By David K. Little, CFP®, CFA

Ah, Orange County. The land of sandy beaches, swaying palm trees, perfect weather … and higher taxes?

The Tax Cuts and Jobs Act (TCJA), signed into law by President Trump in late 2017, was portrayed by the government as a tax bill that would help almost all Americans by reducing their income tax burdens. But people in Orange County can be forgiven for their skepticism about that. Expenses that in the past were almost all deductible have been severely limited. Examples include:

• Your deduction for property taxes on the real estate you own

• Your deduction for state income taxes

• Your mortgage interest deduction

Here are the details on the loss of these deductions.

Property Tax/State Income Tax deductions

The TCJA reduced the total amount of state income taxes and real estate taxes you can deduct to $10,000. You’ll hear this called the SALT deduction (state and local tax).

Median home prices in Orange County are over $700,000, and in Los Angeles, the median home is valued at around $600,000. Buying a $700,000 house would lead to an annual property tax bill of close to $9,000.

The average household income in the county is around $100,000, and with California’s status as a high-tax state, income tax bills are high. Even middle income taxpayers can easily pay more than $6,000 in state income taxes.

So even with combined state and local taxes of $15,000 in the examples above, you’re allowed to deduct only $10,000 on your federal return. Car registration fees also fall into this category, so the taxpayer above would be out of luck in receiving a deduction for that.

Mortgage Interest Deduction

The mortgage interest deduction has been reduced from previous levels too. Under the new tax code, you can deduct only the interest attributable to $750,000 in real estate loan balances on your residence. Many homes in Orange County are purchased with loans of well over this $750,000 limit.

So if you’re an Orange County resident, you’re probably asking yourself how in the world the tax bill could possibly benefit you. Here are some potential benefits:

• Bigger tax breaks for your kids

• Higher standard deductions

• Lower income tax brackets

• Qualified business income deduction

Child Tax Credit

The big news for people with kids is the increased child tax credit, which is now $2,000, up from $1,000 previously. True, personal exemptions have been eliminated, but the $2,000 credit more than offsets that loss. And you’re more likely to be able to take the credit. Before 2018, the child tax credit began to disappear when a married couple earned more than $110,000. That $110,000 threshold has been increased to $400,000.

Standard Deduction Change

The increase in the standard deduction will be really helpful to many taxpayers. First, a refresher on what the standard deduction is. Under our tax system, you can either itemize your deductions or take the standard deduction. You want the largest possible deduction, so if your itemized deductions add up to more than the standard deduction, that number goes on the tax return. If not, you take the standard deduction.

In 2018, the standard deduction for a married couple is $24,000. Single taxpayers get a $12,000 standard deduction. Additionally, if you’re over 65, your standard deduction goes up by $1,300. So a married couple who are both over 65 get a whopping $26,600 as a standard deduction.

Because of the large increase in the value of the standard deduction and the limitation on what expenses qualify as itemized deductions, many more people will take the standard deduction. Initial estimates are that only 8% of tax filers will continue to itemize their deductions.

Lower Income Tax Brackets

Lower tax brackets are another source of potential savings on the 2018 tax return. In very broad terms, tax rates are down by 3–4% percentage points across the board. For high incomers, the brackets are lower too. The highest bracket under the new law is 37% and doesn’t kick in until your taxable income exceeds $600,000. In 2017, the highest bracket went into effect on income over $470,000 and was almost 40%.

Qualified Business Income Deduction

One of the largest potential benefits in the tax bill goes to business owners in the form of the qualified business income (QBI) deduction. Business owners of “pass-through entities” get to deduct up to 20% of their business income on their returns. That means 20% of their net income is not subject to taxation. Again, potentially a huge a benefit. Pass-through entities are sole proprietorships, partnerships, limited liability corporations, and S corporations. Net income is “profit” from the business. It’s not anything that’s taxed as salary.

As an example, a small business owner with a $50,000 salary and $100,000 of profit could deduct 20% of the $100,000 ($20,000) from her income. Depending on her tax bracket, that deduction alone could save her around $5,000 in taxes.

There are some limits on this deduction, notably for very high-income taxpayers in “specified services” like law, health, finance, and athletics.

Planning Opportunities

Because of the complex nature of the tax bill and the fact that every taxpayer’s return is different, it’s important to get tax planning advice from an Orange County financial advisor who has expertise and experience working in this area.

Some of the planning opportunities we’ve recommended in response to the tax bill include:

• “Bunching” deductions

• Funding donor-advised funds with charitable contributions

• Utilizing qualified charitable deductions (QCDs)

• Changing the structure of business owner compensation

Bunching Deductions and Donor-Advised Funds

These strategies work together in some cases. The general idea here is that taxpayers should take advantage of itemized deductions if possible, but if not, utilize the higher standard deduction. Shifting the timing on property tax payments and donations to charity are at the core of this strategy.

QCDs

For taxpayers not eligible to itemize because of the higher standard deductions, giving money to charity directly from an IRA is a valuable strategy. In effect, it allows you to itemize deductions that would otherwise not help with your federal taxes.

Business Owner Compensation

In general, classifying business income as profit instead of wages will help reduce a taxpayer’s bill. This is even more critical with the advent of the QBI, discussed previously. If possible and allowable, companies should pay more compensation to owners in the form of profit, and less in the form of wages.

Schedule a 15 minute discovery call with a fee only financial advisor to discuss your personal situation.