News and resources about the impact of the new federal tax law on real estate professionals and investors
On December 20, 2017 Congress passed the most extensive tax reform since 1986, which was subsequently signed into law by President Trump.
Included in the TCJA are changes to the Internal Revenue Code (“Code”) that impact taxpayers engaged in the real estate business, and those who otherwise own real estate. (See this post for a discussion of who is considered a real estate professional for tax purposes.)
Individual tax rates
The TCJA lowers the marginal (top tax bracket) tax rate applicable to individuals from 39.6% to 37%. The net investment income tax (NIIT) and Medicare surtax of 3.8% and 0.9%, respectively, remain. The reduction in tax rates is not permanent like the corporate tax rate reduction, and is scheduled to expire after 2025. The tax rates applicable to long-term capital gains of individuals remains at 15% or 20%, depending on adjusted gross income (AGI).
Get the background on how tax reform impacts real estate in this post from The Real Estate Tax Guy.
Deduction for qualified business income of pass-through entities
The TCJA creates a new 20% tax deduction for certain pass-through businesses. For taxpayers with incomes above certain thresholds, the 20% deduction is limited to the greater of (i) 50% of the W-2 wages paid by the business, or (ii) 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable property (which includes structures, but not land).
Pass-through businesses include partnerships, limited liabilities taxed as partnerships, S Corporations, sole proprietorships, disregarded entities, and trusts.
The deduction is subject to several limitations that are likely to materially limit the deduction for many taxpayers. These limitations include the following:
Qualified business income does not include IRC Section 707(c) guaranteed payments for services, amounts paid by S corporations that are treated as reasonable compensation of the taxpayer, or, to the extent provided in regulations, amounts paid or incurred for services by a partnership to a partner who is acting other than in his or her capacity as a partner.
AICPA wants ‘immediate guidance’ on pass-through business income under new tax law. Read more
Qualified business income does not include income involving the performance of services (i) in the fields of, among others: health, law, accounting consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests or commodities.
Qualified business income includes (and, thus, the deduction is applicable to) only income that is effectively connected with the conduct of a trade or business within the United States.
The deduction is limited to 100% of the taxpayer’s combined qualified business income (e.g., if the taxpayer has losses from certain qualified businesses that, in the aggregate, exceed the income generated from other qualified businesses, the taxpayer’s deduction would be $0).
Interest expense deduction limitation
For most taxpayers, TCJA disallows the deductibility of business interest to the extent that net interest expense exceeds 30% of Earnings before Income Taxes Depreciation and Amortization (EBITDA) for 2018 through 2022, or Earnings before Income Taxes (EBIT) beginning in 2022. An exemption from these rules applies to certain taxpayers with average annual gross receipts under $25 million.
A real property trade or business can elect out of the new business interest disallowance by electing to utilize the Alternative Depreciation System (ADS). The ADS lives for nonresidential, residential and qualified improvements are 40, 30, and 20 years, respectively. All of which are longer lives, resulting in lower annual depreciation allowances.
Read more about the new tax law, real estate and business interest expense.
Immediate expensing of qualified depreciable personal property
The TCJA includes generous expensing provisions for acquired assets. The additional first year depreciation deduction for qualified depreciable personal property (commonly known as Bonus Depreciation) was extended and modified. For property placed in service after September 27, 2017 and before 2023, the allowance is increased from 50% to 100%. After 2022, the bonus depreciation percentage is phased-down to in each subsequent year by 20% per year.
Learn more about Bonus Depreciation in this post.
Are you buying or selling a principle residence, vacation home, or rental property?
Get a free tax savings tip sheet.
Expansion of Section 179 expensing
Taxpayers may elect under Code Section 179 to deduct the cost of qualifying property, rather than to recover the costs through annual depreciation deductions. The TCJA increased the maximum amount a taxpayer may expense under Section 179 to $1 million, and increased the phase-out threshold amount to $2.5 million.
The Act also expanded the definition of qualified real property eligible for the 179 expensing to include certain improvements to nonresidential real property, including:
- Heating, Ventilation, and Air Conditioning Property
- Fire Protection and Alarm Systems
- Security Systems
Mortgage interest and real estate
Before the tax law changed, you could deduct mortgage interest on mortgages up to $1 million, if you’re married, and $500,000 if you’re single. Interest on a Home Equity Line of Credit (HELOC) could be deducted up to $100,000. Under the new law, individuals are allowed an itemized deduction for interest on a principal residence and second residence up to a combined $750,000. Mortgages obtained before 12/16/17 are grandfathered and new purchase money mortgages may be grandfathered if the purchase contract is dated before 12/16/17.
Refinancing of grandfathered mortgages is grandfathered, but not beyond the original mortgage’s term and amount, with some exceptions for balloon mortgages. Interest on HELOCs is no longer deductible.
The rules for capital gain exclusion for a primary residence remain unchanged, which is good for the real estate market. When you sell your primary residence, you get to exclude $500,000 of gain. As the taxpayer, you must own and use the home as your primary residence for two out of the previous five years. This exemption can only be used once every two years.
You will still be able to do a like-kind exchange on real estate, but no longer on personal property. This type of exchange allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the gain on the sale of the first asset.
Read more in The Tax Cuts and Jobs Act and Code Section 1031.
Follow the Real Estate Tax Guy on Twitter @RETaxGuy
We’ve got your back on the Tax Cuts and Jobs Act
The new tax code is complex and every taxpayer’s situation is different. Don’t lose sleep wondering what impact the new law will have on your real estate investments. Contact KRS partner Simon Filip, CPA at 201.655.7411 or [email protected].
“With the new tax law, it’s more important than ever to structure your real estate operations and investments in a tax efficient manner. Taxes may be a significant portion of your annual cash expenditures without proper planning.” – Simon Filip, CPA, aka “The Real Estate Tax Guy”