On 12/22/2017, President Donald Trump signed the much talked about GOP tax bill into law.
This was a fast process for such a large bill. The Tax Reform Act of 1986 took two years to hash out differences and approve. Two years. Fast forward to 2017, in a short seven weeks the GOP has developed, amended, reconciled, and signed into law a $1.456 Trillion (with a T!) tax bill.
That’s crazy fast. Not to mention the final bill has over 1,000 pages of text.
Regardless, we’re not here to talk about whether or not our elected officials have read the bill they approved. We’re here to talk about what’s in the bill and how if may affect you.
This article is not meant to be all encompassing. Instead, we’re pointing out key changes that affect real estate investors and business owners.
Almost all of these changes begin on January 1, 2018 and revert in 2025.
Tax Bracket Modifications
- 10% Tax Bracket
- MFJ: $0 – $19,050
- Single: $0 – $9,525
- 12% Tax Bracket
- MFJ: $19,051 – $77,400
- Single: $9,526 – $38,700
- 22% Tax Bracket
- MFJ: $77,401 – $165,000
- Single: $38,701 – $82,500
- 24% Tax Bracket
- MFJ: $165,001 – $315,000
- Single: $82,501 – $157,500
- 32% Tax Bracket
- MFJ: $315,001 – $400,000
- Single: $157,501 – $200,000
- 35% Tax Bracket
- MFJ: $400,001 – $600,000
- Single: $200,001 – $500,000
- 37% Tax Bracket
- MFJ: $600,000+
- Single: $500,000+
Changes to Itemized Deductions
Please note that itemized deductions do not affect rental property. You will still be able to deduct ordinary and necessary business expenses on your rentals.
Starting 12/15/2017, mortgage interest is deductible on the first $750,000 of new acquisition debt on primary and secondary residences. Originally, the proposed limits were much lower so it’s nice to see that they walked it back.
Home equity debt now poses a problem unless you use the proceeds to purchase or improve rental properties or for business. Interest on home equity debt is no longer deductible. Home equity debt includes refinances on your primary or secondary residences as well as HELOCs.
State and local income and property taxes are now limited to an aggregate $10,000 annual deduction. This is going to be painful for taxpayers in high tax states.
You will no longer be able to claim miscellaneous itemized deductions, such as tax preparation fees and unreimbursed employee expenses. Though you can still allocate tax preparation fees to Schedule C and E.
Standard Deduction Increases but Personal Exemptions Eliminated
The standard deduction has almost doubled. Single taxpayers will now claim $12,000 and married taxpayers will claim $24,000. This will cause fewer taxpayers to itemize deductions.
Personal exemptions have been eliminated. This may hurt taxpayers with multiple dependents since you were previously allowed to take a personal exemption deduction of $4,050 per person on the tax return.
Child Tax Credit is Enhanced
Though personal exemptions have been eliminated, the new rules surrounding the child tax credit will help balance things out.
The GOP has made changes to the child tax credit. The credit will increase from $1,000 to $2,000 per qualifying child. The refundable credit will increase to $1,400.
The income phase outs have increased to $200,000 if single and $400,000 if married filing joint.
Use of 529 Plans Expanded
529 plans received a much needed bonus. You can now use 529 plans to pay for private, public, and religious elementary and secondary schooling and qualified education expenses.
Alternative Minimum Tax (AMT) Stays Alive
I was pretty excited when the AMT was proposed to be eliminated. Unfortunately, the GOP had to pay for tax cuts in other areas and couldn’t completely eliminate the AMT. The exemption amounts have increased to $109,400 for married filing joint and $70,300 for all other taxpayers. The phaseout thresholds are increased to $1,000,000 for married taxpayers filing a joint return, and $500,000 for all other taxpayers (other than estates and trusts). These amounts are indexed for inflation.
And tax professionals still have to stumble through the AMT calculation each year.
Obamacare Penalty Eliminated
Good news for folks who are young, healthy, and don’t want or need health insurance. Beginning in 2019, you will not be assessed a penalty for not having health insurance.
Unfortunately it’s bad news for everyone else who wants or needs health insurance. With the expected reduction in people buying health plans beginning in 2019, premiums are anticipated to increase.
Pass-Through Deduction Added
This gets complicated fast, but try to hang in there. This “freebie” deduction is going to be huge for landlords and business owners. The deduction is granted after the calculation of AGI, so it’s a “below the line” deduction.
A new deduction is available for sole proprietors, LLCs, and S-Corps generating qualified business income. If you are a partner in a business, you will receive the deduction based on your allocable ownership.
The deduction is the sum of:
- The lesser of:
- Combined Qualified Business Income, or
- 20% of the excess of: the taxable income over the sum of any net capital gain.
- And the lesser of:
- 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer, or
- taxable income reduced by the net capital gain.
Combined qualified business income is the lesser of:
- 20% of the qualified business income with respect to the qualified trade or business; or
- The greater of:
- 50% of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
There are tons of scenarios to test with these new calculations. From all of the tests we’ve run, if your rental properties are generating net income after depreciation and amortization, you will either take a 20% deduction on the net income or a 2.5% deduction on your property’s unadjusted basis. Remember: unadjusted basis does not include the value allocated to land.
The 20% deduction appears to apply to the aggregate rental income for all rentals, but it applied on a business-by-business basis for businesses.
Service businesses will not receive a deduction at all, unless the taxpayers who own the service businesses have taxable income less than the below thresholds. The GOP brought down the hammer when they defined a service business as “any trade or business where the principal asset is the reputation or skill” except for engineers and architects.
If your total taxable income is less than $157,500 if single or $315,000 if married filing joint, then you just get a 20% deduction on combined qualified business income. You don’t have to worry about the additional calculations with wages and unadjusted basis.
C-Corporation Rates Reduced to 21%
A 21% tax rate is a huge boon for C-Corporations. Unfortunately, many of our clients, and likely most of the folks reading this right now, will not be directly affected by the reduction.
You could be indirectly affected depending on what corporations choose to do with their almost $1 Trillion in newfound savings.
Bonus Depreciation Increased to 100%
If you place assets with useful lives of less than 20 years into service beginning September 29, 2017, the asset will qualify for 100% expensing through bonus depreciation. Examples of property with useful lives of less than 20 years include:
- Land improvements (driveways, parking lots, landscaping)
Notably, rental properties have a 27.5 year useful life. In the original motivational speeches from our President, he suggested 100% expensing for all assets. The passed bill will allow 100% expensing for most assets, but not for rentals and commercial property.
It is important to note that this is bonus depreciation. That means that when you sell the assets, you will pay depreciation recapture tax. So you get a nice write-off upfront, but you’ll have to pay it back some day.
Lifetime Gift Exclusion Doubles
Good news for folks with large estates. The lifetime gift exclusion has increased from $5MM to $10MM per person. This means you can pass $10MM of wealth tax-free.
Gifts are often a misunderstood concept. In any given year, you can gift anyone $14,000 each without incurring any tax filing requirements. So ff you’re feeling generous, you can gift me $14,000, and each person on my team $14,000. Because you’re gifting each person $14,000 or less, you don’t have to file a gift tax return.
But if you gift me $20,000 in one year rather than $14,000, then you must file a gift tax return and report the $6,000 in gifts. This is not taxable until your lifetime gift exclusion of $5MM (now $10MM under the new bill) has been completely used up. The $6,000 simply reduces your lifetime exclusion by $6,000.
The $10MM will be indexed for inflation and shelters many more estates from federal estate taxes.
Rehabilitation Tax Credit Reduced in Scope
The rehabilitation tax credit is now only available for certified historic structures. The 20% credit has been retained, however the 10% credit for pre-1936 buildings has been eliminated.
Section 179 is Now More Useful for Commercial Property Owners
Section 179 allows you to write off the entire cost of certain property. The aggregate cost amount able to be expensed has increased to $1MM, up from $500k. Additionally owners of non-residential property can now use Section 179 for roofs, HVACs, fire systems, and security systems.
Non-residential property is commercial property and certain short-term rental property. So if you own a NNN property or an AirBnB property, you may qualify for immediate expensing of big time improvements.
1031 Exchanges Now Only Allowed for Real Property
The good news is that real estate investors can still use 1031 exchanges. The bad news is that if you have had a cost segregation study performed on your property, you may be in trouble.
1031 exchanges allow you to exchange like-kind property and roll your gain forward without having to pay tax. It’s a great tax deferral strategy that investors have been using for ages.
Why is it bad news if you have previously had a cost segregation stuy performed? Well, the point of cost segregation studies is to identify personal property components and depreciate them over a shorter time frame. With the new 1031 rules applying only to real property, the question then becomes whether or not the personal property identified by the cost segregation study is eligible to be included in the 1031 exchange.
We’re not quite sure yet.
Domestic Production Activity Deduction (DPAD) Eliminated
Unfortunately for flippers, developers, and builders, the DPAD has been eliminated. This was a deduction allowed to be taken based on the wages paid through the ordinary course of business.
Though DPAD has been eliminated, business owners will make up for it through the new pass-through deduction discussed earlier.
No Change to the Section 121 Exclusion
The section 121 exclusion allows you to exclude $250,000 if single, and $500,000 if married filing join, of capital gain from the sale of a primary residence. In order to qualify, you must live in your primary residence for the past two of five years.
Investors across the country flipped out when changes were proposed to Section 121. The plan was to change the year qualifications to five of eight years and add an income limitation to phase high earners out of being able to take the deduction.
Luckily, the GOP heard the outrage and decided not to make any modifications. You can now sleep stress free.
No Change to Depreciation Schedules
Interestingly, the Senate had proposed reducing the useful life of both residential and commercial property to 25 years. This would have been a huge boon to owner of commercial property as the useful life is currently 39 years.
Unfortunately, this was not included in the final bill.
No Change to Self-Employment Tax Rules Related to Rental Income
In an early rendition of the House bill, there was a three sentence clause that subjected rental income to self-employment taxes. That meant landlords would pay an additional 15.3% in taxes on their net rental income. And that would have been insane.
Naturally, chaos ensued and this clause was ultimately called a “mistake.” Rental income is not going to be subject to self-employment taxes.
This tax bill is huge and was rushed through legislative procedure. Because of this, there will be ample opportunities and loopholes that become exposed as we are able to dig into the finer points of the bill.
If you have been hesitant to work with a CPA in the past, now is the year to get one on your bankroll. Don’t brave these tax changes alone, or you’ll likely miss many of the new benefits.