Highlights of the Republican Tax Plan, The Tax Cuts & Jobs Act
Highlights of the Republican Tax Plan, The Tax Cuts & Jobs Act
Last week, the House Republicans unveiled their highly anticipated plan for tax reform. Although clients should not rush into planning based on the House plan, it is important to be aware of potential changes in the tax code. In particular, business owners and individual high net worth clients should be prepared for the adverse and beneficial aspects of the proposed plan because the plan is intended to be effective for tax years beginning January 1, 2018.
The "Tax Cuts and Jobs Act" (the TCJA) is a 429 page "opening offer" on tax reform. Although the bill will change as it goes through the legislative process, clients should be aware of the potential for massive changes to their tax affairs in the near future. Many of the TCJA changes have been discussed in the tax press and the popular press. Below we summarize some provisions that are most likely to affect our clients.
I. Changes to the Mortgage Interest Deduction and Principal Residence Gain Exclusion
Currently, taxpayers are allowed to deduct the amount of mortgage interest paid during a year on home loans of up to $1,000,000. Under current law, a taxpayer can exclude gain so long as the taxpayer has lived in the home for 2 of the last 5 years. The TCJA:
- Reduces the qualified residence interest cap to $500,000 for loans made after November 2, 2017; and
- Extends the holding period for gain exclusion; under the TCJA, gain is only excluded if the taxpayer has lived in a home for 5 of the last 8 years.
For California residents thinking about purchasing a new home or refinancing, keep in mind that any new loan may cost significantly more due to the limited income tax deduction.
II. Elimination of the State and Local Tax Deduction
Under current law, taxpayers may deduct all amounts used to pay state and local income, property, or sales taxes. The TCJA:
- Removes the deduction for state and local income taxes; and
- Caps the amount of the deduction for local property taxes as $10,000 per year
For California residents, it is estimated that the elimination of the state and local tax deduction will effectively increase their total tax burden by 1.5 to 5.1%. That is, Californians may end up paying more in taxes overall due to the loss of the state and local tax deduction.
III. Pass-Through and Passive Income Maximum Rate.
Under current law, certain types of income are considered "passive" and subject to special rules under IRC § 469. Most familiar to taxpayers are the passive activity rules relating to real estate. Generally, passive income is taxed at the ordinary marginal income tax rates (up to 39.96%). The TCJA:
- Reduces the top rate of income tax on passive income to 25%; and
- Applies the 25% rate to dividends from real estate investment partnerships (REITs).
This break is good for individuals who rent out a second home, collect a K-1 from an investment partnership, or have other passive income. For businesses in which the taxpayer actively participates, the TCJA:
- Assigns 30% of the income derived from active business activity as subject to the lower 25% rate; and
- The other 70% would be treated as compensation and taxed at ordinary individual income tax rates.
Note, however, that the 25% rate may not apply to owners of pass-through professional services businesses (e.g., law firms, consulting firms, etc.).
IV. Increased Unified Credit Against Estate, Gift, and Generation-Skipping Transfer (GST) Tax and Elimination of the Estate and GST Taxes in 2023
Under current law, individuals are entitled to a gift and estate tax exemption of $5.49 million ($10.98 million for married couples). Taxpayers with assets in excess of $5.49 million dollars will be pleased to hear that the TCJA:
- Increases the unified credit against estate, gift, and GST taxes to $10 million per person (annually adjusted for inflation); and
- Eliminates the estate and GST taxes for those that die after December 31, 2023. The tax rate for gifts made after 2023 also will be reduced (to a maximum rate of 35%).
While many commentators expected a change to existing law regarding the basis step-up on death (Section 1014), the TCJA does not change the existing rule.
V. Repeal of the Alternative Minimum Tax (AMT)
Under current law, certain taxpayers are required to recalculate their taxable income each year without accounting for certain deductions; any difference between normal taxable income and the recalculated taxable income is subject to AMT. The TCJA:
- Eliminates the AMT altogether; and
- Taxpayers that paid AMT in prior years may get a refund.
VI. Business Rate Changes
As has been widely reported, the TCJA:
- Reduces the rate on corporations from 35% to 20%, with one notable exception.
- In the case of "personal service corporations" (i.e., services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting), the corporate rate is reduced to 25%.
VII. Bonus Depreciation Extended and Deepened, Section 179 Bonanza
Under current law (Section 168(k)), businesses may take a deduction for 50% of the cost of qualified property placed in service during a taxable year. The TCJA:
- Continues the bonus depreciation deduction through January 1, 2023; and
- Increases the deduction to 100% of the cost of qualified property.
Unlike other provisions of the TCJA, the bonus depreciation provisions are retroactive to any property acquired after September 27, 2017, and placed in service after that date.
Similarly, current law allows taxpayers to treat certain "Section 179 property" as an expense. The TCJA:
- Increases the Section 179 maximum ten-fold, from $500,000 to $5,000,000.
VIII. Section 1031 Like-Kind Exchanges of Property Limited to Real Property
Under current law, Section 1031 allows a taxpayer to defer gain on the exchange or disposition of a piece of property held for investment or productive use in a trade or business, for which the taxpayer trades property of "like kind". The TCJA:
- Eliminates like-kind exchanges, except with regard to real property, after December 31, 2017; and
- Eliminates the special tax avoidance rules for 1031 exchanges between related parties.
Many Californians engage in 1031 exchanges with real property due to the vast built-in gains due to rapidly rising real property prices. For those taxpayers, this route will become easier with the related party rule relaxation. For those in agriculture or other fields that use 1031 exchanges for other than real property, there are two months left in 2017 to get a deal done.
IX. In-House Intellectual Property is Not Treated as a Capital Asset
Capital assets are subject to preferential tax treatment under current law and the TCJA. The definition of "capital asset" currently excludes "a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property" but does not exclude a patent or non-patented secret intellectual property (Section 1221). The TCJA:
- Amends the definition of capital asset to specifically exclude "a patent, invention, model or design (whether or not patented), a secret formula or process."
Like most provisions of the TCJA, this change would be applicable to sales or exchanges after December 31, 2017. So for software developers with existing IP that may be sold in the future, clients may consider selling before the end of 2017, to the extent capital gain is preferable.
X. New Deduction for Foreign-Source Portion of Dividends Received
The TCJA creates a new section (Section 245A) which:
- Allows a 100% deduction to domestic corporations which own 10% of a non-U.S. corporation for the foreign source portion of dividends received.
- As a trade off, the domestic corporation will not be able to claim a foreign tax credit for any portion of the dividend (foreign or domestic).
XI. Repatriation of Foreign Earnings
As part of the American Jobs Creation Act of 2004, a temporary deduction was passed to motivate large multinationals to repatriate foreign earnings. The TCJA:
- Revises existing Section 965 completely to change the rules relating to Subpart F income and deem repatriation of earnings from 1986 to 2017 with a 5% and 12% tax;
- Subjects cash (and cash equivalents) to a one-time 12% tax; and
- Subjects noncash assets to a one-time 5% tax.
XII.Reduction in Private Foundation Excise Tax
Under current law, most domestic tax-exempt private foundations must pay an excise tax of 2% on the net investment income. An exempt operating foundation is not subject to the tax. The TCJA:
- Reduces the rate of the excise tax from 2% to 1.4%; and
- Repeals existing Section 4940(e) which provides a rate reduction to 1% in some cases.
XIII. New Ivy League Excise Tax
The TCJA would also impose a new excise tax on private colleges and universities. New Section 4969 would:
- Tax the net investment income of applicable educational institutions at a rate of 1.4%.
- Not apply to institutions with less than 500 students, or institutions with operating assets per student of less than $100,000.
XIV. Newman's Own Exception for Excise Tax
Currently, private foundations must pay an excise tax if the foundation (or related persons) own large portions of a for-profit business. The last few years have seen the brand Newman's Own (established by the late actor, it is a for-profit business venture that donates all profits to charity) embroiled in a brutal court case with the IRS. The TCJA would:
- Provide an exception to the excise tax, if a private foundation owns 100% of a for-profit venture and all of the for-profit venture's profits are donated to charity.
While this will be a welcome result for Newman's Own, for private foundations that wish to own between 35% and 99% of a for-profit venture, the excise tax will still apply.
The TCJA has a long road to passage. A Senate bill is expected next week and there will also be committee mark-ups and amendments. Nevertheless, clients should be aware that some deductions and transactions are on the chopping block. Using the remaining months of 2017 and careful planning for the future may allow clients to use this time of change to their advantage. Please contact us to help you determine whether you should do any individual or business planning before the close of 2017.