On September 1, 2018, the California State Legislature adjourned without conforming the California State Income Tax to any part of the Republican Federal Tax Law, known as the Tax Cuts & Jobs Act, passed last December. Consequently, the federal law will not cause Californians to pay more in state income tax for 2018 (more below on what they could have changed), but the new tax code will nevertheless have a substantive impact on many Californians — they will be paying a lot more in federal taxes come April 15, 2019.
State and Local Taxes (SALT)
One of the biggest changes from the new federal law is a severe limit on state and local tax (SALT) deductions. Under the previous federal law, SALT deductions were unlimited for individuals and families — Californians could deduct all of their state income taxes and all of their property taxes on their federal returns. Yet under the new federal law, SALT deductions are limited to $10,000. This can have significant consequences for taxpayers in states with high state taxes and those with high home values. These circumstances might just sound familiar to some Bay Area residents.
Let’s take Oakland residents John and Sally as an example. For their joint income, they owe $95,000 to the state. They also owe $20,000 in property tax to Alameda County, so their SALT total = $115,000. Before the new federal law, John and Sally could deduct all $115,000 from their federal income tax. Now that the limit has plummeted to $10,000, John and Sally have $105,000 in non-deductible state and local taxes and will consequently owe an additional $40,000 in federal income tax. That is quite a leap from what they would have paid in 2017.
Capital Gain, Standard Deduction, and Personal Exemption
There are several ways that the California income tax code does not conform to the new federal law. California taxes long-term capital gains as ordinary income; federal law taxes long-term capital gains at a lower, or “preferential”, rate. Congress nearly doubled the standard deduction to $24,000 for couples and $12,000 for singles. At the same time, they eliminated the personal exemption, which amounted to a $4,050 deduction for each person listed on the federal return including dependents. However, California state taxes will not conform to this elimination of the personal exemption; even though Congress killed it at the federal level, California taxpayers can still claim that $4,050 exemption deduction for themselves and their dependents on their state return in addition to the new, higher standard deduction on their federal return.
Starting in 2018, the new federal tax law limits the mortgage balance up to which taxpayers can deduct the interest to only $750,000 on a first or second home. The prior law set the limit at the interest on $1 million in mortgage debt. Homeowners who were at the $1 million limit prior to 2018 will be grandfathered in for deducting interest at that level. For anyone starting a new mortgage in 2018, the limit is $750,000.
In contrast, on their state returns a California taxpayer can still deduct interest on up to $1 million in mortgage debt used to buy or improve a first or second residence, along with $100,000 in home equity debt that was not used to buy or improve a home. The federal law allows zero interest deduction on home equity debt not used to improve a home.
Experts expect some breakdowns for people using software to file 2018 returns and even more trouble for people doing their own returns unassisted.
Acknowledgment to Pender, Kathleen. “Federal law won’t raise California income taxes” SF Chronicle 8 Sept. 2018
Our readers can find further analysis and explanation of these tax code changes in my multi-part series, “What is Relevant About the New Tax Law?” on the Bell Finance Blog. Those can be found on our website, www.bellinvest.com.