BY JUSTIN MASON AND CASEY TOM
The War Revenue Act of 1917 authorized the first tax deduction for charitable giving. Since that time, charitable tax deductions for giving have incentivized taxpayers to make charitable contributions to minimize their overall federal tax liability. One hundred years later, in 2017, the passage of the Tax Cuts and Jobs Act (TCJA) may have a significant impact on the tax benefit of making charitable contributions. Changes have paved the way for additional planning opportunities regarding charitable contributions for 2018 and beyond.
Under the TCJA, we have seen an expansion of the standard deduction and a cap placed on the state and local income tax (SALT) deduction. Combined, these changes have made it more difficult for taxpayers to clear the hurdle of the standard deduction in order to itemize deductions. It is estimated that as many as 90% of households will no longer itemize deductions and will simply claim the standard deduction. Because of this, many taxpayers will no longer receive an additional tax benefit from their charitable deductions that they previously received.
For 2018, the standard deduction has been raised to $12,000 for individuals and $24,000 for married couples filing jointly. These are significant increases from 2017, which allowed for a standard deduction of $6,350 for individuals and $12,700 for married couples filing jointly. This can be attributed to a consolidation of the eliminated $4,050-per-individual personal exemption and the standard deduction.
As mentioned above, the TCJA of 2017 has also placed a cap on the state and local tax deductions. What this means is that the sum of state income taxes and property taxes will provide no additional tax benefit above a level of $10,000.
Below is a graph with a simple comparison of two identical situations from 2017 and 2018. For this example, we are assuming state taxes of $9,900, property taxes of $10,000, mortgage interest of $7,500 and charitable contributions of $5,000. In 2017, the household easily clears the standard deduction of $12,700 and was able to take full advantage of their state and property taxes, along with their charitable contributions.
For 2018, with the expansion of the standard deduction – combined with the $10,000 SALT cap – will have the household claiming the standard deduction of $24,000 as opposed to itemizing. This means that for the $5,000 contributed to charity in 2018, the household effectively receives no tax benefit.
However, with proper planning and the use of a donor advised fund, it is possible for this household to receive the tax benefit of their charitable contributions.
Although donor advised funds were originally recognized under the Tax Reform Act of 1969, it seems that more recently, their planning benefits are being utilized more commonly. Prior to TCJA, their primary use was to make large charitable donations to offset income in years in which a taxpayer’s income was going to be higher than usual. One can think of years in which a business may be sold, a year in which an executive was to exercise stock options, etc. The substantial increase in income presented to accelerate future charitable contributions into the present year.
Under the TCJA of 2017, the planning benefits of a donor advised fund have become increasing important. To summarize how they work, a taxpayer first establishes an account with a charitable fund. Major custodians, such as Charles Schwab, Fidelity, Vanguard, etc. as well as local organizations, such as the Community Foundation for the Land of Lincoln, can provide taxpayers with such accounts. Once established, the taxpayer will make a large irrevocable donation, representing some level of future charitable intent, enough to get over the hurdle of the standard deduction. Often times, we look at three, five or even 10 years of future contributions.
The taxpayer will receive the entire amount as a tax deduction, in the year of contribution. The taxpayer can then make contributions to charitable organizations over multiple years, albeit without additional tax deductions in subsequent years, due to the receipt of the deduction in the year of contribution.
In the second graph, the taxpayer chooses to accelerate the next five years of annual contributions into the present at $25,000 (five years at $5,000 per year). The acceleration of these contributions into the donor advised fund allows the taxpayer to total deductions of $42,500, easily clearing the standard deduction hurdle and allow them to receive the benefit of their entire charitable contributions.
Once contributed, the assets could then be distributed out to charities, by the taxpayer, at an amount equal to $5,000 per year over the next five years. In each of the next five years, the taxpayer would then claim the standard deduction.
This method of contributing to a donor advised fund works with cash contributions; however, if the taxpayer can use appreciated securities from a taxable investment account then the taxpayer also receives the tax benefit of avoiding tax on the gain of the appreciated securities. This is where the planning benefit of a donor advised fund really shines.
The expansion of the standard deduction, coupled with the cap on the state and local tax deduction, has decreased many taxpayers’ abilities to clear the level of the standard deduction. For charitable taxpayers, in many cases, this has taken away the tax benefit incentive for charitable contributions. Using a donor advised fund and proper planning techniques, a taxpayer may still be able to take advantage of their charitable intent and receive a tax benefit.
* The above example is simplified for context. Every individual situation is different and requires consideration. It is always important to consult with a qualified financial advisor and tax professional to assess your specific situation. Investment Advisory services provided by KEB Asset Management, LLC, a fee-only registered investment advisor. Tax and Accounting services provided by Kerber, Eck, & Braeckel LLP.
Justin Mason is a CFP and wealth advisor with KEB Asset Management, LLC. Casey Tom is a CPA and senior tax manager with Kerber, Eck, & Braeckel, LLP.