How the New GOP Tax Law Affects Owners and Investors of Real Estate

December 28, 2017 Business planning, Real Estate, Small Business, Tax Planning Comments Off on How the New GOP Tax Law Affects Owners and Investors of Real Estate

Real estate has always been a major step in achieving the American dream and so there was plenty of concern within the industry that major changes in the taxes affecting owners and investors of real estate would negatively impact the industry and the tax benefits of owning real estate.   While the final tax changes are expected to diminish the tax benefits for some owners such as:  homeowners who take out mortgages above $750K, homeowners using home equity lines of credit, or homeowners in certain markets with high state tax, the overall impact on real estate, in our opinion, is likely to be nominal.   Below is a summary of the current laws and changes to the tax laws affecting owners and investors in real estate.

State and Local Tax:

Prior Law:

Individuals who itemize their deductions can claim deductions for specific state and local taxes including real property taxes, state income taxes, and sales taxes.  Property taxes incurred in connection with a trade or business can be deducted from adjusted gross income without the need for itemizing.

New Law:

Individuals who itemize (which will likely decrease in light of the increase in standard deductions) are allowed to deduct up to $10,000 ($5,000 if married filing separately) for any combination of (1) state and local property taxes (real or personal), and (2) state and local income taxes.  Prepayments on state income taxes in 2017 for future tax years may not be deducted.

However, state, local and foreign property taxes or sales tax may be deducted when incurred in carrying on a trade or business or for the production of income (reported on Schedules C, E or F).

Conclusion:  Generally worse for Taxpayers who itemize and pay high state and local taxes.

Mortgage Interest:

Prior Law:

Individuals may deduct mortgage interest up to $1M ($500K if married filing separately) of home “acquisition indebtedness”  (secured debt to acquire, construct or improve) on their principal residence, and one other residence of the taxpayer which can include a house, condo, cooperative, mobile home, house trailer, or boat.

Individuals with Home Equity Lines of Credit (HELOCs) were allowed to deduct interest paid on up to $100K ($50K if married filing separately) of a Home Equity Line of Credit.

New Law:

For homes purchased after December 15, 2017, the deduction for 1st home mortgages would be limited to interest paid on mortgages up to $750K ($375K for married filing separate) and is not limited to only your principal residence.  For refinances, the refinanced loan will be treated the same as the original loan so long as the new refinanced loan does not exceed the amount of the refinanced indebtedness.

The deduction for interest on Home Equity Lines of Credit has been eliminated which applies retroactively.  However, the new tax law did not modify the definition of “acquisition indebtedness” and so interest on a Home Equity Line of Credit that was used to “construct or substantially improve” a qualified residence continues to be deductible.

Conclusion:  Worse for Taxpayers since the qualifying indebtedness was reduced from $1M to $750K for debts incurred after December 15, 2017, and indirectly due to the increase in standard deduction plus the elimination of deductions of home equity lines.

Depreciation of Real Estate:

Prior Law:

The cost of real estate “used in a trade or business” or “held for the production of income” must be capitalized and deductions made over time through annual depreciation deductions over 39 years (for non-residential) and 27.5 years (residential) using straight line depreciation.

Certain leasehold improvement property, qualified restaurant property and qualified retail  improvement property can be depreciated over 15 years.

New Law:

Same recovery period for residential rental real estate and non-residential.  However, the previous exceptions for qualified leasehold improvements, qualified restaurant property and qualified retail improvement have been modified and consolidated so that they each must meet the definition of a “qualified improvement property” which is then depreciated over 15 years.

Conclusion:  Nominal change

Capital Gains:

Current Law:   Capital Gains rates apply to any net gain from the sale of a Capital Asset or from Qualified Dividend Income.   Capital Gains and Qualified Dividend Income are subject to rates of 0%, 15% or 20%.  Any net adjusted capital gain that would otherwise be subject to the 10% or 15% income rate is not taxed.   Any net adjusted capital gain that would otherwise be subject to the rates between 15% to 39.6% income rate are taxed at 15%, and amounts taxed at 39.6% income tax rate are taxed at 20%.

New Law:  No change in structure, except that the income tax brackets are modified and the amounts subject to these rates will be indexed for inflation based on the Chained Consumer Price Index (C-CPI-U) beginning the end of 2017.  For 2018, the breakpoints would be as follows:

Under $77,200 (married filing jointly) or $38,600 (single) of income, no capital gains

15% Rate:            From $77,400 married filing jointly ($38,700 for single)

20% Rate:            From $479,000 married filing jointly ($425,800 for single)

Conclusion:   Generally better for investors due to the new tax brackets and indexing for inflation.

Exclusion on Gain on Sale of Personal Residence.

No change.  The rule allowing for an exclusion from capital gains in the amount of $500K married ($250K single) for sale of the personal residence used as such for two out of the last five previous years remains.

1031 Exchanges:

Current Law:  No gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for like kind which is held for productive used in a trade or business or for investment.

New Law:  For transfers after 2017, gain deferral allowed for like kind exchanges of real property only, but real estate held primarily for sale (i.e. flips) would not be eligible.   This applies to exchanges completed after December 31, 2017.  However, so long as the relinquished property is disposed of prior to December 31, 2017, the non-recognition provisions of the prior law applies.

About the author

Lee is an attorney at the California office of Kyler Kohler Ostermiller & Sorensen located in Irvine, California. Lee focuses his practice on real estate and business transactional/ litigation, debtor/creditor law, IRS negotiations, business planning, asset protection and estate planning. Lee’s practice includes advising clients on the formation of business entities, partnerships, and general tax planning relating to business entity formations. Lee also provides advice on structuring real estate investment deals and asset protection issues arising from investments in real estate. He also regularly advises and assists clients in IRS matters including audits, collections, installment agreements and offers in compromise.