The Tax Cuts and Jobs Act that’s winding its way through Congress, if enacted, will be the single largest piece of tax legislation since the Tax Reform Act of 1986. It features several proposed unfavorable changes to itemized deductions.
Most notable would be a repeal of state and local income tax in the House and Senate proposals and a repeal of medical deductions in the House proposal. The House would also reduce the $1 million limit on home mortgage interest that’s applied to two homes to $500,000 on one home and cap real estate tax deductions at $10,000.
Charitable deductions, on the surface, would be unscathed. Included in the House and Senate bills is a proposed increase in allowable contributions to public charities from 50% to 60% of adjusted gross income (AGI). The ability to carry over contributions exceeding the AGI limit to the five succeeding years would be unchanged.
Middle-Income Taxpayers May Become Less Charitable
While charitable contributions wouldn’t take a direct hit, middle-income taxpayers who are incentivized by income tax deductions may become less charitably inclined. The reason for this is the almost doubling of the standard deduction. Middle-income individuals living in states with high state income tax rates will be most affected.
The best way to explain this is with an example. Tommy and Mary Johnson live in California. They claim itemized deductions totaling $40,000. This includes state income taxes of $20,000, real estate taxes of $5,000, mortgage interest of $10,000, and charitable contributions of $5,000.
If the Tax Cuts and Jobs Act is passed, Tommy and Mary will lose their state income tax deduction of $20,000, reducing their total itemized deductions from $40,000 to $20,000. Since their standard deduction, which is currently $12,700, would increase to $24,000, Tommy and Mary would forego their itemized deductions of $20,000 and claim the higher standard deduction of $24,000 instead.
The Johnsons would realize no income tax savings from their charitable contributions since they would be able to claim the standard deduction of $24,000 whether or not they make any contributions. Assuming that Tommy and Mary have been historically motivated by tax savings, they would reduce, or potentially eliminate, this expense going forward.
Even if you don’t live in a high state income tax state like California, to the extent that your standard deduction exceeds your otherwise allowable itemized deductions, there would be no income tax benefit from charitable giving. As previously stated, the standard deduction for married filing joint status would be $24,000. The amount would be $12,000 for single and married filing separate and $18,000 for head of household.
Potential Increased Tax Savings for High-Income Taxpayers
The Tax Cuts and Jobs Act is being promoted as tax relief for the middle class. Interestingly, high-income taxpayers who are charitably inclined may be able to realize greater tax savings than under current law. This is due to the proposed repeal of the limitation on itemized deductions for high-income taxpayers combined with other proposed changes as previously discussed.
The Pease limitation, named after former Rep. Don Pease (D-OH), caps itemized deductions for high-income taxpayers. The limitation is the lesser of (a) 3% of AGI exceeding a specified threshold based on filing status ($261,500 for single and $313,800 for married filing joint) or (b) 80% of the amount of itemized deductions otherwise allowable.
As an example, a single taxpayer with AGI of $500,000 and itemized deductions of $150,000 forfeits $7,155 (3% x ($500,000 – 261,500)) of itemized deductions under current law, reducing allowable itemized deductions from $150,000 to $142,845.
With the proposed changes, a greater percentage of high-income taxpayers’ itemized deductions will be attributable to charitable contributions in many cases. Consequently, taxpayers in this situation will, in effect, be able to deduct a larger amount of their charitable contributions than under current law.
No Income Tax Deduction is Sacred Anymore
If the Tax Cuts and Jobs Act as currently proposed is enacted, middle-income taxpayers who give to charity based solely on tax savings may be less inclined to do so if the amount of their standard deduction is greater than their allowable itemized deductions.
Whether it’s a repeal of the deduction for state income taxes and medical expenses, capping of mortgage interest and real estate tax deductions, or a reduced incentive for charitable giving, no itemized deduction is sacred anymore. Furthermore, any potential benefit to be derived from a higher standard deduction will be offset by the repeal of the personal exemption, the current amount of which is $4,050 per qualifying individual.
At least the controversial alternative minimum tax, or “AMT,” would finally be repealed under the House and Senate proposals. I guess we need to be thankful for something, especially since Thanksgiving is just a few days away.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.