Changes to itemized deductions
What you can and can't deduct under the new law
Cheryl Dickerson, CPA
There have been whispers over the years of changing what individuals can deduct as itemized deductions. In December 2016, the Congressional Budget Office released a study on the impact of eliminating or reducing the tax benefits associated with the deductions. The report argued one major reason to reduce or get rid of them was inefficient allocation of economic resources. The Budget Office said the availability of the deductions encouraged taxpayers to spend more money on deductible activities to receive the tax benefits. In the argument for itemized deductions, the Budget Office noted that the deductions were intended to yield a measure of taxable income that was associated with the taxpayer’s ability to pay taxes. As you know, changes to itemized deductions ultimately became reality on December 22, 2017 with the signing of the Tax Cuts and Jobs Act (TCJA).
The new tax law increased the standard deduction for taxpayers filing Form 1040. The standard deduction amounts beginning in the 2018 tax year are:
- Single $12,000
- Head of household $18,000
- Married filing joint $24,000
The expectation is that with the increased standard deduction and changes to itemized deductions, fewer taxpayers will claim their itemized deductions. The thought pattern expressed by the Ways and Means Committee, and a cornerstone of the tax bill, is that this will lead to simplification for taxpayers.
Itemized deductions changes
So, what has changed for you and are there any possible responses?
Taxes. Perhaps the itemized deduction that has received the most press coverage is the change to the deduction for taxes. The old tax law allowed a deduction for state and local income tax or sales tax, real and personal property tax without limit. For tax years beginning after December 31, 2017 and before January 1, 2026, the deduction for taxes is limited to $10,000 ($5,000 if married and filing separate). The new law also eliminates the deduction for any property taxes paid on foreign real property.
Taxpayers in states with higher rates such as New York and California likely will feel the biggest impact of this change. As a taxpayer in Arizona you can reduce your state income tax by taking advantage of Arizona credits. The credits represent federal charitable contributions and reduce your Arizona state income tax on a dollar for dollar basis. The credits for contributions to qualifying charitable organizations, qualified foster care organizations, public schools, private school tuition organizations and the military relief fund (limited availability) are available to individual taxpayers in Arizona.
Medical expenses. The TCJA provided a bit of relief for the deduction of medical expenses, which has been subject to a floor. The floor prior to the tax act in 2017 was 10% of adjusted gross income (AGI). For example, if your AGI was $100,000 and your medical expenses for the year were $12,000, you would be allowed an itemized deduction for $2,000 of medical expenses. The amount that exceeded 10% of your AGI, which in this case is $10,000, represented your deductible medical expense. The new tax law decreased the percentage of AGI to 7.5% for tax years 2017 and 2018.
The reality of the medical deduction is that most taxpayers’ unreimbursed medical expenses did not exceed the floor and accordingly, they were not able to claim a medical deduction. While the TCJA decreased the floor, it is still likely most taxpayers will not see any additional itemized deduction related to their medical expenses.
The changing health insurance market has resulted in many taxpayers with high deductible plans. If you are a qualifying taxpayer, you should consider a health savings account. The health savings account is a trust or custodial account that is established for the exclusive purpose of paying for qualified medical expenses of the account beneficiary. Contributions to the plan may be deductible as an above line deduction if paid outside of the employment context, or part of a cafeteria plan, if offered by your employer. Employer contributions to the health savings account are excluded from the employee’s gross income.
Charitable contributions. Under the old tax law, charitable contributions were deductible depending on the type of organization to the extent that your donations did not exceed 50%, 30% or 20% of your AGI. The TCJA has increased the limitation for cash contributions to public charities and certain private foundations to 60% of AGI for tax years beginning after December 31, 2017 and before January 1, 2026. Cash contributions exceeding the 60% limitation can be carried forward and deducted for up to five years, subject to the later year’s ceiling.
Under the new law, there is no charitable deduction allowed for any payment to an institution of higher education, where in exchange, the taxpayer receives the right to purchase tickets or seating at an athletic event. Previously, 80% of the payment could be deducted as a charitable contribution, provided it met certain requirements.
The expansion of the standard deduction may result in an inability to itemize, so charitable contributions would not provide any additional tax benefit. Charitable giving, however, is often much more than a tax motivated event. Taxpayers who are receiving required minimum distributions from their individual retirement accounts (IRAs) may wish to consider a qualified charitable distribution. Individuals who are age 70 ½ and older may contribute up to $100,000 from their IRA directly to a qualified charitable organization without including the distribution in their income.
Miscellaneous itemized deductions. Gone are the days of the deduction for miscellaneous itemized deductions that exceeded 2% of your AGI. Items such as investment advisory fees, employee business expenses, union and professional dues and tax preparation fees are some of the more common items that were classified as a miscellaneous itemized deduction.
Home mortgage interest. The deduction for home mortgage interest has been a sacred deduction for individual taxpayers. The old law allowed taxpayers to deduct the interest on acquisition indebtedness of $1,000,000. In addition, the interest on home equity indebtedness was deductible on $100,000 of home equity debt. Now, for mortgages after December 15, 2017, the deduction for acquisition indebtedness is limited to underlying debt of $750,000 ($375,000 for married filing separately). The new law suspended the deduction for interest on home equity indebtedness.
It is important to recognize the definition of acquisition indebtedness. It’s defined as indebtedness that is incurred in acquiring, constructing or substantially improving a qualified residence of the taxpayer and which secures the residence. Interest paid on debt within the limits that meets the definition continues to be deductible. Interest paid on debt that was used to say pay off credit cards by using a home equity loan is not deductible under the TCJA. It is extremely important that taxpayers using what is termed a home equity loan or line of credit can trace their expenditures to the acquisition, construction or substantial improvement of their residence to maintain it as deductible home mortgage interest. For tax years after 2025, the prior limitations are restored and the suspension for home equity indebtedness expires.
Tax strategies and your 2018 return
The tax landscape has changed considerably with the passage of the Tax Cuts and Jobs Act. It seems more likely than not that your 2018 return will look considerably different than your 2017 return. The changing environment also represents an opportunity to employ new strategies. You’ve likely noticed that the changes are not permanent and tax years beginning in 2026 see a return to the “old” rules. At this time, we do not know how Arizona will respond in the state tax code to the changes in federal law. There will undoubtedly be whispers again and odds are that this will not be the last article I write about changes to itemized deductions in tax law.