This article by Bernie Kent was originally published on Forbes.com.
The new tax bill will offer a tax planning opportunity (dare I say loophole?) that may be unfamiliar to most high income taxpayers: the standard deduction!
If you have a home mortgage interest deduction in excess of $15,000, you can stop reading now (unless you are able to pay down your mortgage significantly). This tax savings idea will not apply to taxpayers who have deductions that occur every year in an amount equal to or greater than the standard deduction.
The new tax bill will raise the standard deduction in 2018 to:
- $24,000 for married couples filing jointly,
- $18,000 for heads of household filers and
- $12,000 for single taxpayers.
There is an additional standard deduction of $1,300 for each married person over age 65 ($1,600 for single taxpayers). The additional standard deduction is also available to taxpayers who are legally blind.
The legislation limits the deduction for state and local taxes to $10,000 and eliminates many other deductions. For taxpayers who have no home mortgage interest deduction, the only other common deduction which is preserved is the charitable contribution deduction.
Whether your income is $100,000 or $100,000,000, you may be able to benefit from the standard deduction, even if you are very charitable. All you have to do is bunch your contributions. For example, you can make all of your charitable contributions for next year before December 31, 2017. Then make no charitable contributions until 2019. Your itemized deductions will be, at most, $10,000 of state and local tax. Thus a married couple filing jointly will have at least $14,000 of additional tax deductions by using the standard deduction every second year.
Most taxpayers will have a lower marginal tax rate in 2018 when the tax bill comes into effect, which further enhances the benefits of making your charitable contributions before the end of this year.
If bunching your charitable contributions to take advantage of the standard deduction sounds good to you, you may love the idea of creating a donor-advised fund, sometimes referred to as a philanthropic fund or “phil fund.” A donor-advised fund can be established through most community foundations and some other tax-exempt organizations. Many large mutual funds and brokerage firms also make these funds available. You can make a contribution this year that could cover several years of future contributions. You are entitled to the charitable contribution deduction in the year you make the contribution to the fund, even though the funds may go to your charities over many years in the future.
The charitable fund has legal ownership of the funds you commit, but will allow you to recommend charitable beneficiaries of the fund whenever you decide to do so. The minimum contribution to establish a donor-advised fund is established by the sponsoring organization. You may make recommendations to the sponsoring organization to make contributions to your charities, subject to a minimum contribution (such as $250). The sponsor will ask you to acknowledge that you are not receiving anything of value from the charity in exchange for recommending the contribution. You may not ask that the funds be used to satisfy a pledge you made to a charity. However, the IRS recently announced that they plan to issue regulations which will say that there will be no penalty if the charity applies a donor-advised fund contribution to an existing pledge you have made.
A large contribution to a donor-advised fund this year will allow you to make charitable contributions from the fund for many years into the future while receiving the full tax benefit now. The charitable contribution deduction is limited to 50% of your Adjusted Gross Income (AGI). In 2018, this limit will increase to 60% of AGI. If you wish to gift appreciated long-term capital gain property to a donor-advised fund, your charitable contribution deduction will be limited to 30% of AGI. Any contributions in excess of these limitations can be carried forward to the following five tax years (however this would not be beneficial to the extent you are going to take the standard deduction in future years). When your donor-advised fund runs out of funds, you can replenish it with a large contribution and restart the standard deduction in the following year.
Taxpayers who are over 70 1/2 years old have an additional way to receive a tax benefit for their charitable contributions while still claiming the standard deduction. They can contribute up to $100,000 from their IRA directly to charities (not to donor-advised funds) without including the income or deduction in their tax calculation.
Itemized Deductions Retained
In addition to the home mortgage interest expense deduction, there are three other itemized deductions which may put you over the standard deduction threshold:
- Medical expenses which are not covered by insurance. The current law only allows a deduction for such expenses that exceed 10% of AGI. The new bill lowers this threshold to 7½% of AGI for 2017 and 2018,
- interest expense incurred in connection with investment income, or
- casualty losses in a Federally declared disaster area.
These deductions combined with the $10,000 state and local tax deduction and the mortgage interest deduction may reduce or eliminate the opportunity to bunch charitable contributions to benefit from the standard deduction.
The alternative minimum tax (AMT) has been revised so that it will apply to fewer taxpayers by increasing the exemption and increasing the AGI level at which the exemption begins to phase out. Taxpayers in AMT in 2018 do not benefit from the standard deduction.
Most of the changes in the tax law discussed in this article are set to expire after 2025. So you may have eight years to implement this strategy. On the other hand, tax laws change frequently. Although this seems like a loophole, it is perfectly legal and it is hard to think of anything the IRS could do to change this.
The tax strategy of bunching deductions is not new. Taxpayers whose itemized deductions are near the standard deduction have been able to do this for years, not only with charitable contributions, but with property taxes and to some extent with income taxes. The new tax bill significantly increases the number of taxpayers who should consider this strategy for their charitable contributions.
To read more from Bernie Kent on Forbes.com, click here.