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Musings: The New Tax Law and Governor Brown

Rick Roeder       January 2018

The 2017 “accomplishment” of the Trump Administration was to pass the most wide-ranging tax bill since 1986. The merits of the tax bill have been highly debated. Some think tanks believe that the bill will add long-term debt to government coffers: To the tune of an estimated trillion or so. Others have criticized that the tax cuts for individuals are temporary whereas the corporate tax rates are permanent. One potential benefit of the bill is the repatriation of corporate monies stashed abroad due to lower corporate rates. Top corporate rates plummeted from 35% to 21%.

Republicans were clearly aware that states with pricey real estate such as California, New York and Massachusetts are bastions of Democrat voters. How can you tell? Let us count the ways. First, the maximum deduction for interest on new purchases is now based on a mortgage ceiling of $750,000 instead of the previous ceiling of $1,000,000. The cutback proved to be less severe than the initial House of Representatives bill which would have slashed the mortgage cap to $500,000. If you live in Kansas or Mississippi, such reduction is almost never relevant. However, when a non-descript starter home in San Mateo is now on the market for over a million dollars, the significant loss of the interest deduction will be a potential issue for expensive housing markets. (Editor’s note: Given Tom Brady’s latest comeback victory and his prep career at San Mateo’s Junipero Serra, the author felt compelled to use a San Mateo example). Interest deductions on home equity loans have been eliminated. Will these changes be enough to slow down the raging California real estate market? We’ll see.

Valuable real estate was impacted in a third way. State and local property tax deductions are limited to $10,000, another shot at the two Coasts. Four million taxpayers are estimated to be impacted by this change. However, there is some compensating relief for certain high income earners. One of the underreported aspects of the new tax law are two significant changes to the alternative minimum tax (“AMT”). This will help reduce or eliminate the AMT impact for the 4.4 million impacted by the AMT before the tax bill. Most impacted by the AMT are in the $200,000-$500,000 earning range. The AMT income exemptions have markedly increased by roughly 30%. For married households, the AMT income exemption has increased from $84,500 to $104,900. In addition, the income thresholds at which the dollar exemption starts to phase out has increased. We note that if either political party was truly interested in tax simplification, the AMT would be one of the first elements to be eliminated. We do know that the AMT calculations alone would be difficult to put on a post card.

The top individual tax rate was only slightly reduced from 39.6% to 37%. Donald Trump railed against a “carried interest” loophole in his Presidential campaign. This allows a hedge fund manager to be compensated from a fund on a basis that earnings are capital gains instead of ordinary income. Given that the capital gains rate is currently 23.8%, this represented a significant tax break for Wall Street. Over Trump’s objections, carried interest remains alive and well, although the minimum asset holding period was lengthened to 3 years.

So, was Trump a loser in the tax bill? Au contraire, those in the commercial real estate business may have been the biggest winners. Not only was the depreciation period on buildings significantly shortened to 25 years, the cap on immediate expensing of certain improvements (as opposed to establishing a new depreciation base) was doubled from $500,000 to $1,000,000.

When 1986’s sweeping tax changes passed, a significant tax credit was created for construction of affordable housing for low income families. The credit proved so successful as to evolve into a $9 billion/year social program. However, with the lowering of corporate tax rates, the credit becomes less tax effective. Some feel that the lower corporate rates will put a big dent in the creation of added low-income housing. America has already seen an unfortunate explosion in homelessness. If the projections come true that the growth of subsidized housing will be reduced by 225,000 units over the next decade, an undesired and unintended byproduct of lowered corporate tax rates will occur.

There are a number of subtle changes to the law which will have impact not capable of immediate measurement. For example, one item came to the attention to yours truly, having written a book on college football history (College Football Odyssey is an ebook in its 2nd edition on Amazon). High profile college football programs are upset about the change in treatment of personal seat licenses. For numerous teams that have a high demand for season tickets, buying a season ticket is not a straight forward process. To have such “privilege”, buying a personal seat license can be a prerequisite. In some cases, this license is so pricey that it makes the face value of the tickets look like comparative chump change. Prior to the tax law change, 80% of the personal seat license was deductible. Eliminated! We imagine there will be a number of such areas of unintended impact.

Back in California, a political living legend, Jerry Brown, has embraced the Kris Kristofferson lyric, “Freedom is another word for nothing left to lose.,” Skyrocketing pension costs have been crippling the ability of many entities’ ongoing ability to provide basic services. When Brown led the march for the state legislature to pass “PEPRA” in 2012, benefits were significantly lowered for post- January 1, 2013 hires. What was the immediate effect on skyrocketing pension contributions for affected California entities. Nada. Since the changes were limited to new hires, the impact would only be gradual, not Brown’s desired, immediate antidote. Why not do something more immediate, one might ask: Because the legislature’s hands were tied. Under the “California Rule, “ established in the 1950’s, the vesting rules protect just not the higher benefits associated with past service but also with potential future service. Thus, if you were hired in December 2012, you are grandfathered in a higher benefit formula even if your retirement date does not occur until 2050. In the private sector, no comparable law has ever existed which protects potential prospective benefits. Even with PEPRA’s passage, the state’s two gargantuan pension plans, CalPERS and CalSTRS, currently have a combined unfunded liability of $250+ billion. Many of the state’s 35 other independent retirement systems and the local CalPERS contracting agencies face similar funding challenges.

Brown’s willingness to take actions frowned upon by numerous unions were steps most Democrats would not dare to do. In addition to the benefit cutbacks for post-2012 hires, the PEPRA bill contained some “take aways’ for otherwise grandfathered employees. Certain safety employees were forced to make additional employee contributions. Definitions of allowable pension pay were tightened in an effort to curtail the “spiking” of pay during a member’s final average compensation period. Employees were no longer allowed to purchase additional years of service (aka “air time”). Various unions filed lawsuits in regard to such “take aways,” taking the reasonable position that there was no compensating added benefit that would satisfy the provisions of the California Rule. The application of the California Rule will be critical in the state Supreme Court’s coming decisions.

Jerry Brown, a Democrat in one of the few states where labor still retains very strong clout, has minced no words in taking on the California Rule, opining that pension costs should not be so high as to compromise other essential services. Brown’s stance may be influenced by the reality that the spunky 79-year-old will not be running for any more political offices. To date, Brown has been successful in getting favorable rulings from the lower courts in overturning the California Rule in these fact situations. The Supreme Court’s coming ruling will undoubtedly reverberate with numerous other states with similar laws. Stay tuned.

Jerry Brown has often defied orthodox stereotypes the public imposes on a politician. Shortly after Brown became the one of the youngest Governors in California’s history in 1975, he received notoriety for being in a high-profile relationship with singing diva, Linda Ronstadt. (Remember that dating a pop star defied the political norms of that period. Such time was well before the Clinton and Trump White Houses shattered those norms). Despite such notoriety, Brown developed a reputation for his frugality, in contrast to the stereotype that Democrats, legislatively, tend to be bigger spenders than their Republican brethren. Most folks approaching their 80th birthday are content to go quietly into the night. Not Brown. He has been the anti-Trump in terms of attempting to aggressively deal with global warming and embracing California as a state of “sanctuary.” In 2017, California sued the Trump administration no less than 17 times. The Sacramento-Trump war is not abating in 2018 as legislators are taking clear aim at Trump’s attempts to overturn “net neutrality.”

Brown is openly scornful of the new tax law, labeling the bill as an “assault by Congress on California.” Being the son of a governor, Pat, who beat a guy named Richard Nixon in the 1962 gubernatorial race, Jerry had a lot to live up to. By most accounts, he clearly has done so.

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