New law’s effect on income tax

If California decides not to conform to federal code, it might pay off to itemize on state return

Even if your federal taxes go down or up as a result of the federal tax overhaul, your California income taxes generally won’t change unless the Legislature passes a bill adopting some or all of the federal changes.

Absent what is known as a conformity bill, some Californians who switch from itemizing deductions to taking the standard deduction on their federal tax return may find it worthwhile to continue itemizing on their statetax return.

“Taxpayers should still remember the old rules and save their receipts, as they may be able to deduct expenses on their California return even though federal law allows no deduction,” said Richard Pon, a San Francisco CPA.

Like many states, California bases its tax code on the Internal Revenue code, but has never followed it to a T. When Congress changes federal law, California does not automatically follow suit except in very limited cases — the notable one being retirement-savings provisions. For other changes, the Legislature must vote to adopt them.

The last time California conformed to the federal tax code was Jan. 1, 2015, but there are still many differences, large and small.

For example, California taxes most dividends and long-term capital gains at the same rate as ordinary income; under federal law they are taxed at a lower rate. Teachers can deduct up to $250 in unreimbursed classroom expenses on their federal return, but not on their

state return. If you itemize, you can deduct state and local income and property taxes on your federal return (although the amount will be limited starting this year); on your state return you can deduct property tax but not state income taxes.

California has always maintained its own tax rate schedule, and even though conformity bills never change rates, they can affect how much you pay in state tax if they change what you can or cannot deduct.

The Republican tax overhaul signed into law on Dec. 22 makes major changes that take effect with tax year 2018. It lowers tax rates, limits or eliminates many deductions, roughly doubles the standard deduction to $24,000 for married couples and $12,000 for singles and does away with personal exemptions.

Many people who previously itemized on their federal return will take the standard deduction. But they still could be better off itemizing on their state return, depending on their individual circumstances and how California responds.

Under the old law, taxpayers could deduct 100 percent of their state and local taxes — including income and property taxes — as an itemized deduction on their federal return. Under the new law, they can deduct a total of $10,000 in state and local taxes combined, whether they are single or married filing jointly.

A married couple would need more than $14,000 in other deductions — such as mortgage interest and charitable contributions — to make itemizing worthwhile on a federal return. On a California return, they still couldn’t deduct their state income tax but they could deduct 100 percent of their property tax, assuming California does not conform. The property tax deduction alone could put some homeowners over California’s standard deduction — which for 2017 is $4,236 for singles and $8,472 for married filing jointly.

They could also deduct interest on up to $1 million in mortgage debt on one or two homes and up to $100,000 in home-equity debt not used to buy or improve a home on their state return, again assuming California does not conform. The federal law eliminates the home-equity deduction entirely and limits the mortgage interest deduction to interest on up to $750,000 in debt used to buy or improve a home purchased after Dec. 14, 2017.

State lawmakers are just beginning to ponder how the biggest federal tax overhaul in three decades will affect California and what they should do about it. On Wednesday, the Senate Governance and Finance Committee will hear from the Franchise Tax Board about conformity issues.

Although the federal tax law eliminates some deductions and the personal exemption you can claim for each member of the household, most Americans will pay less because it also cuts rates. If California conformed to the new federal law without cutting its own tax rates, most people would pay more in state income taxes.

“Nonconformity would help most taxpayers,” Pon said.

Some people, however, could benefit from conformity. The federal law creates a new deduction for independent contractors, sole proprietors and owners of partnerships and other pass-through entities whose business income is taxed at their personal rate (instead of the corporate rate, which is coming way down). Under the new law, they can deduct 20 percent of their business income on their federal taxes, subject to income and other limits.

The federal law has other provisions some people may like, such as the ability to use tax-free money from 529 college savings plans to pay for private schools, including religious ones. If California does not conform, that money would be taxable on state returns, Pon said.

Not conforming to the federal law will create headaches for tax preparers and taxpayers who would have to operate under two very different sets of rules. The Franchise Tax Board might even have to come up with a state version of Schedule A, the federal form for itemized deductions, said Renée Rodda, a vice president with Spidell Publishing.

As it has done in the past, the Legislature could adopt some parts of the federal tax law, but not others. “They could say we are going to still allow the deduction for $1 million in mortgage interest or not conform to the partnership deduction,” said William Gorrod, a tax attorney with Greenberg Traurig. The mortgage interest deduction is a likely survivor “because home values are a big deal here.”

Because the tax law was crafted entirely by Republicans and the California Legislature is overwhelmingly Democratic, adopting any part of the law will be politically challenging. “Even if they conform a little, they are going to say they are not conforming,” said attorney Brad Marsh, also with Greenberg Traurig.

“Taxpayers should still remember the old rules and save their receipts, as they may be able to deduct expenses on their California return even though federal law allows no deduction.” Richard Pon, San Francisco CPA