What Most People Get Wrong About the New Tax Rules
The new tax reforms set forth in the Tax Cuts and Jobs Act go into effect for the first time this tax filing season. Many people are confused about how the changes in the tax code might impact them as they prepare to file their 2018 tax returns.
The Tax Cuts and Jobs Act
In 2017, President Donald Trump signed into law the Tax Cuts and Jobs Act (TCJA). The law was full of sweeping tax reforms which are scheduled to remain in effect until December 31, 2025. Want to learn more about the TCJA? Here are 22 things tax experts wish you knew about the new tax law.
Misunderstanding #1: The new tax reform changed home sale gain exclusion rules
The home sale gain exclusion has existed in some form since 1951. The exclusion permits a single taxpayer to exclude up to $250,000 of gain on the sale of their primary residence, while married taxpayers who file jointly can exclude up to $500,000. But there’s a catch. You have to have lived in your home for at least two of the five years (prior to the sale of your home) to qualify for this exclusion.
Logan Allec, CPA and owner of Money Done Right, explains that “although this requirement was completely unaffected by TCJA, many people have the misconception that tax reform changed the required live-in period from ‘two out of five years’ to ‘five out of eight years.'” Allec points out that Congress did propose changing the requirement, however, the proposal didn’t stick. “In the final bill that became law the ‘five out of eight years’ live-in requirement was removed, and the original requirement remained unchanged,” Allec explains.
Misunderstanding #2: The changes are permanent
People tend to forget that many of the tax breaks for individuals in the TCJA come with an expiration date; many of the new tax breaks are set to expire in 2025 unless Congress renews them or makes them permanent. This means that people who want a chance to protect their retirement funds from tax rates likely to increase in the future might want to make moves now, such as converting traditional IRAs to Roth IRAs.
Why? Traditional IRAs are subject to taxes whenever you withdraw your money out and Roth IRAs are taxed on the front end, but not when you withdraw (though you’ll have to meet the requirements). If you convert your traditional IRA to a Roth IRA, you’ll pay taxes now at the current low rates, but if you wait to convert or withdraw from a traditional IRA, a higher future tax rate might cost you more money.
Misunderstanding #3: Tax reform limited property tax deductions on rental property
It’s true that TCJA did limit the itemized deduction for combined state, local, and property taxes to $10,000 (better known as the SALT deduction), yet only property taxes paid on your primary residence are included as itemized deductions and subject to this limit. “I’ve heard some newbie landlords complain that tax reform limited their property tax deduction on their rental properties, but this is not the case,” Allec says. Property taxes paid on a rental property have never been itemized deductions. Rather, property taxes are claimed separately as a rental deduction and as such, the $10,000 SALT cap doesn’t apply.
Misunderstanding #4: The rules benefit everyone
“Despite the headlines you may have seen, some lower and middle-class families might actually pay more taxes in certain areas, ” explains Robert Farrington, founder of The College Investor. For example, larger families with three or more children might pay more in tax due to the changes in how the child tax credit is calculated (versus the old exemptions), he says. Families in higher-tax states like New York or California might pay more as well, especially those who could previously deduct all of their state and local taxes and now face caps. Those caps, according to Farrington, “could result in a much higher Federal tax bill.”
Misunderstanding #5: You can’t deduct interest costs on home equity loans and HELOCs
Another big misconception people have about the new tax law is the assumption you can no longer deduct interest costs on Home Equity Lines of Credit (HELOCs) and home equity loans. That’s incorrect. Justin Pritchard, CFP and founder of ApproachFP.com (a fee-only financial advisory practice), says “it may still be possible to deduct interest on a HELOC or home equity loan, assuming you follow specific IRS rules (which you need to verify with a tax professional).”
For example, Pritchard explains, “you must use the funds to build, buy, or make substantial improvements to the property you borrow against, but it doesn’t necessarily work if you borrow against Property A to improve Property B, or if you borrow above certain limits.”
Keep in mind, it might not matter anyway if you’re going to take the standard deduction instead of itemizing. Itemizing is an essential requirement of getting the deduction.
Misunderstanding #6: You can’t deduct the mortgage interest on your home
It’s true that the TCJA has made it less advantageous to be a homeowner for tax purposes. Before the tax reform, homeowners could deduct the mortgage interest on the first $1 million of their primary mortgage and, sometimes, the first $100,000 of a home equity loan or HELOC.
Riley Adams, CPA and founder of The Young and the Invested, says the new tax reform “changed to only allow the interest expense associated with the first $750,000 for taxpayers who are married and file jointly and $375,000 for single taxpayers.” It is worth noting this limit only applies to new loans originated after 2017, Adam mentions. Preexisting mortgages are grandfathered under the old limits.
Misunderstanding #7: You think your withholdings are current
You may not remember, but you were required to fill out IRS Form W-4 whenever you began working at your current job. A W-4 is the form you used to calculate your allowances so your employer knows how much money to withhold out of your paycheck and send to the IRS on your behalf throughout the year.
Many people think a W-4 isn’t something that needs to be updated. That’s a mistake, especially after recent changes to the tax code. Paul Allen, CFP and co-owner of PIM Tax Services, has found that “most people never even looked at their federal/state withholding when the law changed, never mind adjusted it.” If you failed to adjust your withholding when the tax laws changed last year, it could have a big impact upon your tax refund (or tax bill) this year.
Misunderstanding #8: A lower refund equals higher taxes
If you didn’t change your withholding amount last year, there’s a good chance that your take-home pay increased in 2018 due to the new tax tables. Why? Your employer may have taken less money out of your check to send to the IRS on your behalf throughout the year.
When you file your taxes, the IRS calculates how much you owe and compares it with how much you paid during the year. If you paid too much, you get a refund. If you paid too little, you’ll have to send the federal government a check. You may love the idea of receiving a big tax refund check every spring, but a large refund isn’t the same thing as lower taxes.
Allen says if you’re upset about the amount you owe or are being refunded this year, you should check to see if you’re paying lower taxes overall. “Nearly everyone knows whether they owed money last April or got a refund,” Allen says. “Almost nobody knows within $1,000 the more important number—how much they actually paid in taxes.” Here’s why you might not be getting a tax refund this year.
Misunderstanding #9: Everyone needs to itemize deductions
The TCJA nearly doubled the standard deduction which taxpayers can claim on their returns starting this tax filing season. In 2017, the standard deduction for married taxpayer filing jointly was $12,700. Now, thanks to the new tax law, it’s $24,000.
“The spirit of the tax law change for individuals was to increase the standard deduction dramatically,” Adams says. “This was, in part, to reduce the number of people who itemize their deductions on their returns and thereby reduce the complexity of filing taxes.” Simpler tax returns also mean faster processing times for the IRS. According to the Tax Foundation, a nonprofit which aims to inform smarter tax policy, the changes from the TCJA could save the IRS between $3.1 to $5.4 billion in compliance costs. Don’t miss the 13 things an IRS agent won’t tell you about tax planning.
Misunderstanding #10: You’ll pay more if you don’t itemize
Thanks to the new tax reform, it won’t make sense for a lot of people to itemize deductions anymore, even if they have always done so in the past. If your deductions don’t add up to an amount which is higher than your standard deduction, itemizing probably doesn’t make sense, Adam explains. (You should consult with a tax professional to be sure.) Check out 13 of the craziest tax deductions ever claimed.