This was certainly a quick process for such a complicated undertaking.
The Trump Administration’s aim with the new tax law is to grow the economy, increase wages and promote economic competitiveness. There are key changes in this tax bill that have a direct impact on real estate investors, owners and developers. If you’re involved in real estate, then you should pay attention to the following highlights.
Effective in 2018, the corporate tax rate will be slashed from 35 percent to 21 percent.
This will result in the corporate graduated tax currently capped at 35 percent to a flat rate of 21 percent. This piece of legislation is considered to be the cornerstone of the tax law and is viewed as a major achievement because the United States is considered to have the highest statutory tax rate of all the advanced economies.
Individual tax rates are maintained with a seven-bracket tax structure with small reductions in the rates paid. The bottom rate stays at 10 percent with the subsequent brackets being at 12, 22, 24, 32, 35 and finally 37 percent for income over $500,000 for single filers and $600,000 for married filers.
The standard deduction is nearly doubled from $6,500 to $12,000 and $13,000 to $24,000 for single filers and married filers, respectively. However, the personal exemptions that are so valuable have been taken away, which means that the standard deduction isn’t really “doubled”.
While the Alternative Minimum Tax (AMT) has been preserved for individuals, it has been eliminated for corporations.
The estate tax exemption threshold is currently at a $5 million base. Under the new tax plan, that exemption threshold base will be $10 million, with such exemption indexed for inflation.
With the new tax law, 1031 exchanges, also known as like-kind exchanges, are retained for real property transfers made on or after January 1, 2018. However, taxpayers will not be able to defer taxes on personal property that is included in the like-kind exchange.
This results in major relief for real estate investors because it was believed that the new tax law put this 100-year old reinvestment vehicle at risk. Upon the selling of investment property, an owner can owe up to four different taxes.
These include the depreciation recapture tax at a rate of 25 percent, federal capital gain tax at a rate of 15 or 20 percent depending on taxable income, net investment income tax at 3.8 percent and the applicable state tax rate.
Pass Through Entities
One of the biggest advantages resulting from the new tax bill for those in relation to real estate is that some property owners will have the benefit of lower taxes on passive income generated by a pass-through business.
These can be structured as partnerships, s-corporations or LLCs. The income earned through a pass-through entity is passed to the owner or owners and taxed at the individual rate. The new tax plan will allow owners of pass-through entities and sole proprietors to deduct up to 20 percent of domestic qualified business income, with certain limitations.
This boils down to a 30% or less tax rate, in many cases, imposed upon pass-through income. However, this deduction is set to expire on December 31, 2025. But, while it is in effect, it will mean big savings for real estate investors.
Depending on the size and number of real estate investments, these savings can be significant.
The 20 percent rule applies only to income and not capital gains. Therefore, opportunistic and value-added strategies that depend on price appreciation will have no tax shelter. The deduction may also be limited if you have too much income.
To be exact, too much income is defined as more than $207,500 for a single filer or $315,000 for those who are married filing jointly. In light of this information, it may be necessary for you to prioritize more favorable income-producing strategies for 2018.
Additionally, if you own investment property and you’ve been holding such investments in your name, now is the time to put your investments in the name of a pass-through entity.
By doing this, you will not only be protected from liability, but you will be able to take advantage of the aforementioned deduction.
Depreciation and Interest Expense
The current tax law allows for a deduction for business interest expenses.
It is worth noting that real estate investors can elect to opt out of the business interest deduction limitation.
However, a caveat to limiting this deduction is that longer depreciation recovery periods are required. Such periods are 20 years for qualified interior improvements, 30 years for residential property and 40 years for non-residential property.
If a real estate investor accepts the limitation, however, then real property depreciation recovery periods are maintained at 27.5 years for residential property and 39 years for non-residential property.
Low Income Housing
The Low Income Housing Tax Credit program has been maintained with the new tax plan. This program encourages taxpayers to invest in affordable housing by allowing owners of certain residential rental property to claim a low-income housing tax credit over a 10-year period.
The new markets tax credit encourages development in other low-income areas and this tax credit is also preserved with the new tax plan. Tax exempt private activity bonds, including multifamily bonds have been maintained with the new tax law.
These bonds have funded a significant number of projects and are expected to finance more than half of low-income housing under the Low Income Housing Tax Credit program.
New Property Acquisitions
The new tax law benefits real estate investors when it comes to expensing when acquiring new properties. Investments will be able to recover costs faster, allowing investors to get their money back faster than ever before. Although this change will likely have little impact on many investments, it will result in a small net positive, and when you’re in a business, every cent matters.
The rules regarding expensing when acquiring new properties include:
- Bonus depreciation allows real estate investors to expense certain business assets with a recovery period of less than 20 percent. Such assets can be expensed at 100 percent versus the current 50 percent. Keep in mind that you have to pay back the depreciation to the IRS when you sell the property. This will have less of an impact on shorter-term investments, but could be significant for those investments that are long-term.
- The new tax law allows you to expense up to $1 million versus $500,000.
- Under the new tax law, expenses are allowed for heating, air conditioning and ventilation systems as well as fire protection systems and security systems.
Deductions for Losses
Taxpayers are restricted from deducting losses incurred in an active trade or business from wage or portfolio income under the new tax plan. This will apply to existing investments and become effective in 2018.
State and local taxes paid in relation to carrying on a trade or business, or in an activity that produces income, will remain deductible under the new tax plan. Thus, a rental property owner can deduct property taxes associated with business assets, including any type of rental property.
It is true that the effects of the new tax bill will take place gradually. Some of the benefits to real estate investors won’t be seen until 2019. However, with the new tax law it appears that real estate investors are the real beneficiaries of favorable provisions. A summary of benefits that real estate investors can expect to reap with the recent tax overhaul include:
- The new deductions for pass-through entities will benefit standard real estate investment vehicles
- Value-added strategies will become even more appealing with changes to the capex deduction
- Private real estate funds will be preferred over other managed funds due to changes to carried interest
- Private investment funds will be the likely beneficiaries of the flood of private capital into real estate which is expected to increase in the near future
With the passage of every tax law there are winners and losers. A major tax overhaul is complex and it can take years to figure out who the real winners and losers are. However, with the most recent tax overhaul, it is clear who the winner is. This would be real estate investors. With all the benefits flooding the real estate industry under the new tax law, we will no doubt see an uptick in commercial real estate transactions.