be applied to “a capital percentage of 30%” of net business income. The remaining 70% will continue to be taxed at the shareholder’s ordinary income tax rate.
- Passive investors in pass-through businesses will be taxed at a top rate of 25% on all of their income from pass-through businesses (real estate investors, for example).
- The current amount that a decedent can leave behind without estate taxation is $5.49M, except for spouses, who can receive an unlimited amount tax-free.
- The tax bill doubles this amount to $10.98M, which will increase with inflation until 2024, at which point estate taxes are eliminated.
- In addition, beneficiaries will continue to receive a stepped-up basis in inherited property. This means you can escape paying capital gains taxes when you sell inherited property.
- Estate taxes are assessed after death and gift taxes are assessed when you make a gift while you’re alive. Currently, the top gift tax rate is 40% on the first $5.49M of taxable gifts you make in your lifetime. Gift taxes are not paid until you surpass that amount of gifting and you can gift up to $14k to any one person in any year without eating into that exclusion. In other words, if you make a gift of $250k in one year to one person, the first $14k is not counted against your lifetime exclusion. But your $5.49M lifetime exclusion is reduced by ($250k – $14k) = $236k, so your remaining exclusion is $5,254,000.
- Gift taxes remain in place, but the amount of the exclusion is doubled, to $10.98M and will rise with inflation. The top gift tax rate on lifetime gifts over $10.98M is reduced to 35%
- Under current law, those who pay alimony can deduct it. Recipients must claim it as income.
- Under the new law, alimony payments will not be deductible by the payor and will not be includible in the income of the payee.
- This provision is effective for any divorce decree or separation agreement executed after 2017 and to any modification after 2017 of any such instrument executed before such date if expressly provided for by such modification.
- Ex-spouses who previously relied on the receipt of alimony as a basis for IRA contributions will no longer be able to do so.
- Jockeying for division of payments between alimony and child support by exes will no longer occur.
Medical, CPA, and Employee Business Expenses
- Under current law, only the amount of medical expenses that exceeds 10% of your AGI is deductible.
- Under current law, CPA fees for personal tax preparation and unreimbursed employee business expenses are deductible only for the amount that exceeds 2% of your AGI.
- These expenses will no longer be deductible beginning in 2018. This provision relates only to itemized deductions for personal expenses. CPA fees will continue to be deductible for business expenses. For most physician clients, these changes will have no impact.
- I would not be surprised to see other expenses in the 2% area be eliminated, including attorney fees, investment management fees, and safe deposit box rentals.
- If your business pays 100% of your CPA’s bill, be sure to allocate an amount to the nondeductible personal part tax preparation fees.
Senate versus House, in general
I referenced much of this article from H.R. 1, the Tax Cuts and Jobs Act, so parts of the above will be somewhat different in the Senate version. Unlike the House bill, the Senate bill, as approved, contains only temporary tax cuts for individuals, sunsetting the rate reductions and most other changes after 2025. While the corporate rate cut, from 35% to 20%, would be permanent under the Senate bill, they would not become effective until 2019.
A final tax planning suggestion: if you may be subject to AMT, please discuss the effect of these 2017 planning tips with your CPA before taking action. A tax planning session including a tax projection is in order before the end of the year to determine what is appropriate for your specific situation. While we can’t be sure about the above until the final bill is signed into law, projections indicate that may not happen until just before Christmas. Follow the news, stay in touch with your CPA, and take proactive measures in 2017 where possible.
A recent post on the WCI forum about the value of Social Security benefits led to this month’s vlog idea. Listen to Michelle as she ruminates about Social Security benefits. What do you think: should you count on Social Security, or not?