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An Under-Covered Aspect of the Tax Bill That Helps Blue State Taxpayers

From the midweek edition of the Morning Jolt…

An Under-Covered Aspect of the Tax Bill That Helps those Blue State Taxpayers

An accountant reader points out that the tax bill includes a key, under-covered change that should mitigate the pain for those who live in high-tax states like New York and California, and who will now find their state and local tax deductions capped at $10,000 instead of unlimited: a big shift in the alternative minimum tax.

Back in 1969, Treasury Secretary Joseph W. Barr told Congress that 155 taxpayers making $200,000 or more did not pay any taxes on their 1966 income, indicating that a wealthy taxpayer with a clever accountant could accumulate enough deductions to reduce the taxable income level down to zero. This caused an uproar, and Congress changed the tax law to hit “wealthy” taxpayers with a higher tax level by not allowing them to take the deductions that other taxpayers do. Unfortunately, they didn’t adjust the income level for inflation, so eventually millions of taxpayers were paying a higher level of tax because of the AMT. The IRS said 4.4 million Americans paid the alternative minimum tax in 2015, paying an extra $7,000 than they would without the AMT. Households making between $200,000 and $500,000 were most likely to pay the AMT.

Under the AMT, a taxpayer can no longer deduct state and local income taxes, medical expenses, mortgage interest on home equity loans and various other employee business expenses and investment expenses. You can easily picture working hard and being successful, enjoying a steadily rising income over a period of years, and then one year you finally get another big sales commission or that big raise you were hoping for, and suddenly you’re wealthy enough to hit the AMT, and then BOOM — your tax bill is much larger because you can’t deduct everything you’ve grown used to deducting in previous years.

The taxpayers who feel the biggest bite from the AMT are HENRYs – “high earners, not rich yet” folks who make a lot of money by national standards but don’t live a particularly luxurious lifestyle because they live in areas with a high cost of living… like California, New York, New Jersey, and other densely-populated coastal states and big cities. These, of course, are also many of the same places with high state and local tax rates, who will be hit the hardest by the cap on deducting state and local taxes.

Here’s the good news: under the new tax law, significantly more income is exempt from the calculations of the alternative minimum tax. “Under the old law, you can exempt $54,300 as a single filer and $84,500 as a married couple filing jointly. The new bill increases those exemptions by almost a third, to $70,300 and $109,400.”

The old AMT system also would reduce your exemption if your income hit a certain threshold: $120,700 for singles and $160,900 for couples. (In a lot of parts of the country, a husband and wife making $81,000 each are doing pretty good, but they’re not living a life of champagne dreams and caviar wishes.) Under the new law, those exemption thresholds are now way higher, $500,000 for an individual and $1 million for a couple.

If you live in one of those high-cost-of-living, high-state-and-local-tax places, there’s one piece of bad news and at least two pieces of good news. The bad news is you can only deduct $10,000 of your state and local taxes, and maybe you’ve gotten used to deducting $12,000, or $15,000, or even much higher sums each year. (Recall the Tax Foundation’s super-cool map of average state and local tax deductions by county. Yes, New York City’s five boroughs top the list with an average of $24,898. But the eighth-highest county in the country is Nassau County on Long Island with an average state and local tax of $11,624. Meaning the average taxpayer in that county will, in future years, deduct $10,000 instead of $11,624. That’s not a tax increase of $1,624; it means their level of taxable income goes up by $1,624.  Unpleasant, but hardly devastating.)

The good news is that if you’re paying that much in state and local taxes, you’re probably making enough get hit by the alternative minimum tax, and the new law will reduce that.  What’s more, should be paying less as your income tax rate went down by a few percentage points.

Of course, your tax filing is dependent upon a lot of your decisions – your income and any investment income, but also things like whether you have a mortgage, your state and local tax payment totals, your charitable contributions, etcetera. My back of the envelope math is that some people will enjoy a big cut, a lot of people will enjoy modest but tangible cut, and a few people might hit the worst possible sequence and see a modest increase. Looking at this chart, if you’re married and your joint taxable income is between $400,000 and $416,000, your tax rate is changing from 33 percent to 35 percent. (Quick, get your taxable income down to $399,000! Your tax rate will drop to 32 percent!) If you’re married and your joint taxable income is around $300,000, great news: your tax rate is dropping from 33 percent to 24 percent!

Here’s the Washington Post’s tax calculator, here’s the New York Times calculator, here’s one from Maxim Lott, executive producer for John Stossel.

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