This week Bruce Norris is joined by Matt MacFarland and Amanda Han with Keystone CPA. Matt has over 20 years of experience in public accounting as a CPA and tax strategist. He has worked for both the big four and regional CPA firms. Amanda has over 18 years of experience as a CPA with special emphasis in real estate, self-directing investments, and individual tax planning. She has extensive Big 4 public accounting experience, and you can catch her book on BiggerPockets Tax Strategies for Savvy Real Estate Investors.
- What income bracket allows some to not pay Federal taxes?
- How will the new plans passed by the House and Senate affect these tax brackets?
- What is currently tax deductible on tax returns, and what can be itemized?
- What are some big changes happening on the mortgage interest side of real estate?
- Who would be paying more and less in the different tax brackets?
- What changes will we see with corporate taxes?
- What is currently happening with CPAs that is a bit of a shock?
Bruce enjoyed the last presentation that they did and thanked them for doing a great job. We hear a lot about people who do not pay any Federal tax. Bruce asked what income bracket allows this to occur under the current tax laws. Matt said it is a not a straightforward answer. Currently, there are seven different tax brackets, and the lowest is at 10%. For a single person, that income for a single person comes to $9,300 and $18,000 for a married couple. Even at 10%, they are still going to pay a little bit of taxes. It all comes down to whether deductions are exceeding their income.
Right now, currently, people in the 10-15% bracket who, after excluding their capital gains, it is an interesting situation for these people who may not pay zero taxes overall but may be paying them for capital gains income. This works out nice for some people.
You hear these rumors that 40-50% of people pay no Federal income tax. Currently there are seven brackets, and Bruce wondered how many there would be if the tax laws get passed. Matt said it depends on which one you are looking at. Right now there is a house bill that has been out there that they passed a couple days before, and the Senate has their own version they are trying to pass by Thanksgiving. If they don’t and the House and Senate don’t agree on it, then Congress has to step in and put together dry plan.
Under the House plan that just passed, there is going to be four income tax brackets. Under the Senate one, you are looking at seven different ones. There are slightly different rates, and the actual brackets are not entirely known yet in terms of how much income is in each bracket. However, it is roughly between four and seven brackets.
Bruce asked what the current top Federal tax bracket is. Matt said it is 39.6%, and under the House bill this would not change. Under the Senate, it is supposed to drop 1.1% to 38.5%. Bruce asked when the 39.6% kicks in during the current environment. Matt said right now for a married couple it kicks in at $467,000. Bruce asked if this is significantly higher in the new tax law changes, but Matt said it is not. It is still in the $400,000 range. Under the Senate plan, the 35% top bracket kicks in at over $400,000. The 38.5% kicks in at $1 million, and this may be the case with the House bill too. It’s possible they were trying to spread out, which makes sense. There is a 4.6% difference between the two plans, both the current one and the one that goes up to $1 million.
Bruce asked if California is mimicking the Fed as far as the dollar amount when the highest rate kicks in. Amanda said they have not heard anything from the state of California in terms of rate changes. For state tax rates, California does not follow Fed rules. A couple years ago, California raised the top rates to close to 12%, and it was called the Millionaire Tax. There have not been any talks of changes when it comes to increasing rates, at least as of now for California purposes. Matt chimed in by saying that under the House bill, the top rate for a married couple does start at $1 million. Under the Senate, for a single person it is $500,000. It is probably similar under the House bill where the 35% bracket carries most of what people are paying at 39.6%. The top rate does not kick in until you are making over $1 million under the new plan.
Bruce asked about the Obama tax, which Amanda said it is at 3.8%. He asked when this currently kicks in, at what level of income, and whether it will disappear or stay around. Right now for a single person, that kicks in with adjusted gross income of $200,000 and $250,000 for a married couple. Amanda said she has not seen anything so far indicating that it will go away. Matt said they are talking about getting rid of the actual Obamacare mandate to have insurance. It looks like the House bill still has that part of it where they would penalize you if you do not have insurance. The Senate totally wants to repeal the Obamacare health insurance mandate.
Bruce asked if they have seen anything where that 3.8% kicks in at a higher income level than it currently does or will likely be the same. Matt said if the Senate repeals the health insurance mandate, then the 3.8% tax theoretically should go away since it came out as a result of the health insurance mandate. This would be under the Senate Bill, so under the House Bill it’s hard to say what will happen. However, it’s hard to say what will happen.
Amanda and Matt’s clientele does not mimic the normal or national average, but he wondered what percentage of tax returns currently itemize. Amanda said the most recent information they saw from taxfoundation.org was from 2015, so they have not seen anything recent. It looks like the percentage of filers who itemize was only about 30% and not really representative of the tax returns they see on a day-to-day basis. However, this seems to be the national average and is fairly low.
Bruce asked what is currently tax deductible on tax returns and what could he itemize. Matt said the biggest itemized deductions, especially for people who are in California are taking, are the mortgage interest deduction on their primary residence and the property taxes they pay on their primary residence and second homes. There are also the local income taxes, so those lucky enough to live in California pay up to 13.3% state income taxes on their money. This is a deduction on your Federal return for the taxes you pay to California. These are the biggest ones.
The other itemized deductions that kick in a lot are charitable contributions and donations, medical expenses to the extent if they exceed 10% of somebody’s adjusted gross income. There are other miscellaneous things such as investment fees and tax prep fees. Bruce next asked what is deductible from a state of California tax return. It is not surprising that California does not allow you to take a deduction for taxes you pay to California. They do let you take mortgage interest deduction in charitable donations. These are the big ones for the state of California, and property taxes are deductible for California. For those in the state of California, this is a big adjustment. For the new tax law changes, it looks like we are getting a lower rate of 39.6%-35%, but we are also saying that the deductions are changing.
Bruce asked what is disappearing and to what is the standard deduction going. Matt said 70% of the people in 2015 took their standard deduction, which for a single person is around $6,500 and $13,000 for a married couple. It may be different from a couple years ago since they were slightly indexed for inflation. Someone can take their regular deduction the IRS gives, or you can add up all your itemized deductions and take those. The itemization may change since they are looking at adjusting the property tax deductions. Under the Senate plan, they are looking to completely take away your deductions through your property taxes. Under the House Bill, they are saying you can deduct it, but only up to $10,000. If you pay $20,000 in property taxes for your primary residence one year, you can only deduct half of that.
The other biggest changes on the mortgage interest side involve the House wanting to limit the interest deduction on the first $500,000 of new primary residence debt you take on after essentially November of 2017. Right now you can deduct interest on $1.1 million of a loan on your primary residence. The House wants to cut that in half, and the Senate wants to keep it at around $1 million. However, it is only applicable to your primary residence, which is current law. On the Senate side, they are not looking to change much, but on the House side they want to cut the loan balance in half for any new loans. It will also only be on one property, and you cannot deduct interest going forward on this vacation home you are not renting out.
Bruce asked about the ability to subtract the state tax on any of the new plans. Matt said Bruce makes a good point since this will go away too. The only tax you will essentially be deducting going forward will be the property taxes. On the Senate bill, there would essentially be nothing as they would take away the state income tax and property tax deduction. Bruce asked what the standard deduction will likely go to, which Matt said would be it would double. We will have about $12,200 for single and $24,000 for joint, married couples. If 70% of the people are already in this plan, that could increase to 90%. It would depend on where people are living and how much their income is, but it seems that number would definitely go up depending on what percentage of the people are taking the standard deduction.
The question is if you lower the top rates and increase the standard deduction if people would get a tax break. However, until they come out and finalize the income tax brackets, it is unknown. You can lower rates and increase the standard deduction; but if you take other things away it might work for some but not others. If you take a look at the certain income levels and say what is a benefit for one and not for another, this was something we had a few weeks ago before the House tweaked their plan.
Matt had read something the day before about how based on the analysis of the Joint Committee on Taxation, in 2018 the average taxes for most income groups will go down under the plan. However, by 2027 they will go back up again for almost all income groups. Bruce wondered if this was because your income grows to the next bracket, which Matt said it could be this or because they want to repeal some things.
A recent report from Forbes showed different income tax brackets and who would be paying more versus who would be paying less. Amanda said it looks like most people can expect a tax cut. The range where you may see your income tax go up for single and married individuals could go from 33%-35% for the married and single if they make $260-$424k of taxable income and $200-$425k respectively. This is the little black hole where you can expect to be paying higher than normal. The higher income should be expecting a lower tax bill.
This is a major difference, even though the percentages sound close. If you lose all the other deductions and go for $24 grand, that could be a big deal. Bruce asked if this is supposed to be producing less revenue for the IRS or more. Matthew said overall it is producing less revenue for the government. How they will make up for increasing the deficit down the road is a different story. It was cutting tax revenue, so theoretically that means it is a tax break. Amanda said you hear people talk about decreasing taxes for the wealthy; but if you look at the rates and how things fall out, those making between $200-$400,000 are well off but not the super wealthy. In Orange County, you can probably barely qualify for a home. It’s not really taxing the ideal group.
Bruce next asked about corporate tax changes. Amanda said what is interesting about the overall theme of the tax cuts is it looks like the taking away of a lot of deductions is really on the individual side. For businesses, most of what is coming out in the proposals is actually beneficial in terms of deductions and rates. The corporate rate is at 35% currently, the highest under the proposal both from the House and the Senate. They agree on a cut down to 20%, which is almost a 40% cut.
Bruce said when you have something like this, someone is going to look at it and say they will just leave a lot of money C Corp. Bruce asked if this is something they could see happening, which Matthew said is definitely a possibility. It is a numbers game; but with a lower rate inside the corporation, the income treatment for dividends from corporations would definitely play into it. Matthew said it is an exciting time because there are a lot of potential changes they need to stay on top of and advise their clients. One thing for ten people is going to be totally different for the other ten people.
Amanda said another interesting thing is the C Corp. tax rates will be lower, but also for the first time we may see flow-through entities pay a different tax rate than what the individuals were paying. Currently the flow-through entities like LLCs and partnerships are taxed at individual rates, which can be as high as 39.6%. Under the proposals, there may be a new tax rate for flow-through entities with a max being 25%. If you are an individual, like a realtor, who makes a lot of income through S Corp. and are currently paying 39.6%, part of the income could potentially be lowered all the way down to 25%.
In the proposal, they are also talking about increasing the dollar amount of expensing that is available. Right now there is a 50% bonus depreciation. If you wrote off 50%, the rest would depreciate over the life of the asset. There was also talk in the proposal about increasing that to 100% on the depreciation with a media write off. Those are all potentially impactful tax savings from a business perspective. This would be a huge deal for the entrepreneur who takes income flipping houses from an S Corp. Their taxes just might go down from 35-25. This is a big deal.
Amanda said there are some restrictions. They want to define, so not all S Corps and LLCs get the lower tax rate. In the current proposal, there are definitions of what types of income within the flow-through entity qualifies for the lower tax rate. Unfortunately, for service providers like physicians, attorneys, and CPAs, servicing currently would not qualify for the lower tax rate end of the proposal. However, on the example Bruce gave with someone doing fix and flips, that appears to be one that could qualify for the lower tax rate.
Another shocking thing for the CPAs is that the lower income of 25% looks like it would also apply to sole proprietorships. If you are someone who is flipping under your individual name, which is what a proprietorship is, that profit could still be subject to or eligible for the lower tax rate. Bruce next asked about interest income coming from trust deeds. If you had an LLC, were earning interest, and right now it is all taxed in normal income, Bruce wondered if this fits that new criteria. Amanda said they have not mentioned investment income at all in the proposals. So far, they have only differentiated between service and sales income. It is not really known whether interest or rental income would be subject to the lower rates. She imagines no since they have not mentioned it yet, but it is something they are all sitting on the edge of their seats to figure out what they will do with interest and rental income. This is most of the clientele with whom Amanda and Matthew work at Keystone CPA.
Currently, we have a 50% bonus depreciation on certain types of assets like real estate. However, rental real estate is not one of those eligible assets. It will be interesting to see if they move it up to 100% expensing under the proposal. This could mean real estate or other real estate related assets could be eligible for that expensing since it would be a huge impact in terms of tax savings.
Bruce thinks what is very interesting is the habits that may change. Once we know the rules of engagement, you could see people saying they cannot deduct California state tax anymore, but the standard deduction is the same no matter where you live. They would maybe then want to move to a tax-free state. This is something Bruce could see making sense to somebody. He could see the decision not to own a house being contemplated since it does not matter anymore in terms of deduction. The real estate world is really concerned that the holy grail got taken out and somebody is touching that third rail. He does not know if it will have that big of an impact at these interest rates, but it could very well at an interest rate of 8 if we see that someday. It will be based on what people are promoting out there.
If people are talking about how they took away the mortgage interest deduction, the gist of it will be to not buy a house since you cannot take the interest deduction. We all know that is not a reason to buy the house, but it helps. It is an added bonus that will no longer be there, although it won’t boost home sales.
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