Congress Approves Sweeping Tax Bill
President Signs the Bill, Changes Start in 2018 Tax Year
President Trump has signed the sweeping tax reform package that required a second vote in the House of Representatives due to a procedural issue. The lower chamber approved the bill 227 to 203 on December 19 but had to vote again after the Senate stripped out two minor provisions that the parliamentarian ruled violated Senate rules. In the end, 12 Republicans – including California Representatives Darrell Issa and Dana Rohrabacher – joined every House Democrat in opposing the measure. The Senate vote, on the other hand, fell strictly along party lines.
The legislation – known as the Tax Cuts and Jobs Act (HR 1) – represents the first major overhaul of the U.S. tax code in over three decades. Among other things, the bill will preserve the seven-rate structure for individuals, while modifying the marginal tax rates. In addition, HR 1 nearly doubles the standard deduction and expands the Child Tax Credit. However, the measure also eliminates the personal exemption, which is currently valued at $4,050 per person.Furthermore, in an effort to simplify the code and increase revenues, the legislation eliminates or caps a number of tax deductions and credits.
With regard to businesses, HR 1 reduces the corporate tax rate from 35 percent to 21 percent, beginning in 2018. It should be noted that many of the individual tax provisions, including those for small businesses, will expire at the end of 2025, while many of the corporate tax components are made permanent.
To follow are highlights of the final conference report to HR 1:
State and Local Tax Deduction
The final bill allows taxpayers to deduct property taxes and income or sales taxes up to a combined cap of $10,000. The initial House and Senate proposals would have eliminated the deduction for income and sales taxes and capped the deduction for property taxes at $10,000. While many of the individual tax provisions of HR 1 expire at the end of 2025, the changes to the SALT deduction do not expire until 2028, when state and local taxes will once again become fully deductible.
Under current law, federal taxpayers can deduct the entirety of their state and local property taxes, as well as their state income taxes or sales tax. This benefit, which has been in place since 1913, provides counties with some measure of autonomy over their own tax systems and also incentivizes local investment in long-term infrastructure projects and various county services.
Municipal Bonds
HR 1 fully preserves the tax exempt status of municipal bonds. As the single most important tool for financing public capital improvements and critical infrastructure projects, municipal bonds provide funds for roads, bridges, schools, and hospitals. Under current law, investors are not required to pay federal income tax on interest earned from most bonds issued by state and local governments. The effect of this tax exemption is that local governments receive a lower interest rate on their borrowing than they would if their interest was taxable to investors. As the nation’s largest issuer of municipal bonds, any changes to the tax exemption would have had a disproportionate impact on local governments in California.
Private Activity Bonds
The final legislation fully preserves the tax-exempt status of qualified Private Activity Bonds (PABs). With the initial House legislation proposing to eliminate the exemption on newly issued PABs, counties fought hard to preserve this critical financing tool.
PABs are widely used to attract private investment for projects that have some public benefit. Under current law, the interest earned on the bonds is tax exempt, which helps facilitate the development of projects that may not otherwise be feasible if financed at market rates. Over the past decade, approximately 36 percent of PABs in California have been used to finance affordable housing developments for low-income families and seniors, 40 percent has gone to fund hospital construction, and the remaining 14 percent has been used to build schools.
Advance Refunding Bonds
The final conference report eliminates the tax exemption for advance refunding bonds. Under current law, advance refunding allows counties to refinance outstanding bonds once over the life of the bond to take advantage of better terms and rates.
Affordable Care Act Individual Mandate
Beginning in 2019, HR 1 repeals the penalties used to enforce the Affordable Care Act’s (ACA)individual mandate. In the absence of this enforcement mechanism, it is likely that a percentage of the population – particularly those who are younger and healthier – will choose to go without insurance. Those left in the insurance pool would generally be older and sicker, which would essentially force premiums to rise more than they otherwise would.
The Congressional Budget Office (CBO) estimates that repealing the mandate will increase average premiums on the individual market by approximately 10 percent. CBO also projects that an additional 13 million people over the next decade will go without health insurance. In California, where counties are the provider of last result, any increase in the uninsured population will result in further strains to county resources.
Disaster Deduction
HR 1 preserves taxpayers’ ability to claim personal losses due to disaster, theft, or other casualties as itemized deductions so long as those losses stem from a presidentially declared disaster. To be eligible to claim this deduction, the loss must exceed 10 percent of an individual’s gross income and cannot include losses that are compensated by insurance.
Additionally, the final bill allows individuals to temporarily withdraw as much as $100,000 from their retirement accounts for disaster recovery without triggering the 10-percent early withdrawal penalty.
Notably, the original House measure would have eliminated the deduction for personal losses, including losses as a result of wildfires.
Mortgage Interest Deduction
The final tax bill reduces the mortgage interest deduction cap to $750,000 for new homes and allows the deduction to continue to apply to second homes. Pursuant to the legislation, the $1 million cap allowed under current law will continue to apply to existing mortgages and will be fully restored to apply to all mortgages beginning in 2026.
It should be noted that the original House bill recommended reducing the cap to $500,000 for future home purchases and eliminating the deduction for a second home. The Senate legislation, on the other hand, would have kept the current mortgage interest deduction cap at $1 million. Conference negotiators decided to meet somewhere in the middle.
While the median value of a home in California is $385,500, mortgages throughout the state can exceed the $750,000 threshold. In fact, approximately 12 percent of homes in the state are valued above the new cap. It should also be noted that the lowered threshold will not be indexed to inflation, so as home prices continue to rise, more and more homes could exceed the cap.
Charitable Deduction
HR 1 largely keeps the charitable deduction intact. However, estimates show that the number of itemizers is expected to be substantially reduced once the legislation is implemented, which could ultimately create a disincentive for giving. A projected decline in public giving for charitable services could increase demand and costs for county government services.
Estate Tax
HR 1 doubles the estate tax exemption and sunsets the provision at the end of the 2025 tax year. Under current law, the estate tax applies to assets – mostly real estate and stocks – that are passed on after death following a $5.5 million exemption per individual ($11 million exemption per couple). This means that the first $5.5 million of assets is not subject to a tax, but everything above that level incurs a 40 percent tax. These numbers are indexed for inflation and, as a result, increase each year.
Adoption Tax Credit
The final legislation preserves the adoption tax credit, which allows taxpayers to claim a credit of as much as $13,750 per eligible child. An initial version of the House bill included a full repeal of the credit.
Medical Expense Deduction
The conference report retains the medical expense deduction and temporarily (for two years) reduces the threshold – from 10 percent down to 7.5 percent of adjusted gross income – to be eligible to claim it. Under current law, medical expenses that exceed 10 percent of an individual’s adjusted gross income may be deducted from federal taxes. This deduction assists filers with significant out-of-pocket medical costs, including nursing home care, long-term care insurance premiums, and other medical bills.The original House legislation recommended eliminating the deduction, which could potentially shift costs from private insurers to public sector programs like Medicaid, emergency room care, and uncompensated care in county-owned nursing homes.
Marginal Tax Rates
As previously mentioned, HR 1 preserves the current seven-rate structure for individuals, while modifying the marginal tax rates. Notably, the original House bill would have reduced the number of brackets to four – 12 percent, 25 percent, 35 percent, and 39.6 percent. The following charts provide a comparison of tax rates under current law and HR 1.
CURRENT LAW (2018 TAX YEAR) |
||
Tax Bracket |
Single |
Couples |
10% |
$0 – $9,525 |
$0 – $19,050 |
15% |
$9,525 – $38,700 |
$19,050 – $77,400 |
25% |
$38,700 – $93,700 |
$77,400 – $156,150 |
28% |
$93,700 – $195,450 |
$156,150 – $237,950 |
33% |
$195,450 – $424,950 |
$237,950 – $424,950 |
35% |
$424,950 – $426,700 |
$424,950 – $480,050 |
39.6% |
$426,700+ |
$480,050+ |
TAX CUTS AND JOBS ACT (HR 1) (2018 TAX YEAR) |
||
Tax Bracket |
Single |
Couples |
10% |
$0 – $9,525 |
$0 – $19,050 |
12% |
$9,525 – $38,700 |
$19,050 – $77,400 |
22% |
$38,700 – $82,500 |
$77,400 – $165,000 |
24% |
$82,500 – $157,500 |
$165,000 – $315,000 |
32% |
$157,500 – $200,000 |
$315,000 – $400,000 |
35% |
$200,000 – $500,000 |
$400,000 – $600,000 |
37% |
$500,000+ |
$600,000+ |
Pursuant to the current tax code, income levels for each bracket are indexed annually based on increases in the Consumer Price Index (CPI). Under HR 1, the new income levels are indexed for chained CPI, which is a slightly different measure of inflation. While a number of economists consider the chained CPI to be more accurate, it generally results in lower estimates of inflation than traditional CPI.