Tax Code Tips: Mortgage Deductions and the Kiddie Tax

Are itemized deductions a thing of the past? The recently-enacted Tax Cuts & Jobs Act includes changes to the way we itemize deductions.  Some deductions now have caps or have been repealed altogether.  One of the most significant changes may be the new limitations on the mortgage interest deduction.

Another change in the tax law affects the so-called “Kiddie Tax”. Under the new rules, a child’s unearned income is taxed using a different structure.

Mortgage Interest Deduction

The new tax reform law includes two changes in the way taxpayers deduct interest on loans related to their home(s). Prior to 2018, the mortgage interest deduction was limited to the interest paid on up to $1 million of aggregate debt related to the purchase of primary and secondary residences. Under the new law, this deduction will be limited to the interest on only $750,000 of aggregate debt. To soften the impact, the new debt limit only applies to mortgages secured after December 14, 2017.  Loans taken before that date will continue to have a $1 million debt limit.  So while new high-end home buyers might be affected, most existing homeowners will not experience a change this year.

The other significant change for homeowners is the repeal of the home equity interest deduction, unless the funds are used in certain circumstances. As long as the home equity loan is used to buy, build, or substantially improve one’s home, the interest continues to qualify as mortgage interest and is subject to the same deductibility rules and aggregation limits as those detailed above for first mortgages. If claiming the home equity interest deduction, the IRS will expect the borrower to know and be able to prove how the loan proceeds were used. Borrowers will need to be careful to keep good records.

The Kiddie Tax

Changes to the Kiddie Tax rules may alter tax planning or gifting strategies for some families. The Kiddie Tax is a tax on a child’s net unearned income, that is, income from investment assets – interest and dividends, capital gains, etc. The tax was enacted by Congress in the 1980s to prevent parents and grandparents in high tax brackets from shifting investment income to children in lower tax brackets.  It applies to all children under age 19 and to full-time students under 24 who are not married filing a joint tax return.

Prior to 2018, a child’s unearned income exceeding $2,100 was taxed at the parents’ marginal rate for income and capital gains. Under new rules, a child’s unearned income is taxed at the rates for trusts and estates.

At first look, this may appear to be a big change from a tax-liability perspective, since higher tax brackets for trusts and estates kick in at much lower levels than when applied to individuals. However, many taxpayers (especially the children of affluent parents) may end up paying less tax as a result, some experts say.

Tim Steffen, CPA and Director of Advanced Planning at Baird & Co, provided the following example to “InvestmentNews”:

“A child subject to the Kiddie Tax is the beneficiary of a (deceased) grandparent’s IRA, and takes a $10,000 distribution from the account. Assume the child’s parents are subject to a 35% marginal tax rate. Under prior rules, the child’s total tax liability would be $2,870. However, under the new law, that same child’s liability is $1,644 — in other words, $1,226 less.”

If securities are gifted to a minor and have appreciated substantially over time, teenagers may want to sell such assets to help pay for college. Advisors should keep an eye on these low-basis assets and recommend children of clients consider selling down incrementally sooner rather than later to help take advantage of the exclusion and lowest tax brackets, potentially reducing the Kiddie Tax incurred.

While many Americans will experience changes in their tax liability due to the latest tax reform, the magnitude of these changes with respect to the mortgage interest deductions and the Kiddie Tax may turn out to be minor. The Madison team understands the importance of incorporating tax and gifting strategies into your overall financial plan.  Because everyone’s tax situation is unique, now might be a good time to discuss planning opportunities with your tax adviser and our wealth professionals at Madison.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Madison Wealth Management does not provide tax, legal or accounting advice. Sources include Bureau of Labor Statistics. © Madison Wealth Management 2018