What Was the 1986 Tax Reform Act and How Did It Change Taxes?

The Tax Reform Act of 1986 was one of the most significant overhauls of the U.S. tax code. Signed into law by President Ronald Reagan, it aimed to simplify the tax system, broaden the tax base, and eliminate many deductions while lowering overall rates. The reform sought to maintain government revenue while redistributing tax burdens more equitably.

This legislation introduced sweeping changes affecting individuals and businesses. It reshaped income tax brackets, adjusted corporate taxation, and revised various deductions and credits. Many of its provisions continue to influence tax policy today.

Individual Tax Rate Adjustments and Personal Exemptions

The Tax Reform Act of 1986 restructured income tax brackets and modified personal exemptions. Before the reform, the tax code had fifteen brackets, with the highest marginal rate at 50%. The new law condensed these into two primary rates: 15% and 28%. This aimed to reduce economic distortions caused by high marginal rates while making the system more transparent.

To offset revenue losses from lower rates, the legislation eliminated or reduced many deductions and tax shelters that had allowed high-income earners to lower their taxable income. At the same time, it increased the standard deduction and personal exemption amounts to provide relief for lower- and middle-income taxpayers. The personal exemption rose from $1,080 in 1986 to $2,000 by 1989, helping families retain more of their earnings.

The reform also phased out personal exemptions for high-income earners, ensuring wealthier individuals did not disproportionately benefit. Stricter rules on itemized deductions further limited their availability to high-income taxpayers, reducing advantages from tax planning strategies.

Corporate Rate Changes

The Tax Reform Act of 1986 lowered the top corporate tax rate from 46% to 34% while eliminating numerous deductions and loopholes businesses had used to reduce tax liability. This shift aimed to make the U.S. corporate tax system more competitive internationally and encourage investment.

To offset revenue losses, the legislation repealed the investment tax credit, which had allowed businesses to deduct a percentage of their investment in new equipment and machinery. Its elimination created a more neutral tax environment across industries.

The reform also placed stricter limits on corporate deductions for business expenses. Interest deductions on corporate debt were curtailed, reducing incentives for excessive borrowing. This particularly impacted leveraged buyouts, which had surged in popularity during the 1980s. By limiting interest deductions, the law sought to discourage excessive corporate debt accumulation, which could increase financial instability.

Additionally, the law expanded the corporate alternative minimum tax (AMT) to ensure profitable corporations could not use tax preferences to avoid federal income taxes entirely. This primarily affected large companies that had previously relied on deductions and credits to minimize tax obligations.

Alternative Minimum Tax Modifications

The Tax Reform Act of 1986 strengthened the Alternative Minimum Tax (AMT) to prevent high-income individuals and corporations from using deductions and credits to avoid taxes. The new law broadened the types of income and deductions subject to AMT calculations.

One key change was adjusting AMT exemption amounts and phase-out thresholds. The reform increased the exemption level but limited its availability for higher earners, ensuring more taxpayers were subject to AMT. Additionally, the law reduced the number of deductions allowable under AMT, including eliminating certain tax shelters and preference items like accelerated depreciation methods.

For corporations, the AMT revisions introduced a broader definition of taxable income, incorporating previously excluded earnings such as intangible drilling costs and tax-exempt interest from private activity bonds. These changes ensured that profitable businesses could not sidestep federal tax liabilities through aggressive accounting strategies.

Passive Activity Loss Rules

The Tax Reform Act of 1986 imposed strict limitations on passive activity losses (PALs) to curb tax avoidance strategies that had allowed investors to offset passive losses against active income. Before the reform, taxpayers could use losses from real estate, limited partnerships, and other passive investments to reduce taxable earnings, even if they had little to no direct involvement.

The new rules, codified under Internal Revenue Code Section 469, established that passive losses could only be deducted against passive income, preventing them from sheltering wages, salaries, or business profits where the taxpayer materially participated. Activities were classified as passive if the taxpayer did not meet specific material participation tests, such as working at least 500 hours annually in the business or being the primary decision-maker.

Rental real estate was automatically deemed passive unless the owner qualified as a real estate professional under strict IRS criteria. These changes particularly affected high-income investors who had previously leveraged tax shelters in real estate syndications, as they could no longer deduct paper losses from depreciation or interest expenses against earned income.

Depreciation Provisions

The Tax Reform Act of 1986 revised depreciation rules by introducing the Modified Accelerated Cost Recovery System (MACRS) to replace the previous Accelerated Cost Recovery System (ACRS). These changes affected industries that relied heavily on equipment, machinery, and real estate investments by altering how businesses could deduct the cost of capital assets over time.

MACRS established new asset classes with specific recovery periods, standardizing depreciation across different types of property. Commercial real estate was assigned a 31.5-year recovery period, later adjusted to 39 years under subsequent tax laws, while residential rental property was set at 27.5 years. This lengthened the time over which businesses could claim depreciation deductions, reducing the immediate tax benefits of purchasing long-term assets.

The reform also eliminated the investment tax credit, which had previously incentivized capital expenditures by allowing businesses to deduct a percentage of asset costs upfront. Additionally, it restricted accelerated depreciation methods for certain assets, particularly real estate. Before the reform, businesses could use highly favorable depreciation techniques, such as the 15-year cost recovery period for commercial buildings under ACRS, which allowed for rapid write-offs. The new law mandated the use of the straight-line method for most real property, ensuring deductions were spread evenly over the asset’s useful life rather than being front-loaded.

These adjustments reduced the ability of real estate investors to generate large paper losses in the early years of ownership, aligning with broader efforts to limit tax shelters and speculative investment strategies.