The sweeping changes of the Tax Cuts and Jobs Act of 2017 left many taxpayers uncertain about whether they would be paying more or less in tax than before. “After all, the federal tax brackets lowered and alternative minimum tax (AMT) exemptions increased,” says Elizabeth Jensen, CFP®, a Senior Wealth Planning Strategist with Wells Fargo Private Bank. “But many of the largest personal income tax deductions disappeared. On top of that, a brand new and very complicated deduction for pass-through businesses was introduced.” This is the first year we are seeing the actual impact of all of these changes, so it is crucial to understand—and act upon—the important adjustments you can make now that could have a positive impact.
“You need to take a look under the hood, to ask the right questions and make sure your preparer is doing everything he or she can,” says Jensen. “It’s worth the effort.”
Of course there are a host of important considerations beyond tax efficiency at play, and you should thoroughly weigh all the pros and cons with your team of professional advisors to determine which, if any, might be right for your specific situation.
Here, Jensen outlines four important adjustments to consider as 2019 comes to a close.
1. Leverage your pass-through benefit for qualifying business income
Many high-net-worth business owners and investors have significant “pass through income” from sole proprietorships, entities such as partnerships, S corporations, LLCs, and real estate. Income and deductions all flow through to the individual owner(s). One of the major provisions (known as “Section 199A”) of the Tax Cuts and Jobs Act of 2017 is a new deduction of up to 20% on qualified business income from each qualifying trade or business. However, many families were unable to take full advantage of this in 2018 because the deduction is not applied automatically once taxable income exceeds certain modest thresholds ($160,700 single, $321,400 married).
“When thresholds are exceeded, three factors can limit or eliminate the available deduction—the type of business, how much it pays in wages, and how much capital has been invested,” says Jensen. “Ask your tax advisor how much of that deduction you received for each qualifying business. If it’s below 20%, ask how you can do better this year. That’s probably the most meaningful, impactful thing you can do in 2019.”
2. Investigate opportunity in Qualified Opportunity Zones
Many businesses and investors are aware of the Qualified Opportunity Zone (QOZ) program introduced in the latest tax reform. One feature of the program lets you defer federal capital gains taxes from a wide range of assets (not just real estate) by investing some or all of the gain proceeds into a QOZ Fund within 180 days of the sale event. But Jensen says several clients were unaware the window to re-invest might be longer than that in some cases.
For example, if the gain is recognized by an entity, such as an LLC or S-corp instead of a shareholder, the shareholders may have 180 days from the end of the entity’s tax year to re-invest. Often, an entity’s end of year will be December 31.
“If you sold something in April of 2019,” Jensen says, “you might actually have until end of June 2020 to take advantage. In working with your advisory team to vet any QOZ Fund opportunity, be particularly mindful of all time components as one of the program features requires investing by the end of 2019.”
3. Explore deductions in nonprimary residences
Tax reform set a $10,000 limit on personal state and local tax (SALT) deductions from 2018–2025. That means some families paying higher property taxes on second or third homes no longer get a tax break for those expenses. But keep in mind that properties used in a trade or business are not subject to that limit at all, Jensen says. “It may be a good time to consider converting non-primary residences to investment properties, assuming you are comfortable renting them out,” according to Jensen. “As long as your personal use annually does not exceed the greater of 14 days or 10% of the total days you rent it out at fair rental prices, the property taxes paid may be fully deductible.”
4. Revisit advanced planning strategies
Many families have implemented or are considering irrevocable trusts to transfer wealth efficiently across generations. Because of dramatic transfer tax exemption increases ($11,400,000 per person in 2019), SALT deduction limitations, and new pass-through business deductions, the best way to utilize these structures is changing. “Certainly, high net worth families should be thinking through whether they should be ‘locking in’ these increased exemptions now before the law reverts after December 31, 2025, to previous levels,” says Jensen. “Doing so may provide a benefit of more than $4,000,000 for the family assuming both spouses gift their entire exemptions.”
“Estate taxes are not everything, though,” reminds Jensen. Income tax considerations are now a bigger part of transfer planning than ever before. Irrevocable trusts are frequently structured to be “grantor” trusts, meaning the grantor remains the income tax payer of irrevocable trust assets. “Converting the trust to nongrantor status so the trust pays its own income tax liabilities may result in less income tax for the family overall,” says Jensen. “Why? Different taxpayers can have different deductions—a nongrantor trust may better qualify for deductions that were unavailable or limited to the grantor.”
Jensen recommends bringing together your advisers soon to consider these implications and your plan to address them: “There may be important tradeoffs to consider. Getting the results you hope for is more often achieved when your advisors—especially accountant, attorney, and wealth planner—communicate directly with each other to build consensus so your team has thought through all angles, both short-term and long-term.”