Real estate investor? Know the new tax rules to avoid surprises in 2018
How the Tax Cuts and Jobs Act impacts investment properties
- The debt limit for itemized mortgage-interest deductions dropped to $750,000.
- Pass-through companies receive a 20 percent tax deduction on qualified income.
- Like-kind exchanges were retained, allowing investors to swap properties with similar values.
- Rules about rental-property expenses, repairs and improvements did not change.
- Many of the provisions in the new law may expire at the end of 2025.
The tax rules changed for many real estate investors and landlords with the passing of the federal Tax Cuts and Jobs Act.
To avoid surprises when they file their 2018 taxes, investors should take steps now to learn how tax reform impacted them. The tax reform bill was signed into law in December 2017, and changes took place almost immediately.
“Among the range of small businesses, some were able to take advantage of these lower LLC (limited liability company) pass-through tax rates, and some weren’t,” said Lawrence Fassler, corporate counsel for RealtyShares, a San Francisco-based investment company. “So that’ll create a little tension, I think, that maybe Congress will have to address.”
Understand that individual circumstances can affect tax obligations, so investors and landlords should speak with a tax professional. The Internal Revenue Service’s Publication 527 summarizes many of the tax laws that will remain in place, while many of the new provisions are scheduled to expire at the end of 2025. As with any major legislation, Congress or the IRS may issue some technical revisions to clarify the rules.
Investors have fewer deductions
The Tax Cuts and Jobs Act affects real estate owners in a few different ways. First, itemized deductions for mortgage interest were reduced.
Investors with two properties can itemize deductions, affecting those who earn rental income from a second home or vacation property, for example. Investors can now deduct interest on mortgages totaling as much as $750,000, compared to the previous $1 million limit. The law also eliminated deductions on most home equity loans, although certain second mortgages and home equity lines of credit (HELOCs) can be combined with first-mortgage debt up to $750,000.
Another big change is that deductions on property, income and sales taxes at the state and local level are now capped at $10,000 per year.
Wayne Rose, senior managing director of property tax services at real estate services company Cushman & Wakefield, said there could be some ripple effects on residential property purchases, notably in high-tax states. An example is an investor who could write off $20,000 in property taxes last year is now limited to half that exemption and may turn to less-expensive properties to buy.
“Maybe I need to take it down a notch so that I’m getting as much tax benefit as I can,” Rose said of potential investment strategies.
Steve Marcus, a partner at international law firm Baker Botts LLP, said he didn’t think the new cap would have a major impact on investment strategies, even in states with high tax rates.
“You still get to deduct 10 grand a year,” Marcus said. “For folks that are paying materially more than that, at that point you’re talking about homes that are $1 million, $2 million and up in a lot of cases. And (for) those folks, I suspect, it’s not going to be that big of a deal to lose a chunk of the property tax deduction.”
The $10,000 limit likely will impact single-family home sales in wealthier coastal states, particularly at the upper end of the market, Fassler said, adding that prices probably won’t drop, but are likely to cool. If fewer homes are sold, investors and landlords could benefit through increased rental demand.
“Some of those features that would normally factor into the purchasing decision are not as attractive as they once were,” Fassler said. “It’s hard to tell. Once you get to the high end (of prices), maybe even a high-end apartment just isn’t what people are looking for. They really want to buy their own house.”
Business interest deductions change
Business-related or “business-interest” deductions are now limited to the sum of 30 percent of adjusted taxable income (ATI), plus business income. ATI calculations cover a taxpayer’s income and expenses not related to their business, plus the standard 20 percent deduction for pass-through income. Real estate businesses may see a benefit to opting out of these limits in exchange for a longer depreciation recovery period — 30 years on residential properties.
“Real estate, again, came out smelling like a rose on this one because there’s a specific exception for qualifying real-property businesses,” Marcus said. “And those include anybody in the business of leasing or developing real property.”
Residential properties that utilize business-interest deductions have depreciation schedules of 27.5 years, the same as under prior law. Simply put, a property owner can calculate their annual depreciation by dividing the purchase price of the property by 27.5. Property acquired between Sept. 28, 2017, and Dec. 31, 2022, now qualifies for a 100 percent annual deduction of depreciation. That amount decreases by 20 percent annually between 2023 and 2026.
Pass-through income gaps
Real estate investors may structure their business as pass-through entities so that business income is taxed at individual rates. These businesses — which include sole proprietors, partnerships, S corporations and limited liability companies — now receive a 20 percent deduction. Many now effectively pay a maximum tax rate of 29.6 percent. Qualifying income is restricted, in part, to business activities within the U.S. and to income that does not exceed $315,000 for joint returns or $157,500 for individual returns.
C corporations don’t qualify for pass-through deductions, Marcus said. But since the tax-reform bill shaved the corporate tax rate from 35 percent to 21 percent, C corporations will receive a greater boost than pass-through entities.
“It isn’t more efficient than it was to be in a pass-through as compared to a C corp,” Marcus said. “The benefit (gap) actually has slightly narrowed a bit.”
Like-kind exchanges mostly unchanged
Section 1031 exchanges, or like-kind exchanges, were virtually untouched in the new law. Like-kind exchanges allow investors to swap one property for another of similar value as a means to avoid capital gains taxes.
For example, landlords can exchange single-family rentals for multifamily apartments or a commercial property. You cannot swap an owner-occupied property for rental property, or vice versa, however. The main change? Starting in 2018, these exchanges apply only to real estate and not personal property, such as furniture or equipment that may be included in the exchange. The limit for capital gains taxes remains at 23.8 percent.
Like-kind exchanges, Marcus said, have historically been popular in areas where housing prices have soared, such as California. Investors profit by purchasing a rental property, leasing it until its value appreciates, then trading it for another property and starting the process again.
A shared-ownership structure is another way to utilize a 1031 exchange, Marcus said. In recent years, more investors have partnered to sell tenancy-in-common interests in larger commercial real estate projects, opening more opportunities for all.
“These smaller investors (then) have something attractive to roll their 1031 exchange money into, that they wouldn’t be able to otherwise afford themselves,” Marcus said. “I don’t think that’s going to change.”
Exchanges can cause inflation in purchase prices, especially if the seller knows a buyer is utilizing one and is under a time crunch to complete a deal, Rose said. By law, after completing the sale of one property, 1031 investors must acquire a new property within 180 days or else pay capital gains taxes.
“(If) I’m running up against my time limit to place that money and I’m in a bidding situation against another buyer for property B, I may bid higher than the other buyer because I need to make sure I get my money placed,” Rose said. “… When we’re working with assessors who are looking at a purchase price, we’ll say, ‘Hey, that purchase price may have been driven higher because that buyer had to place the money from their 1031 exchange.’”
The unscathed tax rules
Investors will find a few areas untouched in the Tax Cuts and Jobs Act, including certain tax deductible rental property expenses. According to the IRS, expenses include advertising; auto and travel expenses relating to the collection of rental income, or the management or maintenance of a property; cleaning and maintenance; commissions; depreciation; insurance; legal and professional fees, including tax-return preparation charges; management fees; and utilities.
Repairs are still deductible, but improvements are not. The IRS defines repairs as expenses that keep a rental property in good condition, such as painting, unclogging a drain or replacing a damaged electrical outlet. But projects that add value to the property, such as a remodeled kitchen or bathroom, are considered improvements and are not tax deductible. Improvements can be depreciated over time, however.
Cash-out refinances are still useful in raising tax-free cash to buy other properties. For example, if you own a property worth $300,000 and have a mortgage balance of $100,000, you can take out a new mortgage based on the current value, subject to lending limits, and pocket the difference tax-free, minus the closing costs. The process works the same for personal residences and also includes mortgage-interest deductions for up to $750,000 in total debt.
While interest deductions for up to $100,000 in home equity debt was eliminated, it's possible, in some cases, to combine it with first-mortgage debt up to $750,000. Fassler said sales prices in more-expensive markets may level off, and that could impact how property owners access equity.
“If prices aren’t going to be accelerating in a big way or they’re going to be limited,” Fassler said, “then the amount of those HELOC financings or second-lien loans, which people often use to take cash out of their properties, is probably going to be more limited.”
Finally, if you’ve owned an income-producing property for a year or more and sell it for cash, you’ll continue to pay a lower capital gains tax rate than if the profits were taxed as ordinary income. Long-term property owners will pay between zero and 20 percent, depending on marital status and income. Short-term real estate owners, such as fix-and-flip investors, have profits taxed at higher income rates.