Last week the House GOP finally unveiled the draft legislation of their long-awaited tax reform proposal: the “Tax Cuts and Jobs Act” (TCJA). There will be much arguing and many compromises before this draft makes its way into law, but we have some real meat to dig into here after months of speculation.
In today’s post I’m going to look at how these proposed tax reforms would impact my family and other high-earning families like ours. Our family is currently taxed under the Alternative Minimum Tax (AMT) system. In a battle of AMT versus the Tax Cuts and Jobs Act, who wins?
For those interested, the full draft legislation can be viewed here (all 429 pages of it!) and a summary from the Ways and Means committee can be found here.
The Profile of Our Model High Income Family
I’m going to focus on a family much like my own, but the numbers I use in this post are illustrative and not our actual numbers.
The family in the spotlight today has the following characteristics:
- An Adjusted Gross Income (AGI) of $450,000.
- A tax filing status of Married, Filing Jointly (MFJ).
- Own their residence, but do not own it outright. They have a mortgage. Their mortgage interest is $20,000 per annum and their property taxes are $11,000 per annum.
- They pay $35,000 in state income taxes.
- Currently itemize their deductions, but are subject to the Pease limitation on their deductions. As a reminder, the Pease limitation works by reducing the value of itemized deductions by 3% for every dollar of taxable income above $309,900 (in 2016) for a couple filing as MFJ. The Pease limitations cannot reduce your itemized deductions by more than 80% of their original value.
Our Model Family Under the Current Tax Regime
Given the amount of their deductions, our model family would land in the 33% marginal tax bracket under the current tax regime. However, the current tax brackets are meaningless to our model family, because they are currently being taxed under the Alternative Minimum Tax or AMT.
The AMT is, quite simply, a secondary or shadow system of taxation. You calculate your ‘normal’ taxes based on your AGI and your deductions and exemptions, and then you calculate your taxes under the AMT system. You pay the higher of the two taxes.
How is the AMT calculated?
Welcome to IRS form 6251.
Here is a (much) simplified explanation of AMT calculations for our model family:
- Start with the amount from line 41 on your form 1040. This is your AGI minus your itemized deductions.
- Add back in taxes from Schedule A, line 9. In plain English, you add back in your state taxes and your property taxes. State and property taxes cannot be deducted under the AMT.
- If the amount on line 41 of your 1040 was subject to Pease limitations, you then adjust for the amount that you subtracted from your itemized deductions in line 6 of form 6251.
Is your head spinning yet? The AMT is indeed a thing of beauty.
We will skip over most of the other lines of this form, because nobody wants to read a 6000 word article and not many of us are concerned with things like Research and experimental costs or Mining costs or Intangible drilling costs preference.
So, in this simplified AMT world, adding back in our state and property taxes gives us our Alternative Minimum Taxable Income (or AMTI).
Let us figure out the Alternative Minimum Taxable Income for our model family.
Model family AGI = $450,000.
Model family AMTI = AGI – mortgage interest deductions = $450,000 – $20,000 = $430,000.
Next we will redo this calculation using the steps recommended by the IRS in forms 1040 and 6251. Your head will try to explode, but I’d like you to see for yourself that after you jump through all the crazy hoops, we will end up at the same number we calculated above.
Model family itemized deductions on Schedule A:
Line 9, state and property taxes = $11,000 + $35,000 = $46,000.
Line 15, mortgage interest = $20,000
Line 29, total = $66,000
Pease limitation amount = 0.03*($450,000 – $309900) = $4,203.
Itemized deductions minus Pease limitations = $66,000 – $4,203 = $61,797.
Model family AGI minus itemized deductions (line 41 of the 1040) = $450,000 – $61,797 = $388,203.
Now that the model family has completed form 1040, they turn their attention to form 6251.
- Box 1 of 6251 = line 41 from the 1040 = $388,203
- Box 3 of 6251 = line 9 Schedule A = $46,000
- Box 6 of 6251 = amount of Pease limitations as a negative number = -$4,203
Add up 1, 2, and 3 to get AMTI. $388,203 + $46,000 -$4,203 = $430,000.
The next step is to deduct the AMT exemption from the Alternative Minimum Taxable Income.
If you are MFJ and your AMTI is < $159,700, the AMT exemption is $83,800. If is it more, things get complicated. Pardon me, things get even more complicated than they already are.
If your AMTI is >= $494,500, your exemption is 0.
Otherwise, the IRS provides the following worksheet to calculate the amount of your AMT exemption:
AMTI minus AMT exemption gives us the amount of taxable income under the AMT system of taxation.
Let us compute the values ‘1’ through ‘6’ for our model family based on this worksheet.
- $83,800 (‘standard’ AMT exemption amount)
- $430,000 (model family AMTI, calculated above)
- $159,700 (AMTI above which the exemption is limited)
- $270,300 (amount of the AMTI that is over the $159,700 limit)
- $67,575 (exemption will be reduced by 25% of ‘4’)
Our model family can exempt $16,255 of income from their AMTI.
So, the model family taxable income under AMT = $430,000 – $16,255 = $413,745.
The AMT system has two tax brackets, and they are progressive:
If your AMT taxable income is <= $186,300 you pay 26%. You pay 28% on income above that amount.
Our model family AMT tax is (0.26 * $186,300) + (0.28* ($413,475 – $186,300) = $112,047.
AMT tax calculations can be more complicated than this if there are capital gains and/or foreign tax credits involved, but our model family is happily unencumbered by those complications and so we get to ignore them.
Now let us see how our model family would fare under the proposed legislation.
Our Model Family Under the (Possibly) New Tax Regime
The biggest change for our model family under the new tax regime is the abolition of the AMT.
The new proposed tax brackets are: 12%, 25%, 35%, and 39.6%.
For a couple filing as MFJ,
Up to $90,000 falls in the 12% bracket.
$90,000 to $260,000 now falls in the 25% bracket.
$260,000 all they way to a whopping $1 million is now in the 35% bracket.
And above a million gets taxed at 39.6%.
There are changes proposed to the amount of mortgage deductions possible, but existing loans are grandfathered in.
Much noise is being made in the media about the loss of state tax deductions under this new scheme, but our model family, under the yoke of the AMT, has not been able to deduct state taxes anyway.
They were also unable to deduct property taxes under the AMT, but will now be able to deduct those, up to $10,000.
The Pease limitations have been repealed.
Let’s run the numbers for our model family.
Model family AGI is $450,000.
Itemized deductions = Mortgage interest + upto $10,000 for property taxes = $20,000 + $10,000 = $30,000.
AGI – itemized deductions = $420,000.
Model family tax owed = 0.12*$90,000 + 0.25*$170,000 + 0.35 * $160,000
So our model family would owe $109,300 under the new tax regime (an effective rate of 24.3%) versus $112,122.6 under the existing tax regime (an effective rate of 24.9%).
Our model high income family with itemized deductions that owed taxes under the AMT system of taxation comes out ahead (barely) under the proposed new legislation.
Do you pay AMT? Have you done the math for your family under the new system? If so, which system has you owe less taxes?