Higher inflation is mixed news for taxpayers
Many federal tax breaks will increase in 2027. Others stay stagnant, as they have for years. Income tax brackets will be wider in 2027 because they are annually indexed to inflation. Other tax breaks could also rise. Among them: Standard deductions. Child tax credit. Adoption credit. AMT exemptions. Income limits on U.S. savings bonds that are used for education. Annual gift-tax exclusion. Lifetime estate-and-gift-tax exemption. Income levels for figuring whether long-term capital gains are taxed at 0%, 15% or 20%. The foreign earned income exclusion. And many more breaks. A stealth 2017 tax hike takes away some of the inflation tax benefits.
The Chained CPI-U is used to adjust tax items for inflation. Before 2018, annual inflation adjustments for the tax brackets and other write-offs were based on the Consumer Price Index for All Urban Consumers (CPI-U). Economists argued that the CPI-U tends to overstate actual inflation because the formula doesn’t account for how people change their spending patterns as prices rise. The economists claimed that the Chained CPI-U is a better inflation measure. As a result, the 2017 tax law permanently changed the inflation indexing from the CPI-U to the Chained CPI-U. Using the Chained CPI-U results in a bit lower yearly inflation adjustments… And thus smaller annual increases to tax breaks, with lasting effects over time.
Many tax breaks and income levels aren’t indexed to inflation each year. A prime example is the home-sale exclusion. Since 1997, individuals who own and use a home as their primary residence for at least two of the five years before the sale can exclude from taxable income up to $250,000 of the gain…$500,000 for joint filers. These figures might seem high, but they have never been adjusted for the appreciation in residential real estate during this tax break’s 30-year history. Some lawmakers want to increase the home-sale gain-exclusion amounts. Bicameral legislation...identical proposals introduced by Rep. Jimmy Panetta (D-CA) and Sen. John Cornyn (R-TX)...would hike the exclusion to $500,000…$1 million for joint filers. Both bills would also index these amounts to inflation each year. The odds of enactment into law are a bit better than they have been in past years. But it’s still a steep climb. Neither bill will be enacted as stand-alone legislation, so it must be attached to a bigger tax package or to a must-pass priority. Meanwhile, Republican proposals to make all home-sale gains fully tax-free are going nowhere.
Among other key tax items not annually indexed to inflation: Income levels for the 3.8% net investment income tax. Income amounts for figuring whether people are hit with the 0.9% Medicare surtax on earned income. Provisional income thresholds at which Social Security benefits start getting taxed. Modified adjusted gross incomes for determining whether landlords can deduct up to $25,000 of their rental losses. The $750,000 home acquisition debt limit for deductible mortgage interest. Plus more.
