2018 is starting to draw to a close, and some people are looking forward to the prospect of filing their first tax returns under new tax reform laws. With the promise of lower tax rates and higher standard deductions, a healthy swath of the taxpayer population will likely see smaller tax bills this time around.
One controversial aspect of tax reform, however, looked like it might punish some taxpayers. Through the tax reform legislation's new $10,000 limits on the itemized deduction for state and local tax payments every year, upper-income taxpayers in high-tax states found themselves dealing with the disappearance of what for many was their biggest tax write-off.
As it turns out, though, the negative impact of the state and local tax deduction limits won't be as big as one might think. That's because for many of those taxpayers, state and local tax deductions only served the purpose of putting them into a completely different situation: one in which they had to pay alternative minimum tax.
What the AMT is
The alternative minimum tax came into being in the early 1980s, and the goal that lawmakers had when they created the AMT was to ensure that every taxpayer paid at least some minimum amount of tax to the federal government. Under old tax laws, there were many more deductions and other tax breaks available to taxpayers, and high-income earners could often take full advantage of these deductions to zero out their regular tax liability.
The AMT imposed a completely different set of rules on the tax process. It had lower tax rates than the regular income tax at the time it was created, but it refused to recognize many of the write-offs that taxpayers could use on their regular returns. The result was that for many upper-income households, AMT was higher than the ordinary tax, and so they were responsible for paying the full AMT amount.
Why state and local taxes played a big role with AMT
The reason why the AMT discussion is relevant here is that state and local tax payments are one of the items that the rules governing alternative minimum tax never recognized. Those who took itemized deductions for state and local taxes had to add those amounts back to their taxable income for purposes of determining potential AMT liability.
Under previous law, state and local tax deductions were a primary reason for many taxpayers -- especially those in high-tax states -- having to pay alternative minimum tax in the first place. Therefore, to the extent that a limit on deducting state and local tax payments for regular tax purposes leads to a higher tax liability, the only practical effect is replace what those taxpayers were paying on AMT in the past. In other words, because AMT payers didn't get a tax break for their state and local tax payments before tax reform, the fact that new tax laws limit the tax break for regular taxpayers doesn't really affect them.
The AMT's last gasp
Interestingly, another impact of tax reform was basically to defang the alternative minimum tax's bite. Lawmakers weren't able to repeal the AMT entirely, but tax reform did two things to make it essentially harmless: raising the exemptions before the AMT starts to apply, and increasing the income limits above which phasing out of the AMT exemptions begins.
The combination of those two factors makes it exceedingly rare for taxpayers to be subject to AMT. Either taxpayers make enough that the regular tax rates are higher than the AMT tax rates, or they make little enough that the AMT exemption effectively prevents them from having to pay extra tax. In either case, what's left is the regular tax liability due.
Look at your taxes
It'll be an eye-opening experience for taxpayers early next year when they file their 2018 tax returns. Even if you previously claimed full deductions for state and local taxes that will be taken away, it's entirely possible that you'll still end up ahead under tax reform -- especially if you were paying alternative minimum tax on previous returns.
The Motley Fool has a disclosure policy.