PERSPECTIVE--Whatever Kim Jong-un does in 2018, it will likely not impact Americans as much as the new tax reform bill, the Tax Cuts and Jobs Act. That’s not to understate the potential for disorder the Rocket Man might be capable of unleashing, but most experts would agree he has not reached the point where he can blackmail the United States and his neighbors in Asia.
But the IRS can make the transition to the new tax rules a painful exercise for many. You see, as with all tax legislation, Congress writes the rules, but the IRS has to interpret and implement them through what are known as Treasury Regulations. Of course, the courts are the ultimate arbiters in disputes between taxpayers and the government; so, what we see now, may not be quite what we get.
I will focus on two of the most pervasive changes affecting Californians: the state and local tax deduction and mortgage interest.
Already, confusion is endemic regarding the $10,000 cap on deductions for state and local taxes, which covers property tax as well as state income tax.
As of the day I am writing this article, the IRS has not definitively ruled on whether prepayments of property taxes will be deductible on the upcoming 2017 tax returns. Taxpayers who ordinarily incur state and local taxes measurably higher than $10,000 are beating a path to the local tax collector’s office to pay next year’s installments – a use it or lose it strategy.
It is reasonably safe to assume that if the 2018 installments represent taxes assessed for 2017, the prepayments will be deductible, but no absolute guarantees. It might be less clear for those whose property taxes are impounded by a loan servicer.
Some have contemplated even significantly withholding more state income tax from their final paychecks this year, but those incremental payments will clearly not be ruled deductible, I can think of ways the IRS might audit for that, but having the resources to do so is another issue.
What about any state tax refunds? These are normally taxable if you itemize deductions under the 2017 rules.
Recoveries of state income tax overpayments may or may not be taxable, at least to some degree. Let’s say you are preparing your 2019 Federal return (in 2020). The state and local tax deduction was reduced by $9,000 in 2018 because of the cap and you received a $3,000 refund in 2019 for an overpayment on 2018 state income tax, none of it should be taxed because you had received no benefit for it. But if the refund were $9,100, $100 would be taxable.
However, a refund of a 2017 overpayment would probably be fully taxable on your 2018 return because you were able to fully deduct the tax from your 2017 federal return.
The mortgage interest deduction is even muddier. The deduction is now limited to the interest paid on up to $750,000 in principal balances related to the acquisition, building or improvement of primary and second homes. No longer will you be able to deduct the interest on $100,000 on borrowings related to non real estate purchases secured by your home, known as home equity debt.
To the extent you had acquisition/building/improvement balances prior to December 16, 2017, they are grandfathered under the current $1 million cap, but there is no such protection for home equity. That deduction is lost starting with your 2018 return.
Many people were probably claiming too large an interest deduction under the old rules because they failed to accurately track the use of their borrowed funds. However, the IRS lacked the resources to aggressively audit for this. The lower cap makes the job of the IRS even more demanding. Whether they ramp up and extend the reach of their audits remains to be seen. My guess is that it will not be a priority for 2018, but mortgage data will be accumulated and analyzed with the goal of developing an audit plan for subsequent years.
If you are currently engaged in a home acquisition, the change doesn’t affect mortgages taken out under binding contracts in effect before Dec. 16, 2017 as long as the home purchase closes before April 1, 2018. So keep your eye on the calendar and make sure your contract is in order.
As I pointed out in an earlier article, this bill does not represent tax reform Until we have a system that makes compliance and enforcement much easier, then all Congress is doing is reshuffling the same old deck of worn out cards.
(Paul Hatfield is a CPA and serves as President of the Valley Village Homeowners Association. He blogs at Village to Village and contributes to CityWatch. The views presented are those of Mr. Hatfield and his alone and do not represent the opinions of Valley Village Homeowners Association or CityWatch. He can be reached at: email@example.com.)