As individuals organize their tax records in order for them or their tax preparers to prepare and to file their 2018 federal income tax returns, there are a number of questions facing these individuals and their tax preparers.
One of these questions is whether to itemize one’s deductions or to take the standard deduction. In other words, which option – itemizing allowable deductions or taking the standard deduction – will result in a lower 2018 federal income tax liability?
The Tax Cuts and Jobs Act of 2017 (TCJA), passed into law in late 2017 and in effect from 2018 through 2025, has made this question more challenging as a result of eliminating or limiting several itemized deductions. This column discusses which deductions have been eliminated and limited, and as a result why the standard deduction may benefit more individuals.
State, local and foreign tax deductions are limited
Under pre-TCJA law, individuals were allowed an itemized deduction for the following taxes: (1) Foreign real property taxes; (2) foreign income taxes; (3) state and local real property taxes, and (4) state and local income or, if larger, sales taxes. Under TCJA, for tax years 2018 – 2025, no deduction is allowed for foreign real property taxes. An Individual’s aggregate deduction for items (2), (3), and (4) is limited to $10,000 or $5,000 for a married individual filing separate. Note that the $10,000/$5,000 limit does not apply to foreign income taxes, state and local properties if these taxes are paid or accrued in carrying on a trade or business, or for the production of income. Such deductions are fully allowable on the individual’s Schedule C, Schedule E or Schedule F.
Medical expense deduction threshold temporarily reduced
Under pre-TCJA, the threshold for deducting out-of-pocket and unreimbursed medical expenses was 10 percent of an individual’s adjusted gross income (AGI). This threshold applied for both regular taxes and alternative minimum tax (AMT). For tax years 2017 and 2018, TCJA reduces the threshold for medical expense deductions from 10 percent of AGI to 7.5 percent of AGI for all individuals for both regular tax and AMT. Effective Jan. 1, 2019, the threshold returns to 10 percent.
Home equity indebtedness
The TCJA allows mortgage interest deduction on mortgage loans up to $1,000,000 that were taken out prior to Dec. 16, 2017. For mortgage loans taken out after Dec. 15, 2017, mortgage interest is deductible on loans not exceeding $750,000. Mortgage interest is deductible on loans taken out on first homes and second/vacation homes. For home equity loans, interest remains deductible provided the loan proceeds are used to buy, build, or improve one’s primary residence. This is the case no matter when the home equity loan was established. Home equity loan proceeds used for any other purpose – for example, buying a car, paying a dependent’s higher education costs, paying off credit cards – will result in the nondeductability in interest paid on the home equity loan.
Miscellaneous itemized deductions
The deductions for miscellaneous itemized deductions that are subject to the 2 percent of adjusted gross income (AGI) floor has been eliminated. This means that out-of-pocket business expenses, union dues, tax preparation fees and investment fees are no longer deductible.
Standard deduction almost doubled
Individuals who do not itemize can reduce AGI by the applicable standard deduction in arriving at taxable income. The standard deduction is the sum of an inflation -adjusted (statutory) basic standard deduction plus, if applicable, an inflation-adjusted (statutory) additional standard deduction for the elderly and blind. The basic standard deduction varies depending on the individual’s filing status.
The TCJA has resulted in the nearly doubling of the basic standard deduction amount for the years 2018 -2025. The basic standard deduction amount for each filing status for tax year 2018, with 2017 standard deduction amounts also shown for comparison purposes, are presented in the following table:
The additional standard amounts for individuals over age 65 (elderly) or blind are shown in this table. Note that these amounts are per person and are doubled if an individual is both elderly and blind.
For those individuals who have not itemized on their federal income taxes in past years and intend to use the standard deduction on their 2018 taxes, the nearly doubling of the standard deduction should result in some tax savings, assuming there is the same amount of total income in 2018 compared to 2017.
The enhanced standard deduction may exceed the amount of the itemized deduction for those individuals who have itemized in the past but as a result of the TCJA have lost or been limited in their itemized deductions. In that case, taking the standard deduction rather than itemizing will result in a lower 2018 federal income tax liability.
A potential question facing an individual who chooses to take the standard deduction on his or her federal tax return is what to do on his or her state tax return, assuming the individual’s state has a state income tax.
In past years, many states with state and local income taxes have required their residents to use the standard deduction on the state return if the standard deduction was used on the Federal return. If the standard deduction on the state return turned out to be larger than the allowable federal itemized deductions, the state permitted the individual to use the standard deduction on the state return. But the reverse procedure – allowing itemizing on the state return while using the standard deduction on the federal return – was generally not allowed.
Under TCJA, some states with income taxes are “decoupling” from the federal in the sense that these states will allow state residents to itemize on the state return while these state residents take the standard deduction on the federal return. But some states such as Maryland and Virginia are not permitting a “decoupling” from the federal.
In trying to decide which option – itemizing or taking the standard deduction – will give a lower total (federal plus state) tax liability, those individuals living in states with state and local income taxes need to consider both their federal and state tax liabilities. Using the standard deduction on the federal return resulting in a lower tax liability could result in a larger state tax liability in a state that does not permit “decoupling”, possibly causing the individual to pay more in total taxes.