Tax Reform Act of 1986

Why it happened

By the mid-1980s the income tax had fourteen brackets, a top rate of 50%, and a shelter industry built on using paper losses from real estate, cattle, equipment leasing and oil to offset salaries. Senator Bill Bradley, a Democrat, had argued since 1982 for trading the preferences for a top rate near 30%; a Republican version followed; Reagan asked Treasury for a plan in his 1984 State of the Union and endorsed it in 1985. The bill nearly died twice. In December 1985 House Republicans voted down the rule and Reagan went to the Capitol in person to revive Dan Rostenkowski’s bill. In April 1986 Senate Finance chairman Bob Packwood abandoned a markup that was adding loopholes faster than it removed them, drafted a far simpler plan over lunch, and brought his committee to a 20–0 vote. The Senate passed it 97–3. The story is told in Showdown at Gucci Gulch, named for the corridor where the lobbyists waited.

The design rule was that the bill raise the same total revenue as before and tax each income group about the same in total — but with far lower rates and far fewer ways around them. About $120 billion over five years shifted from individuals to corporations.

What it did — individuals

• Two rates: 15% and 28%, from 1988, replacing fourteen brackets from 11% to 50%. (1987 was a transition year with five rates.) A 5% surcharge phased out the benefit of the 15% bracket and the exemptions for upper incomes, producing a 33% “bubble” over a range of income before the rate dropped back to 28% at the top.
• The capital gains preference eliminated. The 60% exclusion was repealed and gains were taxed as ordinary income, which at the top meant 28% instead of 20%. (Lower rates for gains came back in 1990 and have been part of the law ever since.)
• The passive activity loss rules (section 469). Losses from rental property and from businesses the taxpayer does not materially participate in could no longer offset wages, interest or dividends — only other passive income, or carried forward until the property is sold. The one exception was $25,000 of rental losses for an owner who actively participates, phasing out between $100,000 and $150,000 of income. Those dollar figures have never been changed. With the longer 27.5- and 31.5-year depreciation lives, this ended the real estate tax shelter and is the reason our rental property page reads the way it does.
• No more deduction for consumer interest — credit cards, car loans, student loans — phased out by 1991. Mortgage interest survived, limited to the home.
• Repealed: the two-earner deduction, income averaging, the sales tax deduction, the exclusion for unemployment benefits. The medical floor rose from 5% to 7.5%; a 2% floor was put under miscellaneous deductions; meals and entertainment were cut to 80%.
• A bigger exemption and standard deduction. The personal exemption nearly doubled to $2,000 by 1989; the standard deduction became a flat $5,000 for a couple; the earned income credit was raised and, for the first time, indexed. About six million low-income people were taken off the income tax rolls.
• IRA deduction limited for people covered by an employer plan, phasing out between $40,000 and $50,000 of income on a joint return — the origin of the nondeductible IRA and Form 8606.
• Social Security numbers required for dependents age five and over. Seven million dependents disappeared from returns the following year.

What it did — business

• Corporate rate from 46% to 34%, with graduated rates on the first $75,000. The dividends-received deduction was reduced, and a corporation that distributed or sold appreciated assets in liquidation now paid tax on the gain (the repeal of the General Utilities doctrine) — one reason S corporations became the dominant form for small businesses after 1986.
• The investment credit repealed for good, and ACRS replaced by MACRS: 3- to 20-year classes for equipment, 27.5 years for residential rental property and 31.5 (now 39) for other buildings. Section 179 was set at $10,000.
• The AMT rebuilt at 21% for individuals and, new, 20% for corporations, with a broader base.
• The low-income housing credit created; a deduction for self-employed health insurance begun at 25% (100% since 2003).

What has since been undone

The two-bracket structure lasted four years: 1990 added a 31% rate, 1993 added 36% and 39.6%, and there are seven brackets today. The capital gains preference returned in 1990 and has widened since. The sales tax deduction came back in 2004 as an option; the 2% floor on miscellaneous deductions was suspended in 2018 and repealed in 2025; the personal exemption is zero. The corporate rate is 21%.

What stayed is the base-broadening: the passive loss rules, the end of personal interest, MACRS, the IRA income limits, Social Security numbers for dependents, the limits on meals, and the principle that a lower rate on more income beats a high rate riddled with exceptions. Every reform since has been argued in those terms.

What it meant

A couple with two children and $30,000 of wages in 1988 paid a flat 15% after a $5,000 standard deduction and $7,800 of exemptions, could no longer deduct the interest on the car loan, and lost the two-earner deduction — a modest cut for most middle-income families, and no tax at all for the six million at the bottom. A dentist who had bought into an apartment partnership for the losses found, after a four-year phase-in, that the losses no longer offset his practice income. A landlord managing her own duplex kept $25,000 of losses only while her income stayed under $100,000, and still does.