The Tax Cut and Jobs Act of 2017 was recently enacted, and it carries many changes for US taxpayers this year.  Although many of the details in the form of regulations are still to be written, we believe that the meat of the bill gives us some good general direction for the final script, and we have done our best to summarize the bill below in a manner easier to digest than the 1097 pages of text that Congress has put together thus far. Although there are numerous changes, we highlight just a few below that we believe will have the most impact for our clients and their portfolio holdings.

Personal taxes:
The largest changes on the personal side were the lower and wider brackets, the Alternative Minimum Tax exemption increase, and the changes to the itemized deductions.  
The lowered Individual Income tax brackets are as follows:

Standard deductions were nearly doubled to $12,000 for single taxpayers/$24,000 for married taxpayers. With 2/3 of Americans already using the standard deduction, coupled with the lower tax brackets, the majority of taxpayers will see a decrease in their taxes paid. Under the new law, it is estimated that another 27 million taxpayers will claim the standard deduction rather than itemizing, greatly simplifying their tax pictures.

For those that itemized in the past and wish to continue to, however, it gets a little stickier. The personal exemption goes away, as do many other deductions. You will get to keep your mortgage deduction if you have one (for the interest on the first $750,000 in principal for debt incurred after 2017, but no longer on home equity loans), as well as your charitable deductions and up to $10,000 of property taxes/state and local income/sales taxes paid.  In addition, the Child Tax Credit was doubled to $2,000, a new non-child dependent tax credit of $500 was added, and both receive an increased income limit at which they are phased out (all the way to $200,000 for single taxpayers and $400,000 for married taxpayers). The medical expenses deduction survived in an altered state, as the amount equal to the first 7.5% of adjusted gross income is eliminated. Up to $2,500 of student loan interest is still allowed, up to $5,250 of employer-paid tuition is allowed tax free, and educators and their dependents receive additional deductions and waivers.  

Long-term capital gain/qualified dividend rates remain the same, but with different, yet corresponding, income rates. For your primary residence, the law stayed the same as well – $250,000 in capital gains ($500,000 if married filing jointly) are excluded from taxes if that home was your primary residence 2 out of the last 5 years.

The new estate tax exemption allows for $10 million per person, adjusted for inflation. As of this writing the IRS is still finalizing this amount, which is expected to be over $11 million per person when adjusted for inflation. Unlimited asset transfers between spouses remain in place.  Keeping with the previous law, the annual gift exclusion amount increases to $15,000 for 2018 due to inflation adjustments. 529 savings plans can now pay for primary school, up to $10,000 per child per year. This will be an additional tax benefit to contributors whose states allow a tax deduction for contributions (for example, CO allows a state income tax deduction for all contributions, VA only allows up to a $4,000 deduction, and CA doesn’t allow any deduction—don’t know about your state?  Call your portfolio manager!.  There is one caveat here—as of this writing, some states are debating whether or not they will allow those funds used for primary education to get the state tax deduction, including Colorado for our clients that live here. Stay tuned…

In addition to the above, the individual health care mandate was repealed beginning in 2019, negating the tax penalty on those that choose not to have insurance. And finally, the dreaded Alternative Minimum Tax is still around but with a much higher exemption amount of $109,400 for married couples, up from $84,500.

Who will be negatively affected?  High earners who previously had considerable itemized deductions (especially those in states with high income and/or property taxes) may find themselves paying higher taxes, even with the lower brackets. The fact that all of these personal tax changes sunset back to 2017 levels in the year 2025, setting us up for another “fiscal cliff” with Congress, leaves us wondering what we will see down the road.

Corporate taxes:
The biggest change for US corporations is undoubtedly the lowering of the top corporate tax rate to 21% from 35%.  In addition to the lower overall rate, the ability to expense 100% of property will be a significant boost to many businesses. The corporate Alternative Minimum Tax has been repealed as well. On the other side of the ledger, carry backs of net operating losses are no longer allowed, and carry forwards are limited to 80% of taxable income. The bill also limited net interest expense deduction which may reduce corporate borrowing in favor of other ways to raise capital.  

“Deemed repatriation” passed as well.  Corporations which have foreign earnings that have been left abroad to avoid paying higher corporate tax rates will be required to pay a 15.5% one-time tax on those cash earnings (or 8% if reinvested) regardless of whether or not they bring that cash back into the US.  In conjunction, and to try to prevent this overseas cash from building up again, the US will move to a territorial tax system, like most other developed countries in the world, where companies are only taxed on income earned within the boundaries of their home nation.

Another big change on the business side of the tax bill was to help balance out the taxes paid by pass-through organizations such as Sole Proprietors, S Corps and Partnerships in a lower corporate tax rate environment. These entities will receive a deduction of 20% of their share of business income (if they earn over $157,500 single or $315,000 married filing jointly, it is capped at 50% of their W-2 wages) OR 25% of their W-2 wages plus 2.5% of unadjusted basis of the property used in the production of income, as long as they are NOT in a “personal service business”. Doctors, lawyers, accountants, etc. are excluded from this deduction.

As investors digest the tax bill, many are asking what impact this will have on their equity holdings. Although many provisions are very industry/company specific, and some companies will see higher taxes, most US corporations will pay less in taxes, freeing up cash flow, which should lead to a stronger, faster growing economy. Certain incentives, such as the 100% expensing provision, encourage investment now, and US corporations will be able to compete more effectively with their foreign counterparts, all of which are likely to lead to higher profits. In addition, if you own your own business and are not in an excluded industry, you should be able to lower your taxes on some of the pass-through income.

Ever silver lining comes with a cloud, and the Tax Cut and Jobs Act of 2017 comes with a big price tag called increased debt to the country. While increased national debt at low interest rates doesn’t seem to spur outrage, at some point in the future, servicing our nation’s debt will become problematic. As you would expect, there are many details not included in the above general comments, so please be sure to talk with your tax advisor before taking any actions with regard to the new tax law.

The Bond Box – Notes from the Fixed Income Trading Desk
Taxable Fixed Income Markets
The Federal Reserve raised short-term interest rates as widely expected in December for the third time in 2017 and for the fifth time in this rate hiking cycle that began in December 2015. History tells us that during Federal Reserve rate hiking cycles the yield curve typically flattens as short-term and long-term interest rates compress. That is exactly what is happening as we write this piece. The ten-year U.S. Treasury rate was virtually unchanged in 2017 while the thirty-year U.S. Treasury yield declined by 0.32% during the year. The Federal Reserve continues to expect economic growth will lead to labor market tightening, then to wage increases and ultimately to rising inflation as fulfillment of their extraordinary easing measures over the last nine years since the Great Recession. The bond market seems to have a much different view, with expectations of only modest growth and low inflation continuing for several years. The combination of an assertive Federal Reserve raising rates pre-emptively to head off the forecasted rise in inflation while inflation remains persistently low has, in our view, been the driving force keeping long-term rates lower than many have been forecasting over the last several years.

2017 ended with a bang for the municipal bond market. After a calm October, the first tax reform proposal was put forth in early November. At first look it appeared that municipals were going to come out unscathed but as analysts dug into the bill, they found quite the opposite. While tax exemption wouldn’t be affected, it looked to reduce the size of the municipal market through other ways; specifically getting rid of pre-refunded bonds which makes up about 15% of the municipal bond market. This proposed reduction of supply initially caused a strong market rally, that was quickly retraced as issuers flooded the market with a large wave of supply in December, hoping to get ahead of enactment of the bill in January. December ended up setting a record for municipal bond issuance at $62.5 billion, easily surpassing the last record of $54.7 billion set amidst the last major tax overhaul in 1985.

All things must end and while we see some signs of excess (see bitcoin, above) in the markets, economic fundamentals still look supportive of growth and rising profits. Now would be a good time for rebalancing portfolios and re-assessing one’s risk tolerance. Both are key elements of a well-crafted plan that is essential for a successful financial journey.