New tax legislation is bringing many complicated changes that could both positively and negatively affect your investments. The best way to prepare for these changes, those that took effect on January 1, 2018, with the Tax Cuts and Jobs Act of 2017, is to seek the information you need to become an educated and savvy accredited investor or real estate professional.
The Act has been controversial and may have the greatest detriment on high-value firms that are heavily leveraged and rely on the significant deductions afforded by prior legislation. For real estate investors, real estate professionals, and property owners, the Act provides significant tax advantages and continued capital gains protection. We’ve assembled some of the most common questions our clients have been asking us regarding these new changes:
1. How does the new law affect IRC 1031 Tax-Deferred Exchanges?
1031 tax-deferred exchanges have been retained as long as the properties being exchanged are of ‘like-kind,’ although personal property is no longer eligible for exchange treatment under the 1031 program. If you’re planning to sell income-producing property intended for business or trade use, you can defer capital gains taxes when you trade up to a higher-value property. Under IRC 1031, any type of real property held as an investment can be traded for another real estate investment property, regardless of the form, as long as the primary purpose of the investment is as a long-term investment (not intended for short-term resale).
2. What changes have been made to tax rates, especially those that affect real estate investors?
The Act provides tax benefits to both larger entities such as C Corps, and sole proprietors operating under common business forms such as LLCs and S Corps. The corporate tax rate has been reduced to 21% from 35%, while entities subject to pass-through taxation will qualify for a 20% deduction from qualified business income. Firms that primarily provide personal services will not be allowed to claim this deduction, with the exception of real estate professionals.
3. Will I still be able to deduct interest expenses on real estate?
This is one of the more controversial changes as a result of the new legislation. Prior to 2018, business owners were allowed to deduct 100% of a business interest; the Act has changed this to a maximum of 30% of adjusted taxable income. Fortunately, the new restrictions will only apply to businesses that have generated a total gross income of $25 million over the preceding 3 years.
An indicator of the legislator’s favor of REI, interest accrued in the conduct of businesses involving real property investment will be exempt from the deduction limits. In instances where the new restrictions apply, the business owner can opt for a permanent exemption with more strict depreciation requirements.
4. How will tax treatments change for REITs?
Real Estate Investment Trusts (REITs) stand to benefit the most from the new legislation. REIT dividends are now allowed a 20% deduction, resulting in an overall tax rate of less than 30% for individual stakeholders, and only a slightly higher rate for corporate REIT earnings. The new deductions will provide an overall tax rate that is 10% less than before the Act.
5. Can I continue to deduct state and local property taxes?
Yes. The Act allows both single and married taxpayers to deduct up to $10k in property and income taxes for their principal residences for loan amounts up to $750k. A benefit for professional real estate investors and business owners, the bill provides an exemption to the deduction limit for taxes related to business activities (real estate investment). Interest on home equity debt can no longer be deducted under the new legislative restrictions.
6. Is the profit from the sale of my residence still exempted from taxation?
Yes. This is another tax issue that was under intense debate in forming the final bill as passed by Congress. Legislators in the House and Senate had considered modifying the current exemptions from capital gains tax on the sale of principal residences to generate additional tax revenue. The original bill as approved by Senate intended to change the exclusion for residency requirements to 5 years out of the previous 8 years, a drastic increase from the previous requirement of 2 out of 5 years. Legislators had also proposed eliminating the current income-based exclusions of $250k single, or $500k married.
This is a retained benefit for real estate investors that use the ‘housing-hacking’ strategy to take advantage of current exclusions by maintaining primary residence in multi-unit income property for 2 years before resale.
7. How will the changes to the standard deductions affect the real estate economy?
The Tax Cut and Jobs Act have increased the standard deduction to $12,000 and doubled that for joint tax return filings. While this seems like a clear benefit for taxpayers, it may have a detrimental effect on the real estate market by diminishing housing demand. The increased standard deduction will offset the effect of restrictions on interest and property tax deductions, diminishing the appeal of real estate ownership as a source of deductions. This de-incentivizes homeownership and will result in a minimal tax differential between owning and leasing for most citizens.
8. Is protection from capital gains tax still in place for carried interest?
Yes. Although the issue was debated by parties that insisted investors should be subject to the higher rates imposed on corporate income, the Act allows a capital gains tax exemption on carried interest held for a minimum of 3 years, after which it will be taxed at a rate of 23.8%.
Carried interest is the share of profit in a private equity fund that managers earn for taking risks and pushing the portfolio’s growth and profitability. Opponents argued that the interest should be taxed at the standard corporate rate, while supporters maintain that the deferred payment at the end of the carrying period merits capital gains treatment.
9. Have new tax laws affected depreciation periods for business assets and investment properties?
The Act has retained the current depreciation periods of 27.5 years for residential income properties, and 39 years for commercial. Legislators in the House had proposed allowing immediate expensing of depreciation for real property; however, the final bill does not include a bonus depreciation provision for real estate. For qualified property, items with a depreciation period of fewer than 20 years, the Act allows 100% immediate expensing as bonus appreciation. The intention of the change is to reduce tax liability in the short term to stimulate economic growth.
10. Will the new tax legislation affect the exemptions for older and historic homes in my rental portfolio?
The Bill eliminates the prior 10% credit for structures built before 1936. Only certified historic buildings are allowed to continue receiving the 20% tax credit. The legislation as approved by the House intended to rescind the Historic Rehabilitation Credit, a tremendously beneficial provision for real estate investors that specialize in the redevelopment of older structures.
11. How will tax law changes affect me as a real estate professional?
The new legislation provides tax relief to individual business owners and those operating under disregarded entities such as LLCs and S Corps. The law includes a 20% deduction on qualified business income, with the major exception being those that earned income from personal service businesses. Even though real estate professionals typically fall under the classification of personal services provider, they will be allowed to claim the deduction. In conjunction with the doubled standard deduction, it promises a tremendous reduction in tax liability for real estate professionals.
If you have more questions, please reach out to us. The answers provided here do not constitute legal advice and should not be construed as such. Please consult with a qualified tax and legal professionals for more precise legal and financial counsel.