Key Changes in the Trump Tax Plan That Will Affect Real Estate Investors
by Brandon Hall - CPA
On November 2, 2017, the U.S. House of Representatives released its proposal for tax reform called the Tax Cuts and Jobs Act (H.R.1). Though lacking a creative title, the 429 page bill proposes sweeping changes that will affect how you invest in the future.
Our firm tediously analyzed each page of the bill to compile and condense the key items you must pay attention to. Today’s post will touch on a few of the bigger finds.
Keep in mind that we don’t know what parts of this bill (if any) will actually pass. It’s important for you to read through this post and the bill itself in order to understand the potential affect on real estate investors. However, take a deep breath as this bill still has a long way to go to meet the standards of a few GOP fiscal hawks in the senate.
Biggest Loser: Rental Income Subject to Self-Employment Tax
We couldn’t believe it when we found this one short sentence on the 51st page of the bill “(3) APPLICATION TO RENTAL INCOME.—Section 1402(a) is amended by striking paragraph (1).”
This was found in the section where the bill defines “net earnings from self-employment.” Let’s break this down.
The bill is amending IRC Section 1402(a) by removing paragraph one (aka IRC 1402(a)(1)). If you were to type “IRC 1402(a)” into a Google search, the first link will take you to the current definition of “net earnings from self-employment.” If you look at paragraph one (IRC 1402(a)(1)) as it’s currently written, you’ll see that the paragraph provides an exclusion of rental income from the calculation of self-employment income. This paragraph, which the bill proposes should be removed, saves you from paying Social Security and Medicare taxes, a total tax of 15.3%, on your net rental income.
So if paragraph one is removed as the bill proposes, your rental income may be subject to an additional 15.3% tax.
However, it’s not as simple as saying all rental income is subject to self-employment taxes. First, you’d actually have to show net positive taxable rental income in order for the self-employment taxes to apply. Assuming you do have net positive taxable rental income, you’d also have to be conducting a “trade or business.”
What type of landlords are running a “trade or business” is where it gets murky.
The IRC does not define “trade or business” anywhere in the tax code. Instead, we have to look to tax court cases to understand what “trade or business” means. To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit (Commissioner v. Groetzinger, 480 U.S. 23 (1987)). Profit motive factors are defined in the IRC and there are other Tax Court cases we can look to in order to better define a trade or business.
Your rental income may be subject to self-employment taxes if you:
- Qualify as a real estate professional
- Materially participate in your rental activities
- Invest in short-term rentals
Holding rentals passively will not likely subject your rental income to self-employment tax. So if your rentals house long-term tenants and you have a day job (or business), you will likely avoid qualifying your rental income for self-employment taxes.
Regardless, should this one sentence go unnoticed and pass, it will have hugely negative implications for real estate investors.
Second Biggest Loser: Loss of Itemized Deductions
What you will be able to write off as an itemized deduction on Schedule A will change drastically.
First, you will no longer be able to deduct state and local income taxes paid during the tax year. That tends to be one of the biggest itemized deductions for our clients in high-tax states. The elimination of state and local income taxes as itemized deductions will be costly for those in high-tax states. For folks in low-tax (or no-tax) states, the impact will be less noticeable.
Real estate property taxes are now capped at $10,000 on Schedule A. This will hurt people who own a primary residence or a second home of high value, or own in a locality with high property taxes.
Personal property taxes are no longer deductible.
Mortgage interest on new loans is now deductible only on the first $500,000. I have seen mass hysteria in the real estate investment community with this new limit. However, keep in mind that this limit applies to your primary residence and a second home. Your rental properties will not be subject to this limit as it’s written.
Third Biggest Loser: The Section 121 Exclusion is Harder to Claim
Currently, the IRC Section 121 allows you to exclude $250,000 ($500,000 if married) of capital gains on the sale of your primary residence, as long as you’ve lived in the property for the past two out of five years. The new bill states that you must now live in your primary residence for the past five of eight years in order to qualify for the gain exclusion. The real bummer here is that there is no transition period as currently written in the bill. This means that any sale after January 1, 2018, must meet the new five-of-eight-years requirement.
So if you were planning to sell your primary residence and cash out the capital gains tax-free, you had better get moving on listing the property and hope that either (1) you sell before the end of the year or (2) this measure does not pass.
Other Losers: Elimination of DPAD and Rehabilitation Tax Credits
The Domestic Production Activity Deduction (DPAD) is a nice boon that rehabbers, developers, and builders can claim to further reduce their tax liabilities. You can only claim DPAD if you combine raw materials into an inventory item and then hold them out for sale. The bill currently proposes to eliminate the DPAD.
The Rehabilitation Tax Credit is also on the chopping block. This credit helps investors who fix up decrepit parts of cities and towns and hold the properties for a number of years. The proposed bill will eliminate this credit.
Biggest Winner: Elimination of Alternative Minimum Tax
We jumped for joy when we found out that the Alternative Minimum Tax (AMT) was proposed to be eliminated with this bill. The AMT is an attempt by congress to make sure that rich Americans pay at least a 28% tax on all of their income. The problem is that the AMT negatively impacts the middle class, probably more so than it does the rich. Additionally, it can be insanely difficult to calculate, adding to processing time and professional fees incurred. Basically, it doesn’t serve its purpose and it’s inefficient and rightly being eliminated.
Second Biggest Winner: 25% Entity Pass-Through Tax and 20% Corporate Tax
Some LLCs and S corporations will now enjoy a 25% tax rate on their pass-through income. I say “some” because the calculation on the 25% pass-through rate is complicated, and businesses such as service businesses have been specifically excluded from qualifying for a 25% rate.
The calculation that was created leaves some S corporation owners out to dry. You will now use a “capital percentage” to calculate how much of your net income will be taxed at a 25% rate and how much will be taxed at rates above 25%. Businesses that are capital intensive, such as flippers, developers, and builders, may be able to justify high capital percentages. Otherwise, your capital percentage is 30%, meaning that only 30% of your net income from your business operations is subject to a 25% tax. The remaining 70% could be subject to your marginal tax rate if higher than 25%.
This is a huge bummer, especially considering C corporations now have a 20% tax rate. We are hoping that the calculation for the 25% tax on pass-through income will change as the bill moves through the senate.
Other Winners: 100% Bonus Depreciation and a $10 Million Threshold for Lifetime Gift Exclusion
Currently, the tax code allows for a 50% bonus depreciation on personal property purchases. So if you were to buy carpet that cost you $5,000, you could write off $2,500 today via the 50% bonus depreciation and then you’d depreciate the remaining $2,500 over a five year period.
With this new bill, you will be able to write off the entire amount of the personal property item as long as it has a useful life of less than 20 years.
Another win is the fact that you will now have a $10 million threshold for your lifetime gift exclusion amount. Previously, the amount was $5 million, which was adjusted for inflation giving us a $5.45 million in 2017. This means that each person can now give their heirs up to $10 million in wealth without being subject to taxes.
There are many changes in H.R.1 and we except to see push back from the senate. We’re not sure what will and will not pass, only time will tell. Our firm put together a public Google doc which you can find here. The link will not take you to our website, just to a document where we’ve compiled our detailed findings of this bill.