Starting this week, new tax rules will usher in the New Year with a big win for residential and commercial real estate investors. It’s still too early to know the full impact of the legislation, but many tax professionals say real estate investors and other property owners have hit the jackpot.
Experts say it will take months, or even years, to know the full impact of this bill, including the changes in behaviors the bill will bring about. Here are a few insights on how the new tax rules will benefit both residential and commercial property owners (1).
Tax Rates Lowered (Almost) Across the Board
Starting in 2018, individual taxpayers, corporations and even self-directed IRAs that incur UBIT will see across the board lower tax rates. For investors using pass-through entities or investing in their own name, the individual tax brackets were widened and the rates were lowered for ordinary income (capital gains rates and rates on dividend income remain the same).
For investors using a corporation, the graduated tax rates, that previously went all the way to 35%, were consolidated into a flat 21% rate. Only corporations that had less than $50,000 in taxable income will see a tax rate increase (from 15% to the new, flat 21%). Even tax rates applicable to trusts (and used for self-directed IRAs that have unrelated business taxable income) will see a slight reduction in the tax rates.
Pass-Through Entities Get 20% Bonus Deduction
One of the sweetest deals in this tax package for people in the real estate field is the 20% deduction for pass-through entities like S Corporations, LLCs and limited partnerships. Gains and losses for these companies “pass through” to the members who are responsible for paying taxes according to their individual tax brackets. Under the new rules, these members can take a special bonus deduction of 20% of flow-through income (now called “qualified business income”).
This special deduction is unrestricted until total taxable income reaches the income limitations of $157,500 for single filers and $315,000 for married couples. After that level of taxable income, the special deduction depends on the wages the business pays. However, in a last-minute nod to the real estate industry, Congress approved a secondary calculation of the limit that is also based on asset investment. There are separate and stricter limits for people earning pass-through income in service businesses such as doctors, attorneys, brokers, etc.
Ryan Schellhous, CPA and Principal at IndigoSpire CPAs & Advisors, told us in a recent Real Wealth Show interview, “It’s a huge boon for some folks, and it’s not going to matter all that much for others.” He said the provision allowing for the deduction at higher income levels is pretty complex, but, he said, “It’s something you definitely want to talk about if you’ve got flow-through income and you make less than $315,000 as a married couple,” or less than $157,500 as an individual. Above that level, you can still get some benefits, but you might have to get some professional structuring advice.
Expanded Depreciation Coverage
Many commercial real estate investors will be pleased to see changes to several depreciation rules and special expense deductions. Most notably, the new law changes the definition for things investors can write off in full in the first year, from assets that are brand new to “you.” Those assets are also defined by a recovery period of 15 years or less.
Schellhous said, “It’s going to be huge for single-family investors.” He offered an example of how it will benefit investors saying, if an investor and an individual homebuyer each purchased the same kind of home for the same price, the investor might get to write off, let’s say, $60,000 worth of assets pertaining to that property under the new provisions. The homebuyer would not get that advantage, making the acquisition of an investment property a much better deal, financially.
It’s good for the single-family investor to know the new rules apply to rentals that are purchased fully renovated, as well as those that are bought as fixer-uppers and renovated after the purchase. Schellhous said, investors will need to take a close look at properties they purchase to determine what can be expensed and what can be depreciated.
He said, investors need to divide their properties into categories of land, which is not depreciable, homes and buildings, which are depreciable over a long period, and other tangible assets which can be fully expensed for the year they are put into service under the new law. Examples of assets that fall into the “expense” category include a furniture, fixtures, appliances, certain remodels, etc. It can be fully expensed because it is “new” to you and has a recovery period of less than 15 years. New renovations, landscaping, air conditioning or heating units, window treatments, floor coverings, and other upgrades might also be likely candidates for this category depending on your facts and circumstances.
Schellhous noted that the IRS does not take kindly to property owners and investors that use “rule-of-thumb” percentages or property tax statements for dividing a purchase price into different asset classes. With these enhanced depreciation provisions now available for some assets, the pressure to have a proper segregation of costs and documentation is going to be enormous.
Schellhous’ firm, IndigoSpire CPAs & Advisors (www.indigospire.com) has already developed an online tool that will walk property owners through key aspects of their property and produce a report using IRS approved methodology that divides a purchase price into the different asset classes, including the ones that can be immediately written-off in the first year.
This “one” part of the tax reform package is also effective retroactively to homes placed in service on or after September 27th of this year. Kenneth Weissenberg, of EisnerAmper LLP, said in a Forbes article, “While the fast enactment of the legislation did not give taxpayers much time to act, those that already had projects in the works will certainly benefit from this provision.” (2)
1031 Exchange Preserved
Real estate investors are also rejoicing that the 1031 exchange was preserved for real estate investors. The 1031 exchange allows investors to defer taxes on capital gains when they sell one property to buy another “similar” property (as defined by the IRS). It’s also important to note that lawmakers did kill the 1031 exchange for other kinds of assets. Real estate is the only asset that can now use this tax-deferring strategy.
If you want to hear more about “bonus depreciation” rules and other tax benefits for real estate investors in the new tax reform bill, listen to Podcast Episode #605 of The Real Wealth Show.
(1) Reform Benefits Commercial Real Estate: Seeking Alpha
(2) Forbes Article