In December of 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA) into law. As a result, many Americans have questions about how the new tax laws are going to affect real estate and their personal income tax. Below is a summary of the real estate tax reform.
Mortgage Interest – $750K Limitation
Under the pre-TCJA rules, you could deduct interest on up to a total of $1 million ($500,000 for married filing separately) of mortgage debt used to acquire your principal residence and a second home (i.e., acquisition debt and improvements debt). You could also deduct interest on home equity debt (i.e., debt secured by the qualifying homes). Qualifying home equity debt was limited to the lesser of $100,000 ($50,000 for married taxpayers filing separately), or the taxpayer’s equity in the home or homes.
Starting in 2018, the limit on qualifying acquisition debt is reduced to $750,000 ($375,000 for married taxpayers filing separately). However, for acquisition debt incurred before December 15, 2017, the higher pre-TCJA limit of $1 million applies. The higher pre-TCJA limit of $1 million also applies to debt arising from refinancing pre-December 15, 2017 acquisition debt, to the extent that the debt resulting from the refinancing does not exceed the original debt amount. This means you can still deduct mortgage interest up to a total of $1 million if you acquired a mortgage acquisition/improvement debt before December 15, 2017 of that much.
Importantly, starting in 2018, there is no longer a deduction for interest on home equity debt. This applies regardless of when the home equity debt was incurred.
Both of these changes will last for eight years from 2018 through 2025. Beginning in 2026, interest on home equity loans will be deductible again, and the limit on qualifying acquisition debt will be raised back to $1 million ($500,000 for married separate filers).
Exclusion Amount on Sale of Primary Residence
The rules for the sale of principal residence have not changed. If you sell your primary home with a gain, you can still exclude $500,000 for a couple ($250,000 for single or married filing separately) of gain from your gross income as long as you own and use the residence for 2 out of a 5-year time period.
Itemized Deduction is Limited to $10,000 for State and Local Taxes (SALT)
Under the pre-TCJA rules, you were permitted to claim the following types of taxes as itemized deductions, even if they were not business related:
- State, local, and foreign real property taxes
- State and local personal property taxes
- State, local, and foreign income taxes
You could elect to deduct state and local general sales taxes in lieu of the itemized deduction for state and local income taxes.
For tax years 2018 through 2025, the new law limits deductions for taxes paid by individual taxpayers if the taxes are not paid or accrued in carrying on a trade or business. It limits the aggregate deduction to $10,000 ($5,000 for married filing separately). The aggregate deduction includes the following:
- State and local real property taxes
- State and local personal property taxes
- State and local, and foreign, income tax
- General sales taxes (if elected)
The new law completely eliminates the deduction for foreign real property taxes unless they are paid or accrued in carrying on a trade or business or in a for profit activity.
Miscellaneous Itemized Deduction
For tax years 2018 to 2025, miscellaneous itemized deductions are not allowed. Thus, you cannot deduct investment expenses, tax preparation fees and legal fees for protection of investments. If you have Schedule C, E, or F filings, you can work with your CPAs/Attorneys to have them separate their bill by personal, rental and business. Then, you can deduct the rental or business fees through Schedule C, E or F.
Alternative Minimum Tax (AMT)
The alternative minimum tax (AMT) is a tax system separate from the regular tax that is intended to prevent a taxpayer with substantial income from avoiding tax liability by using various exclusions, deductions, and credits. Under it, AMT rates are applied to AMT income determined after the taxpayer “gives back” an assortment of tax benefits. If the tax determined under these calculations exceeds the regular tax, the larger amount is owed.
For tax years 2018 through 2025, the new law increases the AMT exemption amounts for individuals. For example, the new exemption amount for married filing jointly or surviving spouses is increased to $109,400 (previously $86,200). The new exemption amount for singles is increased to $70,300 from $55,400 under old law. When the alternative minimum taxable income (AMTI) exceeds the exemption amount, the exemption amount will be reduced, but not below zero. When the AMTI exceeds $1 million for joint returns and $500,000 for other taxpayers, the AMT exemption will be zero.
This means that fewer taxpayers will incur AMT because of an increased AMT exemption. And, there are no addback adjustments for items that were major contributions to AMT:
- State and local tax deduction
- Miscellaneous itemized deductions
- Personal exemption
Individual Income Tax Rates and Brackets
The new law retains seven brackets of tax rates for individuals: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. By comparing the old and new tax brackets, most taxpayers are able to enjoy lower tax rates. High net worth individuals with over $500,000 for single filers and over $600,000 for married couples filing jointly will be taxed at the maximum rate of 37% under the new law as opposed to 39.6% under the old law.
However, some middle bracket taxpayers may experience their tax rate increased. For example, single taxpayers who have taxable income in the range of $157,000 to $200,000 will be taxed at 32% (28% under old law). If they have taxable income from $200,000 to $400,000, they will be taxed at 35% (33% under old law).
For exchanges completed after December 31, 2017, the new law eliminates all Section 1031 tax free exchanges except for those of real property that is not held primarily for sale. Thus, exchanges of personal property and intangible property can’t qualify as tax-free like-kind exchanges. However, you still have those real estate Starker 1031 exchanges for rental property.
Flow-Through Entity – 20% Deduction
Under the new tax law, there is a significant new tax deduction that will be in effect from 2018 to 2025. It provides a substantial tax benefit to individuals with qualified business income from a pass-through entity (i.e. partnership, S corporation, LLC, or sole proprietorship).
The new tax deduction is 20% of your “qualified business income (QBI)” from a pass-through entity of a trade or business that is not a “specified service trade or business.” The maximum 20% deduction is allowed to reduce your personal taxable income whether you are itemizing deductions or taking the standard deduction.
This new tax deduction for flow-through income will also apply to real property rental activity when there is net rental income in excess of passive activity loss and at risk loss.
Here is the general deduction calculation, the lesser of (A) or (B) where:
- Is 20% of the taxpayer’s “qualified business income” or
- The deduction amount is limited to the greater of (1) or (2) below:
- 50% of the W-2 wages in connection with qualified trade or business, or
- The sum of 25% of the W-2 wages plus 2.5% of the unadjusted depreciable basis immediately after acquisition of all qualified property (this is the one that will be used most for real estate)
For example, assume that the only flow-through entity that you have is an LLC that has net rental income of $200,000. Your share of interest in the LLC is 50%. And, the unadjusted basis of your rental building is $2 million (land is not depreciable so it is not included). In this example, you do not have any employees with W-2 wages in the LLC. You will need to do the “A” and “B” test to see what your deduction is.
- “A” test: You will have pass-through rental income of $100,000 ($200,000 x 50% interest = $100,000). The 20% deduction of the flow-through income is $20,000 ($100,000 flow-through income x 20% = $20,000).
- “B” test: The B(1) part is zero –> W-2 wages are $0 x 50% = $0. The B(2) amount is $25,000 (W-2 wages $0 x 25% = $0 plus $2,000,000 x 50% x 2.5% = $25,000). The larger of B(1) or B(2) is B(2)’s $25,000. Since the “A” test amount of $20,000 is less than the “B” test amount of $25,000, you can reduce your personal taxable income by $20,000.
The new tax law has effectively lowered the cost of acquiring capital assets by making substantial changes to the income tax rules for bonus depreciation and other “cost recovery” deductions.
Effective for tax years beginning after December 31, 2017, the existing categories for qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property are eliminated and called qualified improvement property. Under the old rules, qualified leasehold improvements, qualified restaurant improvements, and qualified retail property improvements must have been done at least three years after the building was placed in service. Now, this three year rule is repealed.
Under the new tax law, if you make an improvement to an interior portion of a nonresidential building and that improvement is done after the date the building was first placed in service, the improvement is a qualified improvement property and is depreciated over 15 years with straight-line method. Now, you do not need to figure out whether the commercial building is a leasehold situation or not. And, you do not need to wait for three years after the building is placed in service in order to take the 15 years depreciable life. In the past, if the improvement did not fall in the above three categories, you had to depreciate such improvement over 39 years.
Bonus depreciation means you can deduct a percentage of the purchased cost of qualified property in the first year in which the property was placed in service. The qualified property includes residential and nonresidential property that has a recovery period of 20 years or less, or off-the-shelf computer software, etc.
For property placed in service and acquired after September 27, 2017, the new law raised the 50% bonus depreciation rate (under old rules) to 100%. It means that you can write off the whole amount of property as expense in the first year whether it is new or used property. The bonus depreciation is not limited by the business or rental taxable income or loss. The 100% deduction will begin to phase-out starting in 2023, with a full phase-out to 0% in 2027.
Section 179 deduction
For tax years beginning after 2017, the new law expands the Section 179 deduction to $1 million, and the phase-out is increased to $2.5 million. The following improvements to nonresidential real property are also now qualified for Section 179 deduction: roofs, heating, ventilation and air conditioning property, fire protection and alarm systems, and security systems. Under the old rules, these properties were required to be capitalized.
If you use a passenger vehicle in your rental activity, the depreciation limitation for the vehicle is increased as follows:
- Fist year – $3,160 (old) to $10,000 (new) in the first year
- Second year – $5,100 (old) to $16,000 (new)
- Third year – $3,050 (old) to $9,600 (new)
- Fourth and later years – $1,875 (old) to $5,760 (new)
Limits on Deduction of Business Interest
The new tax law limits the deduction for business net interest expense for the tax year to the sum of:
- Business interest income
- 30% of the adjusted taxable income, plus
- Floor plan financing interest (certain inventory), such as car dealership
Adjusted taxable income includes business taxable income without regard to interest expense, depreciation, amortization, depletion, net operating loss, 20% qualified business deduction.
There is an exemption from this limitation if a business has average gross receipts for the previous three taxable years that are $25 million or less (so small businesses and small rentals will be exempt). Real property and farming businesses can elect out of this rule if they use certain depreciation methods (i.e. ADS) to depreciate applicable real property used in the rental business.
The disallowed business interest deduction amount is carried forward to the following tax year and becomes a part of net operating loss carryovers.
The limits on deduction of business interest is effective for tax years beginning after 2017 and does not have a suspension date. Thus, this rule is now permanent.
Net Operating Loss Modifications
For tax years beginning after 2017, a net operating loss is carried forward indefinitely. You can deduct the net operating loss carryover from prior year but it is limited to 80% of taxable income in a tax year. The two-year carryback rule under the old law is repealed.
New “Excess Business Loss” Limitation
Effective for tax years beginning after 2017, certain business losses are no longer allowed to be deducted in full and are subject to limitation. This rule only applies to pass-through entities (i.e.
S corporation, partnership/LLC and sole proprietor), and the limitation applies at partner, S corporation shareholder level, or sole proprietor level. The new rules prevent excess business losses from being used against other sources of income (such as salaries, interest, dividends, capital gains, retirement distributions, etc.).
The maximum excess business loss is $500,000 for married filing jointly taxpayers and $250,000 for single filers. An excess business loss is disallowed and carried over as a net operating loss to the following year with no carry back allowed. This rule is now permanent.
For example, if you sell a rental property with a loss of $900,000, you are only allowed to deduct $500,000 (married filing jointly) to reduce your other income. The remaining $400,000 is treated as net operating loss and carried over to the following year.
Entity Selection – for Real Estate
For tax years after 2017, the new tax rate for C corporations is a flat rate of 21%. If you have a pass-through business, all the flow-through income is taxed at your personal tax rate which is a maximum of 37%. However, if you could qualify for the 20% flow-through deduction it could be beneficial. You will need to do some calculations in order to figure out which route would be most beneficial for you.
Estate and Gift Tax Exemption
Beginning in 2018, many estates will not be subject to 40% tax, and the large estates will owe less tax. The new law temporarily doubles the amount that can be excluded from these transfer taxes. For decedents dying and gifts made from 2018 through 2025, the new laws double the base estate and gift tax exemption amount from $5 million to $10 million. Indexing for post-2011 inflation, brings this amount to approximately $11.2 million for 2018, and $22.4 million per married couple, with some basic portability techniques.
Since the exemption is temporarily increased from 2018 through 2025, you may want to plan to gift more real estate during this period of time to receive greater estate planning benefits.
State Tax Ramifications of Federal Tax Reform Legislation
The State of California does not automatically conform to the provisions of the Tax Cuts and Jobs Act.
California income and resulting tax begins with federal income and is modified for changes or nonconformity. California nonconformity differences currently include (among others):
- Real and personal property tax deduction limitation
- Mortgage interest limitation: $750,000 limit and no deductibility of home equity and second home mortgage interest
- Miscellaneous itemized deductions
- AMT revisions
The State of California will feel budget pressure because state tax is no longer partially subsidized by federal government through the State and Local Tax (SALT) deduction. California is considering changes that will circumvent the repeal of the SALT deduction.
Final Comments and Take Aways of the Real Estate Tax Reform
Provisions of TCJA are complex and unclear in some areas:
- Some provisions require technical corrections to fix errors
- Some provisions require IRS guidance to apply
- There are many questions that practitioners are asking
- We expect some clarity over the coming months
If you have questions about the real estate tax reform or want to learn more about how these changes may affect you, contact us.