Tax Reform and Deductions - What Credit Unions Need to Know
On December 20, 2017, Congress passed the House-Senate tax reform package known as the “Tax Cuts and Jobs Act” (TCJA). The package cuts taxes by roughly $1.5 trillion over ten years. It is important to note the bill does not alter the credit union not-for-profit tax status. The legislation retains the deduction on mortgage interest, however there are several modifications. Due to the changes in interest deductions contained in the bill with regard to mortgages and other notable changes that could impact credit union members, the MCUL has prepared the following FAQ to address and clarify changes at the federal level as well as the state level.1
Q1. Have there been changes to the deduction of state and local income and property taxes?
Before the TCJA became law, the tax code permitted individuals who itemize their deductions to deduct the entirety of their state and local income taxes, sales tax, and property taxes from their federal income tax return. The TCJA makes changes to these deductions removing the ability to deduct the entire amount by setting a cap for a maximum deduction of $10,000 combined for all state, local, and property taxes. This cap will take effect in tax year 2018 and remain in place until 2026.
Governor Rick Snyder and his administration announced January 8, 2018, the restoration of Michigan’s personal tax exemption as well as an eventual increase in the exemption from $4,000 to $4,500 by 2021. The announcement comes after it was discovered the TCJA could have an impact on Michigan’s residents, increasing what they pay in state taxes. The administration has stated they want to change the state tax code so residents can still use all the state tax exemptions.
The issue with the TCJA is the elimination of the $4,050 personal exemption. This is an issue because Michigan law permits taxpayers to claim a $4,000 exemption for each exemption taken on their federal return. Without changes to the state law, a single person could see an increase of $170 in their state income taxes and a married couple with two children would owe $680 more.
Q2. How does the TCJA change the deduction of mortgage interest for first mortgages?
The legislation preserves the mortgage interest deduction. Specifically, for homeowners with EXISTING mortgages (purchased before December 15, 2017), there will be no change in their deductible mortgage interest for loans up to $1 million. For purchases after December 15, 2017, the cap is lowered to $750,000. The new cap expires at the end of 2025.
Example 1. A borrower is purchasing a new home which is scheduled for closing January 15, 2018, for $800,000. Under the TCJA, the homeowner would be able deduct interest on up to $750,000 of the $800,000 mortgage loan.
Example 2. A homeowner has held their mortgage since 2015 with an original loan amount of $1.5 million. Before the TCJA became law, the threshold for deductible mortgage interest was for loans up to $1 million. Because the loan was prior to the changes in the tax code, the homeowner may still deduct interest on up to $1 million.
Q3. Is interest deductible on loans for a second home or vacation home?
For taxpayers with new mortgages on a first or second home, the mortgage interest deduction would be capped on NEW acquisition debt on a first or second home.
The new deduction of $750,000 is a combined limitation, meaning interest payments on up to $750,000 of new acquisition debt are deductible and is applicable to a principal dwelling and one other residence such as a vacation or second home.
Q4. What is the definition of acquisition debt?
Acquisition debt is defined as indebtedness that is incurred in acquiring or constructing a residence. The term also includes indebtedness from refinancing of other acquisition indebtedness, but only to the extent of the amount (and term) of the refinanced indebtedness.
Q5. What about interest on income properties such as rental properties?
If a homeowner owns their primary residence and a rental/income property, the interest would be deductible on the primary residence and the income property. If a homeowner owns multiple income properties, under the TCJA and the previous tax code, interest on additional properties would not be deductible.
Q6. Is interest on home equity loans and home equity lines of credit (HELOCs) deductible under the TCJA or was the deduction removed?
Unfortunately, the TCJA eliminates the deduction for interest paid on home equity and HELOC indebtedness for tax years 2018 through 2025. There is no grandfather provision for this disallowance, meaning the deduction has been temporarily eliminated for ALL home equity and HELOC indebtedness regardless of when the debt was incurred.
Q7. What debt qualifies as “home equity indebtedness” for purposes of the TCJA?
The TCJA defines home equity indebtedness as any indebtedness (other than acquisition indebtedness defined in Q4 above) secured by a qualified residence to the extent the aggregate amount of the debt does not exceed:
- The fair market value of such qualified residence, reduced by
- The amount of acquisition indebtedness with respect to such residence
This means the definition includes any and every kind of borrowing secured by a residence that is NOT used to acquire, build or substantially improve the residence.
Q8. What about a loan that is refinanced?
Regarding refinancing, “acquisition indebtedness” is defined as indebtedness that is incurred in acquiring or constructing a residence as previously discussed. The term also includes indebtedness from the refinancing of other acquisition indebtedness, but only to the extent of the amount (and term) of the refinanced indebtedness.
Example: If a taxpayer incurs $400,000 of acquisition indebtedness (purchases a new principal residence) and pays down the debt to $150,000, the taxpayer’s acquisition indebtedness with respect to the residence cannot thereafter be increased above $150,000 (except by indebtedness incurred to substantially improve the residence). For instance, if the taxpayer refinances the $150,000 remaining, adding $20,000 for a new kitchen to the $150,000 for a total loan of $170,000, interest on the total $170,000 would be deductible as the additional indebtedness was incurred to substantially improve the home.
Q9. Many credit union members are small business owners. Has the deduction for small business loans changed?
The TCJA preserves the deduction for interest on small business loans, including ones made by credit unions. Small businesses with average annual gross revenue that does not exceed $25 million will still be able to deduct interest paid or accrued on their small business loan.
Q10. Are there changes to Unrelated Business Income Tax (UBIT) for state-chartered credit unions?
In its December 2017 whitepaper titled “Tax Reform as Reported by the Conference Committee,” CUNA discusses the issue of UBIT.
The IRS requires that state-chartered credit unions file annual Form 990s, like most other tax-exempt entities. These credit unions must also file a Form 990-T (UBIT Form) if the tax-exempt entity has $1,000 or more of unrelated business taxable income to report. The bill would require tax-exempt organizations currently subject to UBIT (including state-chartered credit unions) to pay UBIT on certain employee fringe benefits, namely transportation and parking benefits, as well as on-site gyms and athletic facilities. In this legislation, any taxpaying entity is no longer allowed to deduct these and other employee benefits. The bill places this new burden on exempt organizations and shall apply to amounts paid or incurred after December 31, 2017. The corporate deduction for business-related entertainment expenses would also be eliminated. Meals provided to employees would continue to be deductible until 2025. When provided by a tax-exempt entity, such fringe benefits would be considered unrelated business income and therefore taxable.
CUNA remains concerned that this vague language could be interpreted to apply to association membership dues. With regard to the above paragraph, CUNA also seeks clarification from the IRS as to whether not-for-profit organizations that are already deducting these expenses against its UBIT income would then no longer be able to do so. This would then increase its UBIT income and taxes. This bill does not appear to make these provisions as taxable as UBIT standing alone. Under current law, when a tax-exempt organization operates more than one unrelated trade or business activity, losses generated by one business may be used to offset income derived from another. Under the TCJA, losses generated by one unrelated trade or business could not be used to offset income derived from another unrelated trade or business. This provision would result in an increase in unrelated business taxable income. A net operating loss (NOL) deduction would be allowed only for the entity where the income loss originated. This provision is effective for taxable years beginning after December 31, 2017. Under a transition rule that has been added to the bill, net operating losses that occurred before January 1, 2018 and that are carried forward to a taxable year beginning on or after such date would not be subject to this provision.2
1This communication should not be considered legal advice. If your credit union has additional questions or concerns please consult with legal counsel or your CPA firm.
2CUNA Whitepaper, “Tax Reform as Reported by the Conference Committee,” December 2017