The Tax Cuts and Jobs Act of 2017 (TCJA) presents major changes to many aspects of tax planning for divorce lawyers. This article covers the major issues you may encounter on itemized deductions and other common deduction changes. Keep in mind, however, that these changes are considered temporary and are set to expire in 2025.
Prior to 2018, mortgage interest associated with Qualified Acquisition Indebtedness (QAI) up to $1,000,000 combined for a primary and secondary home was deductible in addition to home equity line of credit (HELOC) interest or Home Equity Indebtedness (HEI) up to $100,000. Beginning in 2018, the mortgage interest deduction is limited to QAI up to $750,000 combined for new primary and secondary home acquisitions, and interest associated with home equity lines may no longer be deductible, depending on what the funds were used for. Interest related to past and future HEI incurred to buy, build, or remodel the home used as security for that HEI remains deductible; however, interest on HEI incurred for personal uses such as education, cars, boats, credit card debt, etc., is no longer deductible.
Another twist the TCJA adds is that mortgage interest changes apply only to new QAI incurred on or after December 15, 2017, so mortgage interest up to the $1,000,000 QAI limit continues to be deductible for mortgages existing at December 15, 2017. In addition, existing mortgages at December 15, 2017, can be refinanced later, and the interest associated with the refinanced QAI balance can continue to be deductible under the old rules. This is going to create a recordkeeping nightmare for impacted taxpayers!
The IRS never gives something for nothing. When deducting either mortgage or home equity interest, the interest tracing rule still applies. This means you have to prove what QAI purpose the funds were used for and, in the case of refinancing, whether the full refinanced amount is considered QAI (i.e., was some equity taken out and used for something personal and not related to the home?).
Lenders are not likely to break down deductible QAI/HEI on Form 1098, so it will be the taxpayer’s responsibility to prove deductible amounts. Therefore, it is highly recommended that divorcing couples be advised about the tracing rules and disclose various 2017 mortgage and HELOC balances along with the use of such funds. Suggested disclosure items are as follows.
- Identify all mortgage and HELOC balances as of December 15, 2017, and break them down by:
- QAI mortgage balances;
- QAI HELOC balances—funds used to buy, build, or remodel the home securing that HELOC;
- HEI HELOC balances—funds not used to buy, build, or remodel the home securing that HELOC (personal use funds).
- If existing mortgages are refinanced and mortgage debt is increased, break down the newly refinanced debt balance by the:
- portion related to QAI mortgages in place on December 15, 2017;
- portion related to QAI mortgages on new acquisitions after December 15, 2017:
- portion of new debt related to QAI (remodeling/home improvements);
- portion of new debt related to non-QAI purposes (other personal uses).
Family law practitioners should begin discussing with clients the benefits and detriments of utilizing and retaining an interest in a second home in cases where this interest deduction is being eliminated. Considering whether your client’s benefits exceed the loss of tax benefits will be a new form of discussion with clients when planning the settlement of cases with secondary homes.
For those who have mortgage debt in place prior to December 15, 2017, you can still deduct interest on mortgages up to $1,000,000. Practitioners must calculate this reduction into their settlement statements.
State and Local Taxes: Real Estate Caps—$10,000 Combined!
How different life has become for the wealthy who counted on the deductibility of all real estate taxes, let alone all state income taxes. For those who are acronym deficient, the state and local tax deduction is known as “SALT.” As of 2018, there is a limit on all state and local income taxes, as well as all real estate taxes, to a maximum total deduction of $10,000 annually. What the impact of these changes will be on the ongoing retention and division of second homes is yet to be seen. Whether or not this maximum limitation will lower pricing on high-priced homes is also a question to be answered in the future.
Remember two important things when considering the new limits on these tax deductions. (1) Many people prepaid portions of their 2018 real estate taxes in 2017. Thus, be sure to reflect this reduction in realistic terms in 2019 going forward. The 2018 numbers in higher-priced homes are likely to be skewed. (2) The Alternative Minimum Tax (AMT) was not eliminated for individuals; however, significant relaxing of AMT exemptions and thresholds will result in many taxpayers previously subject to this awful tax finding that it no longer applies to them. Thus, even the $10,000 deduction limitation of state and local income taxes and real estate taxes may be further reduced by the AMT impact.
AMT exemptions for unmarried individuals increased from $54,300 to $70,300 and from $89,500 to $109,400 for those who are married, filing jointly. The thresholds for filing also increased from $120,700 to $500,000 for unmarried individuals and from $160,900 to $1,000,000 for those who are married, filing jointly.
These new limits may eliminate the AMT altogether, or, for high-wage earners, the tax will continue to impact and deflate deductions.
Keep your eyes open for creative solutions some states and political subdivisions are attempting to create to help offset the loss of their resident’s SALT deductions. For example, some states have considered and even adopted legislative proposals aimed at allowing taxpayers to characterize certain transfers to funds controlled by state or local governments as charitable contributions for federal income tax purposes, while using the same transfer to satisfy state and local tax liabilities. The IRS, however, is on to these work-arounds, and it issued Notice 2018-54 on May 23, 2018, followed by Proposed Regulations issued on August 23, 2018, to address them. Stay tuned to see how these play out.
The Pease Limitation was repealed under the TCJA. Prior to enactment of the TCJA, itemized deductions for high-income taxpayers were subject to a Pease Limitation, named for the politician who first introduced it in 1991. If a taxpayer’s adjusted gross income was above the annual Pease threshold for his or her filing status, that filer had to subtract three percent of the excess over this threshold from itemized deductions. For example, the 2017 threshold for married filing jointly was $313,800, so if the taxpayer’s AGI was $500,000, then three percent of the excess would be subtracted from the taxpayer’s itemized deductions ($500,000 – $313,800 = $186,200 × 3% = $5,586 reduction in itemized deductions).
Medical expenses deductions are reduced from 10% to 7.5% of adjusted gross income in 2017 and 2018 only. Beginning in 2019, this 2.5% reduction will be eliminated, and the deduction will return to 10% of AGI.
The deductible medical expenses are extensive and include payment of fees to doctors, dentists, surgeons, chiropractors, psychiatrists, psychologists, and nontraditional medical practitioners. A detailed list of all of the expenses can be found in IRS Topic No. 502, Medical and Dental Expenses.
Charitable deductions are allowed for up to 60% of AGI (increased from 50%), but—and here’s where it really hurts—no deduction is allowed for a college donation made where the donor is given the right to purchase tickets for seating at an athletic event. (Previously, 80% of the payment had been deductible.)
The Departed, Fondly Remembered
Miscellaneous Itemized Deductions
In 2018, we lost all miscellaneous itemized deductions. Although the deductibility of these items was rare because they were subject to the two-percent-of-AGI limitation, for some taxpayers, they really added up. Expenses no longer deductible include:
- investment fees,
- tax preparation fees,
- employee business expenses,
- attorneys’ fees,
- moving expenses, and
- job expenses.
Prior to 2018, up to $255 per month of employer-subsidized parking costs or transit passes was deductible to employers and not included as income to employees. In 2018, the tax benefit to the employee is eliminated, and either the company can choose to treat the expense as nondeductible, or if the company deducts the expense, it will be treated as income to the employee.
Business Meals and Entertainment
Prior to 2018, business entertainment expenses such as sports tickets, golf outings, and Broadway shows were 50-percent deductible. Under the TCJA, entertainment expenses are no longer deductible! Business meals, however, will remain 50-percent deductible, but the 50-percent meals limitation has now been expanded to meals furnished to employees for the convenience of the employer (these were 100-percent deductible before the TCJA). So much for bringing lunch in for your staff now!