What Was the Tax Reform Act of 1986? Rates, Deductions, and Shelters

The Tax Reform Act of 1986 was the most sweeping rewrite of the federal income tax code in decades, signed by President Ronald Reagan on October 22, 1986. It collapsed the individual rate structure from as many as 15 brackets down to two (15 percent and 28 percent), cut the top corporate rate from 46 percent to 34 percent, and paid for those lower rates by eliminating or scaling back a long list of deductions, credits, and shelters.¹² The bargain running through the law was simple: broaden the base, lower the rates, and stop the tax code from steering economic decisions.

Lower Individual Rates and the Bubble

Before the reform, individuals faced up to 15 rate brackets and a top marginal rate of 50 percent.² The new law replaced that structure with 15 percent on lower income and 28 percent above a threshold.

To keep the change revenue-neutral, Congress inserted a 33 percent “bubble” rate that applied to a slice of upper-income taxpayers’ income. The bubble phased out the benefit of the 15 percent bracket and the personal exemption for higher earners; once the phase-out finished, the effective rate settled back to 28 percent. So while the headline top rate was 28 percent, some wealthy filers temporarily paid 33 percent on part of their income.

A Bigger Standard Deduction and Personal Exemption

Because so many deductions were being cut, the law raised the two provisions that shield income for nearly every household. The personal exemption climbed from $1,080 in 1986 to $1,900 in 1987 and reached $2,000 by 1989, an increase of roughly 85 percent. Combined with a larger standard deduction, the change lifted millions of low-income families off the tax rolls entirely and let far more filers skip itemizing.

Deductions Cut, Restricted, or Capped

The base-broadening side of the deal hit a familiar set of write-offs.

Interest on credit cards, auto loans, and other personal debt was phased out over five years, from 65 percent deductible in 1987 down to zero by 1991.³
The deduction for state and local sales taxes was repealed, though state and local income taxes and property taxes remained deductible.
Miscellaneous itemized deductions (unreimbursed work expenses, tax-preparation fees, certain investment costs) could only be claimed to the extent they exceeded 2 percent of adjusted gross income.⁴
Unreimbursed employee expenses, previously deducted directly from gross income, were folded into that miscellaneous category and became much harder to claim.

The mortgage interest deduction survived, a deliberate choice to protect homeownership incentives, but for the first time Congress placed a ceiling on it. Loans taken out on or before October 13, 1987 were grandfathered with full deductibility. Debt incurred after that date became subject to caps that have since been revised by later legislation.⁵

Corporate Rate Cut, Investment Credit Gone

The top corporate rate fell from 46 percent to 34 percent, and the number of corporate brackets shrank from five to three.² The lower headline rate came with two significant tradeoffs. The investment tax credit, which had let businesses subtract a percentage of equipment costs directly from their tax bill, was permanently repealed. And the Modified Accelerated Cost Recovery System (MACRS) lengthened the periods over which companies could depreciate machinery and buildings, spreading write-offs across more years.

The design goal was to hold overall corporate tax revenue roughly steady while ending the code’s habit of favoring specific investments. Companies that had leaned heavily on targeted credits paid more; companies closer to the full statutory rate paid less.

Capital Gains and the End of Passive-Loss Shelters

Long-term capital gains had enjoyed an exclusion that effectively capped the rate on investment profits at 20 percent. The reform ended that preference and taxed capital gains as ordinary income, bringing the effective top rate on gains to 28 percent.

More consequential was the new passive activity loss rule. Real estate partnerships and similar deals had produced paper losses that investors used to offset wages and other ordinary income. Under the new framework, if you did not materially participate in an activity (regular, continuous, and substantial involvement), losses from it could only offset income from other passive activities.⁶ Unused losses carry forward until you generate passive income or dispose of the investment, at which point suspended losses can finally be deducted.

A limited exception applies to middle-income landlords who actively participate in rental real estate. If your modified adjusted gross income is $100,000 or less, you can deduct up to $25,000 in rental losses against non-passive income; that allowance phases out between $100,000 and $150,000 and disappears above $150,000.⁷

Because investors had entered deals under the old rules, the passive loss restrictions were phased in over four years for pre-enactment investments. Only 65 percent of otherwise-disallowed losses were blocked in 1987, dropping to 40 percent in 1988, 20 percent in 1989, and 10 percent in 1990, with full restriction from 1991 forward.⁶

Retirement Account Changes

The annual employee contribution limit for 401(k) plans dropped from $30,000 to $7,000, a 77 percent cut. The new cap was indexed to inflation starting in 1988, so it rose gradually, but the initial reduction forced high earners to rework their retirement plans.

The law also restricted the traditional IRA deduction. Before 1986, anyone with earned income could deduct an IRA contribution regardless of workplace coverage. Under the new rules, if you or your spouse are covered by an employer retirement plan, the IRA deduction begins phasing out once income exceeds specified thresholds.⁸ The contribution itself remains allowed; the tax benefit shrinks or disappears as income rises. If neither spouse is covered by an employer plan, the full deduction still applies.

The Kiddie Tax

Parents had routinely shifted investment income to children in lower tax brackets by placing stocks or bonds in a child’s name. The 1986 law shut that strategy down. For children under age 14, the first $500 of unearned income was covered by the child’s standard deduction, the next $500 was taxed at the child’s rate, and any unearned income above $1,000 was taxed at the parent’s marginal rate.⁹ A child’s earned income from a job was still taxed at the child’s rate. The law also eliminated the personal exemption for any child claimed as a dependent on someone else’s return.

A Stronger Alternative Minimum Tax

The Alternative Minimum Tax runs parallel to the regular tax: you calculate liability both ways and pay the higher figure. The reform expanded the list of preference items that had to be added back into income for AMT purposes, including certain tax-exempt bond interest and accelerated depreciation. For corporations, the law replaced an older add-on minimum tax with a true alternative minimum tax at a flat 20 percent rate.¹⁰ The expanded AMT was designed as a backstop so that taxpayers using legal deductions and credits still owed some minimum amount.

A Bigger EITC for Low-Income Workers

At the bottom of the income scale, the reform expanded the refundable Earned Income Tax Credit. The phase-in rate rose to 14 percent, and the credit was indexed to inflation for the first time, so it would grow automatically each year rather than waiting on periodic congressional updates. Combined with the larger personal exemption and standard deduction, the changes were meant to keep families near or below the poverty line largely outside the federal income tax.

A Rush Into S-Corporation Status

One of the most striking effects of the law was structural. Before 1986, the top individual rate (50 percent) sat above the top corporate rate (46 percent), so many small businesses stayed C-corporations and kept profits inside the firm. After the reform flipped that ordering, with a 28 percent top individual rate and a 34 percent corporate rate, S-corporation status (which passes income through to owners’ personal returns) became more attractive. An estimated 144,000 C-corporations converted to S-corporation status for the 1987 tax year alone, about 26 percent of them in services, and roughly 69 percent had been profitable the year before.² The pull toward pass-through entities has continued in the decades since.

What Survived and What Didn’t

The two-bracket simplicity did not last. Congress began adding brackets and targeted breaks within a few years, and the preferential rate on long-term capital gains returned in the early 1990s. The Tax Cuts and Jobs Act of 2017 dropped the corporate rate to 21 percent and restructured the individual brackets again.

Several 1986 structures have proved durable. The passive activity loss rules under Section 469 still govern rental and other passive investment losses.⁶ The MACRS depreciation system, the kiddie tax, and the AMT framework all remain in place. The 2 percent floor on miscellaneous itemized deductions stayed on the books for more than 30 years until those deductions were suspended after 2017.⁴ And the shift toward pass-through business taxation that the law set off has only grown, reshaping how business income is taxed in the United States.

1
GovTrack.us. Tax Reform Act of 1986 (99th Congress H.R. 3838)
2
IRS. S Corporation Elections After the Tax Reform Act of 1986
3
Every CRS Report. Tax Reform Act of 1986: Public Law 99-514
4
Office of the Law Revision Counsel. 26 U.S. Code 67 – 2-Percent Floor on Miscellaneous Itemized Deductions
5
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
6
Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited
7
Internal Revenue Service. Instructions for Form 8582, Passive Activity Loss Limitations
8
Internal Revenue Service. Retirement Topics – IRA Contribution Limits
9
United States Senate Committee on Finance. The Real Effect of the Kiddie Tax Change
10
Internal Revenue Service. Corporate Alternative Minimum Tax, 1987-1990