One thing, for sure, about the new tax bill is that real estate investors are big winners.
This article is not meant to be a comprehensive analysis of the new law. I have just excerpted some parts of the bill that I thought would be relevant to real estate investors.
Almost all of these changes begin on January 1, 2018, and revert in 2025.
- 10% Tax Bracket
- MFJ: $0 – $19,050
- Single: $0 – $9,525
- 12% Tax Bracket
- MFJ: $19,051 – $77,400
- Single: $9,526 – $38,700
- 22% Tax Bracket
- MFJ: $77,401 – $165,000
- Single: $38,701 – $82,500
- 24% Tax Bracket
- MFJ: $165,001 – $315,000
- Single: $82,501 – $157,500
- 32% Tax Bracket
- MFJ: $315,001 – $400,000
- Single: $157,501 – $200,000
- 35% Tax Bracket
- MFJ: $400,001 – $600,000
- Single: $200,001 – $500,000
- 37% Tax Bracket
- MFJ: $600,000+
- Single: $500,000+
Mortgage interest is now only deductible on the first $750,000 of acquisition debt on primary and secondary residences. There is a grandfather clause that allows all previously purchased residences to continue deducting their interest on up to $1,000,000 of debt. Mortgage interest on investment properties continues to be tax deductible without limitation.
Interest on home equity loans is no longer deductible unless the proceeds are used in a trade or business acquisition or to improve rentals. Home equity debt includes refinances on your primary or secondary residences as well as HELOCs.
State and local taxes are now limited to an aggregate $10,000 deduction. This includes state income and property taxes. Folks living in high-income, high-property-tax states, like California, New Jersey, and New York, will be negatively affected. If your state income tax is $12,000 and your state property tax is $8,000, you only get a maximum deduction of $10,000, even though your state and local taxes amount to $20,000 total.
Miscellaneous itemized deductions have been eliminated. This means that you can no longer deduct unreimbursed employee expenses and tax preparation fees (that are not allocated to prepping schedule C and E).
Medical expenses will be easier to claim as the 10% floor has been reduced to 7.5% of AGI. So if your AGI is $100,000, previously you had to incur at least $10,000 of medical expenses before they became deductible. Now you only have to incur $7,500.
Note: these deductions do not limit the ability to claim expenses on rental property. These changes are related only to your itemized deductions (Schedule A).
Standard Deduction and Personal Exemptions
The standard deduction will now be $12,000 for those filing single and $24,000 for those who are married and filing jointly. Personal exemptions have been eliminated.
Previously, a family of five would get a standard deduction of $12,700, and total personal exemptions of $20,250. Combined, this family received a total deduction of $32,950. Now their total deduction is only $24,000.
Child Tax Credit
To avoid mutiny from the above family of five above, the GOP has made changes to the child tax credit. The credit will increase from $1,000 to $2,000 per qualifying child. The refundable credit will increase to $1,400.
The income phaseouts have increased to $200,000 if single and $400,000 if married filing joint.
Alternative Minimum Tax (AMT)
Unfortunately for high-income earners and their tax preparers, the AMT is still in existence. The good news is that the exemption amounts have increased to $109,400 for married filing joint and $70,300 for all other taxpayers. Additionally, the phaseout thresholds are increased to $1,000,000 for married taxpayers filing a joint return, and $500,000 for all other taxpayers (other than estates and trusts). These amounts are indexed for inflation.
Obamacare Penalty Eliminated
The penalty for not having healthcare has been eliminated beginning in 2019. Healthy millennials who don’t want/need health insurance are high-fiving. Their parents are upset that their premiums will likely increase in 2019.
A new “freebie” deduction has been granted to sole proprietors, LLCs, and S corps generating qualified business income. If you are a partner in a business, you will receive the deduction based on your allocable ownership.
The deduction appears to be on an aggregated basis for rental properties but on a business-by-business basis for businesses.
The deduction is the sum of:
- The lesser of:
- Combined Qualified Business Income, or
- 20% of the excess of the taxable income divided by the sum of any net capital gain
- And the lesser of:
- 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer, or
- taxable income reduced by the net capital gain
In order to figure the above, we must know what combined qualified business income is.
Combined qualified business income is the lesser of:
- 20% of the qualified business income with respect to the qualified trade or business; or
- The greater of:
- 50% of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property
Let’s assume that you don’t have any capital gain or qualified cooperative dividends. We’ll also assume you own a rental property you purchased for $120,000, of which $100,000 was allocated to the building and $20,000 was allocated to the land. Furthermore, let’s assume that your rental property generated $5,000 in net taxable income after depreciation and amortization.
Your deduction calculation will be the lesser of:
- 20% of the qualified business income ($1,000; figured by multiplying $5,000 by 20%); or
- The greater of:
- 50% of the W-2 wages ($0; you didn’t pay yourself W-2 wages); or
- The sum of 25% of the W-2 wages ($0) plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property ($2,500; figured by multiplying the unadjusted (unadjusted basis does not include land) basis of $100,000 by 2.5%).
In this example, your deduction will be the lesser of $1,000 or $2,500, so your deduction is $1,000.
This is a freebie deduction. All you have to do in order to claim it is to make more money. It’s a deduction that’s figured after the calculation of your AGI though, so it’s being referred to as a “below the line” deduction.
There is another twist though. If your total taxable income is less than $157,500 (if single) or $315,000 (if married filing jointly), then you are excluded from the having to go through the wage and basis calculation. Instead, you will automatically qualify for a 20% deduction on your combined qualified business income.
Service businesses will not receive a deduction at all unless the taxpayers who own the service businesses fall below the $157,500 (if single) and $315,000 (if married filing jointly). If they can accomplish this, then they too will qualify for the 20% deduction.
Per the new law, service businesses are “any trade or business where the principal asset is the reputation or skill,” except for engineers and architects.
C corporation Rates
If you own a C corporation, you will now see a flat tax of 21%. This is great for C corporations that have large amounts of net income. A C corporation structure is not recommended for rental properties from a tax perspective.
The new law increases bonus depreciation from 50% to 100% for assets with useful lives of less than 20 years. What does that mean, exactly?
If you buy personal property (carpet, appliances, tools, equipment, etc) or if you make land improvements (landscaping, driveways, parking, etc) you can now immediately write off the entire cost of these assets.
You cannot write off the cost of buying a rental property and the property’s key components because they have useful lives of 27.5 years.
It is important to note that this is bonus depreciation. That means that when you sell the assets, you will pay depreciation recapture tax. Keep that in mind.
Bonus depreciation is retroactive to start in September 2017. So if you are making any year-end purchases/improvements, they will be 100% written off.
Lifetime Gift Exclusion
Every year, you are allowed to gift another person $14,000 without having to fill out a gift-tax form. If you gift any one person over $14,000, you must fill out a gift tax form that then reduces your lifetime gift exclusion.
That lifetime exclusion has been increased to $10,000,000 and will be indexed for inflation. This is on a per-person basis and will reduce the number of estates subject to federal estate taxes.
Rehabilitation Tax Credit
The rehabilitation tax credit has been reduced in scope.
Business Entertainment Deductions
Deductions for business entertainment expenses are no longer deductible.
Business-related meals which used to be fully deductible, are now only deductible at 50%.
The amount that is free from estate taxes has doubled to $11 Million for single people and $22 Million for married couples. Taxpayers also continue to receive step-up basis upon death. As such, for many investors who are under the exemption amount, it may still be a good strategy to wait to transfer appreciated investment properties to beneficiaries upon death to obtain tax-free gain during the investor’s lifetime.
1031 exchanges allow you to exchange like-kind property and roll your gain forward without having to pay tax.
The new rules modified 1031 exchanges to include only real property. The intention was to eliminate exchanges of vehicles, planes, and equipment.
Domestic Production Activity Deduction (DPAD)
DPAD has been eliminated. This will negatively affect flippers, developers, and builders.
What Didn’t Change
Section 121 Exclusion
This is commonly referred to as the $250,000 ($500,000 if married) exclusion on gain from the sale of a qualified residence. In order to claim the exclusion, you must have lived in the property for two of the past five years.
The Senate had proposed moving the useful life of both residential and commercial property to 25 years. This would have been a huge boon to owners of commercial property, as the useful life is currently 39 years.
But this did not make it in the final bill.
All in all, while there are pluses and minuses in this tax bill, real estate investors benefit from it.