The Tax Cuts and Jobs Act, signed into law December 22, 2017, significantly affects real estate. We outlined the provisions affecting homeowners in our 12/20/17 blog "Tax Cuts and Jobs Act vs Portland Real Estate." This post covers the provisions directly affecting real estate investors.
Changes that are particularly relevant to real estate investors, large and small:
- No gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a "like kind" which is to be held for productive use in a trade or business or for investment.
- The tax-deferred like-kind exchange rules will apply only to real property.
Capital Gain Rates
- 20% maximum rate applicable to individuals on net capital gain and qualified dividends.
- 25% rate applicable to unrecaptured depreciation.
- No change, except to add inflation indexing.
Federal Estate Tax
- Increased the exemption amount from $5.6 million to $11.2 million per person.
- Exemption amount remains subject to adjustment for inflation.
- Left intact the portability election between spouses.
- Assets still get stepped-up basis upon death, thereby providing income tax savings to the beneficiaries in the form of reduced gain or increased depreciation.
Business Interest Deduction
- Business interest was fully deductible.
- Net interest that exceeds 30% of earnings before interest, taxes, depreciation, and amortization cannot be deducted.
- Real estate investors can elect out of this limitation, but will then need to depreciate property over slightly longer time periods.
- Does not apply if the average annual gross receipts for the prior three tax do not exceed $25 million.
- Hedge funds and private equity firms gained notoriety in the Presidential campaign debates when both candidates attacked "carried interest" as an egregious tax loophole.
- In simple terms, carried interest is the profits interest a partner gets in addition to the percentage of capital contributed. The 'loophole" is that such an interest is usually taxed at long term capital gain rates.
- Example: one partner puts up the money, the other puts in the work, and they split profits on the sale of the asset. The working partner thereby converts what would be ordinary income for services into long term capital gain on asset sales taxed at a much lower rate.
- Must hold property three years to get long term capital gain treatment on carried interest.
- Does not apply to a taxpayer who only provides services to a so-called "portfolio company."
Pass-Through Entity Income - Short Summary
- New IRC Section 199A allows individual who owns an equity interest in a pass-through entity that is engaged in a qualified trade or business to deduct up to 20% of the qualified business income allocated to him from the pass-through entity.
- The deduction does not change how the business calculates its taxable income.
- The deduction is limited to 20% of the individual’s taxable income without considering this deduction.
- The deduction is claimed on the individual's Form 1040 "below the line," meaning it reduces taxable income but not adjusted gross income.
- The deduction is available regardless of whether the individual itemizes deductions or take the standard deduction.
- Active real estate investors qualify. Passive real estate investors probably qualify. Guidance is needed.
- This is a federal tax deduction. The effect on state income taxes will vary by state.
Pass-Through Entity Income - More Details
When the graduated corporate tax rates that topped out at 35% were being replaced by a flat 21% tax rate a number of private companies, who operate as S corporations and limited liability companies, complained that they were not getting the benefits of the rate reductions intended for businesses. Such businesses are not taxed at the entity level; instead their owners (partners, members, shareholders, etc.) are taxed individually on their share of the business's net income. So the new law includes Section 199A Deduction for Qualified Business Income. The provision is complex, the definitions are ambiguous, and there are virtually no committee reports or records of other discussions to provide guidance. Treasury Regulations and other forms of guidance will appear over time. The saying "the devil is in the details" was never more applicable, so consult a professional as needed. The following summary is the best we can do for now:
An individual who owns an equity interest in a pass-through entity that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him by the pass-through entity.
The term 'pass-through entity' means:
- Sole proprietorship (Individual Form 1040 Schedule C)
- Real estate investors (Individual Form 1040 Schedule E)
- Single member LLC (a 'disregarded entity')
- Partnership (Form 1065)
- Multi-member LLC (Form 1065)
- S corporation (Form 1120S)
- Trusts and estates, REIT's and qualified cooperatives
The term 'qualified business income' means the net income from any qualified trade or business of the taxpayer, without regard to reasonable compensation paid by an S corporation, guaranteed payments paid for services, or payments for any services paid by a partnership to a partner.
The term 'qualified trade or business' means any trade or business other than -
- a specified service trade or business, or
- the trade or business or business of being a employee.
A 'specified service trade or business' is "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners." Excluding them from the definition of a 'qualified trade or business' is designed to deter high-income taxpayers from converting wages or other compensation for personal services into income eligible for the deduction. There is a threshold below which the exclusion doesn't apply (meaning the 20% deduction is available), a range is which it is phased out, and a higher threshold above which there is no deduction for income from a specified service trade or business.
Real estate investment is expected to be a 'qualified trade or business,' but the law in this area is not clear. Neither the statute nor the committee reports directly address whether a rental is trade or business in the context of Section 199A..
Further Limitations (Still Under Construction):
- If taxable income (before QBI deduction) is greater than $315,000 (married filing jointly)/$157,500(all others), the deduction is limited to the greater of:
- 50% of the taxpayer's share of aggregate W-2 wages paid by the business, or
- 25% of the taxpayer's share of aggregate W-2 wages paid by the business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (i.e., structures, not land) that is held at the end of the taxable year.