This week Bruce Norris is joined by Matt MacFarland and Amanda Han with Keystone CPA. They are the owners of Keystone CPA in Orange County. Matt has over 20 years of experience in public accounting as a CPA and tax strategist. He has worked for both the Big 4 and regional CPA firms. Amanda has over 18 years of experience as a CPA with a special emphasis in real estate, self-directed investing, and individual tax planning. Amanda has extensive Big 4 public accounting experience, and you can catch her book on BiggerPockets Tax Strategies for Savvy Real Estate Investors.
- With these new tax law changes, what changed in California and what did not change at all?
- Is there anything new in regards to the withholding of Social Security or Medicare tax?
- What changes were made to capital gains rates?
- How much will the tax bill be lowered for most Americans?
- How will this affect charitable donations?
- How many families currently itemize deductions, and will this change with the new rules?
- Are these changes pro real estate for both homeowners and investors?
Bruce started the interview discussing things that did not change at all. Bruce asked if there is anything new with the state of California regarding taxes. Matt said not that they are aware of, although California does work a little behind schedule after the IRS. It might take them a few months to catch up. Amanda said historically speaking, a lot of times we see that when the IRS comes out with new tax deductions or immediate write-offs, California does not follow the Federal rule. It will be exciting to see if California will follow the Federal rule in terms of tax benefits.
Bruce asked if there is anything new with the withholding of Social Security or Medicare tax. Amanda said in terms of payroll related taxes and reform, one of the interesting things is that the next investment tax that came out as part of the Obamacare package remains unchanged as well. This is the 3.8% additional tax that started a couple years ago. Part of this tax reform is, starting in 2019, they have repealed the mandate that requires everyone to have health insurance. This 3.8% tax was supposed to curb the cost of the health insurance. They are not getting rid of this, but they are getting rid of the requirement to have health insurance.
Bruce next asked if there are any changes to capital gains rates. Matt said there is no change to these, so they still have the 0% capital gains rate for people in the lower income brackets. They also still have the regular 15% rate and the 20% rate for people in the higher income brackets. The only thing that slightly changed is the dollar amount for when the 15% and 20% rates kick in. Things have not really changed much since 2017, so essentially it is the same.
Bruce asked if this lowers the tax bill for most Americans. Matt said on average it will lower the taxes for 95% of Americans in 2018, while 5% will see an increase in their taxes. Amanda said research is showing that Americans in the 95th percentile, the wealthiest, is the group that gets the biggest tax breaks and will save the most in terms of income taxes. This might be one of the reasons why you don’t see any Democrats voting for it. Most Americans should expect to see lower taxes overall.
Matt said one of the things that caught his attention was he thought one of the intentions to simplify things. However, it does not look like this is happening. One of the takeaways he got was you can have two families with the exact same amount of income who pay a different amount of taxes since it will depend on the makeup of their family, the income they are earning, and where they live. You and your neighbor have the same amount of taxable income, but you cannot necessarily expect to pay the same amount they are.
One of the questions Bruce had was how you become unfortunate enough to be that 5A% that pay more. He asked if they are single or if the makeup of their income the wrong type. Amanda said historically speaking, the group that generally pays the highest tax or most amount of taxes are the W2 income workers. These are the people with W2s who do not have a side business or invest in assets such as real estate. This remains unchanged with the tax reform. Amanda and Matt had discussed about some of their clients who only have W2s will not benefit from the loopholes and changes as much as other taxpayers who are real estate investors or business owners.
With the current itemized deductions, you deduct state and local tax as well as real estate taxes. Bruce asked if there are any limits for those categories in 2017. Matt said currently you deducting your state and local taxes, property taxes, DMV fees, medical expenses, charitable contributions, and other miscellaneous itemized deductions people can get if they exceed 2% of someone’s income. However, if you pay $100 grand in state and local income taxes you can deduct that on the Federal income tax. There is an overall limit on itemized deductions depending on somebody’s income. There are three ways to go with that calculation. However, there is no limit on the state and property taxes.
Starting for the taxable year, if you pay $20,000 in income taxes and $10,000 in property taxes, only $10,000 of this $30,000 would be tax deductible. This is a pretty significant hit to those who live in higher income tax states like California and New York. At the end of 2017, there was not much time left at all. However, Amanda and Matt were trying to encourage a lot of their clients to consider pre-paying taxes before the end of the year if they anticipated paying more than $10,000 in taxes. There instances where you may be somebody in alternative minimum tax may lose out on some of the benefits of pre-paying. However, it could still make sense to pre-pay if you have the cash available. What they know for sure is that $10,000 will be deductible in the future. If you pre-pay this year, there is still that possibility of getting something.
Bruce said the interest he owes on his residence and second home is deductible up to $1.1 million. Going forward, a couple things changing is that the interest will be deductible on a new acquisition loan related to your principal and up to a total loan balance of $750. If you buy a new house in 2018 for $900,000, you can deduct interest on the first $750. A couple questions they have been getting is what happens to existing mortgages. If you just bought your house or bought it three years ago and your existing mortgage is $900,000, nothing is changing for you. Going forward, you can still deduct interest on up to $900,000. It really has a lot to do with new loans you take out starting this year.
If you have a significant mortgage, you may stay put for this reason. The $750,000 cap is for new primary home acquisitions and does not apply to investment properties. You can deduct interest up to $1 million and the interest on another $100,000, which is usually a HELOC for most people. Going forward, the interest on the HELOC will not be deductible unless you are using the proceeds to buy a rental property or a business. Right now, someone could theoretically borrow $100 grand, go on vacation, pay interest on it, and deduct the interest.
Bruce asked what the status will be on deductions for donations to charities. Matt said nothing is really changing here. The only thing that changed is right now you can take a deduction up to 50% of your AGI. Going forward, it will be bumped up to 60%. This could help the 95 percentile people. Amanda said even though the cap is going up next year, if you are someone who donates every year it could make sense to accelerate the donation to this year.
Bruce asked if they have seen an estimate on how many families currently itemize deductions and how this might change with the new rules. Matt said he has not seen an estimate of this in a while. The latest data he had seen was from 2014-2015. He did not remember the number, but for the people living in the high income tax states they will see a drastic decrease in how many people will be claiming itemized deductions. The rest of the country may have already been taking standard deductions and will now get an extra one going for them. Amanda did not know the exact percentage of decrease, but she recalls from the Tax Policy Center that it was a significant number of people who will likely be moving over to taking standard deductions.
Amanda said with fewer people itemizing and them taking away the ability to deduct tax preparation fees, maybe you will see fewer CPAs actually in business. These could then turn into real estate investors full time. Maybe there will be an investment group that needs an in-house accountant. One category Bruce had not thought about was a married couple with two kids with a median-priced home on which they owed $400 grand. In 2017, you have personal exemptions. You had four of these times about $4 grand each, but now in 2018 this is gone completely too. Theoretically it is supposed to be replaced with the higher standard deduction, but the doubling of the standard deductions is great for some people but not for larger households with multiple kids. These are the ones who may be losing out as part of the change. It really differs from person to person who will come out ahead.
The deductions went from $40 grand to basically just taking the standard deduction. Everything they had to deduct equaled the standard deduction. You also have lower rates. Another category Bruce was interested in was AMT. He looked at his taxes for 2015 and 2016. Having to pay AMT raised his Federal tax 18% in both of those years. Bruce wondered what caused the category of income or deductions cause AMT to kick in and how this will change after the tax rule changes. Matt said for those who live in California, the biggest ticket item that puts people into AMT is paid income tax deduction. AMT is a parallel tax system that was put in place 30 years ago to prevent the wealthy from using loopholes to avoid paying taxes.
The IRS wants everyone to pay a minimum level tax. For AMT purposes, with this parallel tax, you do not get the deducted state income taxes. When somebody has taken a big deduction of state income taxes relative to all their other income. This is especially true if they live in California. Going forward, theoretically, with that big deduction going away there will be the potential impact of AMTs hopefully being less. When you do the calculation, the first amount of income is taxed for AMT. Right now, for a married couple the first exemption amount is $85 grand. This means with the first $85 grand, you do not pay any AMT taxes on it.
Going forward, that exemption amount is going up to $9,000 for a married couple, basically giving you some more money free for AMT taxes. The exemption amount phases out as your income goes higher and does it pretty quickly. Starting this year, married couples would have to make $1 million before that $109,000 AMT exemption amount or exclusion amount goes away. With all that being said, it is possible that the AMT tax will be less impactful going forward. In one of the previous versions, they were trying to repeal it all together. For some reason, this went away.
Bruce asked if they consider the tax change bill pro real estate for occupant owners. Amanda said for residential real estate, there are several changes coming out that are beneficial. Some are specific to real estate on the housing side, but the majority of the deductions for business expenses also apply to real estate investors. To some extent, the IRS treats real estate activity as a regular business. Overall, holistically there are many changes that should be helpful to real estate investors reducing overall taxable income.
When it comes to homeowners, Bruce wondered if you will have more reasons to own a home today than you would prior. Amanda said that for a vast majority of Americans, the cap on mortgage interest deduction of $750 should not really have a huge impact. In California, specifically Orange County, it does effect a lot of people. At large, however, she does not think this is something that is going to significantly limit people from owning a home. Other than this, there is really not that much. Property taxes is part of it. People who own a home will own it for reasons outside of tax savings, and the mortgage side of it is not really that significant.
Bruce asked if they consider the tax changes on the bill pro real estate if you are investors. Amanda said there are definitely a lot of beneficial changes. There are things that are now going benefit investors that were never available prior. He also asked if they consider the tax bill positive or negative for charities and if they see it being a problem. Matt said with the deduction on the owner side, they are not making it harder but rather allowing them to deduct a little bit more. The question would be whether the tax cut will deal with what they say it will do in terms of stimulating the economy. The question is whether people will spend more money, and in turn donate more money. If people have more money, they may be more willing to donate. The question is whether they will spend that money or not.
Amanda said there are two schools of thought. By doubling the standard deduction, fewer people are going to itemize. Charitable donations are one of those itemized deductions. Everyone wants to say that by doubling the charities will be hurt. However, it seems a lot of the higher income earners will still itemize. These are the people who are generally able to donate a significant amount of their income every year to real estate. The fact that the tax changes are now increasing the cap from 50% to 60% might lead us to see some larger donations from those with higher income and net worth. She does not know, on a whole, which will outweigh the other, but she could see it both ways. Maybe lower income people will donate less while higher income people might be able or willing to donate more.
Bruce ended this segment by talking about corporate income. The current top tax rate right now is 35, and the current law is that it starts at 0 and is a graduated scale. It goes all the way to 35 and actually gets there pretty quickly.
For more information, you can call Keystone CPA at 1-877-975-0975.
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