It’s always a good idea at year end to prepare for the upcoming tax season and this year end of year planning is particularly critical in light of major changes to the individual income tax that became effective in 2017. Here are a few points to consider.
Consider the changes to the Itemized Deduction
For 2018, the personal exemption has been eliminated, the standard deduction has been increased, and the ability to take advantage of a number of former itemized deductions has been eliminated or limited, most notably the cap of the itemized deduction for state and local taxes at $10,000. Clients need to sit down and prepare a pro forma return to determine whether or not they will be able to take advantage of the remaining available itemized deductions this year. If particular deductions will not be available this year, it might make sense to defer these expenses and bunch them in a later year.
Consider the Charitable Deduction
For individuals who are claiming the standard deduction, a charitable contribution for this year may not provide a tax benefit. It may make more sense to defer the charitable contributions and bunch them in a later tax year so as to qualify for itemized deductions. Other alternatives may include making a substantial contribution to a charitable donor advised fund, essentially making a large contribution up front that will be disbursed over time. If the client is eligible to receive distributions from an IRA account, a qualified charitable contribution from the IRA may be advantageous. If itemized charitable deductions are going to be taken, be sure that you have adequate substantiation. For non-cash contributions, Form 8283 and a qualified appraisal may be required.
Review the Mortgage Expense Deduction
Rules for the deduction of home mortgage interest paid have been substantially changed, particularly with respect to home equity mortgages and refinances for reasons other than acquisition or improvement of a residence. The new law modified eligibility for the mortgage interest deduction in several ways. For 2018 a taxpayer will only be able to deduct interest on up to $750,000 in mortgage debt, down from $1 million under prior law. The old $1 million limit is grandfathered in for existing mortgages, but if the loan is refinanced, the taxpayer will be subject to the lower limit.
Under the former law, you could deduct interest on up to $100,000 of home equity debt. This allowed you to do whatever you wanted with the money, including paying down other types of debt or spending on things unrelated to your home, and still deduct the interest. The new law limited this deduction. The taxpayer can still deduct interest on such debt if it’s used to buy, build, or improve your home and doesn’t bring your total outstanding mortgage debt above the $750,000 limit. But deductibility is no longer available if you used the proceeds for other purposes.
Refinancing an existing mortgage will require careful thought if the goal is to preserve the grandfathered $1 million limitation. If a taxpayer refinances a mortgage that counted as home acquisition debt, the refinanced mortgage will also count as home acquisition debt as long as it’s in the same amount. If the taxpayer borrows more in the refinancing, then the extra amount of cash will be treated as home equity debt, and so that portion of the interest won’t be deductible unless it’s used to improve the home.
Finally, the biggest potential problem for homeowners is that the increase in the standard deduction will effectively take away the tax benefit of paying home mortgage interest. If a taxpayer’s total itemized deductions don’t exceed the now-higher standard deduction, then the taxpayer will not be able to itemize, and the fact that mortgage interest is deductible won’t provide any additional deduction.
Maximize Retirement Contributions
Retirement incentives for traditional retirement accounts like a 401(k) or individual retirement account still offer some of the most valuable tax benefits. It’s not too late for taxpayers to increase their contributions. Contributions reduce taxable income at the time they are made, and clients don’t pay taxes until they take the money out at retirement. The 2018 contribution limits are $18,500 for a 401(k) and $5,500 for an IRA (not including catch-up contributions for those 50 years of age and older).
Consider State and Local Tax Obligations
As noted above, the itemized deduction for various state and local taxes paid is capped at $10,000. In some instances, an advantage can be obtained by concentrating state and local tax payments in alternate tax years or prepaying or deferring state and local taxes when appropriate. It is also important to consider situations where state and local income tax rules are different from the federal rules and may require more careful planning. For example, here in Maine, personal exemptions will still be available even though limited at the federal level. Although Maine recently passed a law conforming Maine state law to the federal income tax law in most cases there are still a number of specific areas where Maine did not follow federal law.
Review Miscellaneous Itemized Deductions
Most of the miscellaneous itemized deductions such as unreimbursed work related expenses, investment fees and management expenses, tax preparation fees, rental fees for safe deposit box, IRA fees, casualty losses, moving expenses, and hobby losses have been eliminated.
Consider Annual Exclusion Gifts
The recent increases in the federal gift and estate tax credit shelter exemption has reduced the risk of estate tax exposure for many individuals but these increases are not permanent and are scheduled to end in 2025. There are still some advantages to taking advantage of the annual giving exclusion of $15,000 per donee per year. This may be a particularly valuable strategy for assets likely to appreciate in value.
Maximize Flexible Spending Accounts
A taxpayer who participates in an employer sponsored cafeteria plan, health care reimbursement arrangement or other similar plan should make sure to utilize all available funds are used for qualified distributions.
Harvest Capital Losses
If the taxpayer has a capital loss position, it may make sense to harvest losses to offset gains.