In a matter of seven weeks, the GOP has developed, amended, and reconciled a $1.456 trillion tax bill. On December 22, Donald Trump tweeted the tax bill into law.
If it feels like this all happened fast, it’s because it did. The Tax Reform Act of 1986, our country’s last major tax overhaul, took a little under two years to pass from start to finish.
This legislative history was promised to be aimed at the middle class. While I’m not going to dive into whether or not that promise was fulfilled, I can tell you this: real estate investors are major winners.
This article is not meant to be all encompassing. I have pulled out changes that I feel will impact the majority of BiggerPockets readers. So even though alimony rules have changed, this is the last time I’ll be mentioning it.
Almost all of these changes begin on January 1, 2018, and revert in 2025.
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
Mortgage interest is now only deductible on the first $750,000 of acquisition debt on primary and secondary residences. There is a grandfather clause that allows all previously purchased residences to continue deducting their interest on up to $1,000,000 of debt.
Interest on home equity debt is no longer deductible, unless the proceeds are used in a trade or business acquisition or to improve rentals. Home equity debt includes refinances on your primary or secondary residences as well as HELOCs.
State and local taxes are now limited to an aggregate $10,000 deduction. This includes state income and property taxes. Folks living in high-income, high-property-tax states, like California, New Jersey, and New York, will be negatively affected. If your state income tax is $12,000 and your state property tax is $8,000, you only get a maximum deduction of $10,000, even though your state and local taxes amount to $20,000 total.
Miscellaneous itemized deductions have been eliminated. This means that you can no longer deduct unreimbursed employee expenses and tax preparation fees (that are not allocated to prepping schedule C and E.
Medical expenses will be easier to claim as the 10% floor has been reduced to 7.5% of AGI. So if your AGI is $100,000, previously you had to incur at least $10,000 of medical expenses before they became deductible. Now you only have to incur $7,500.
Note: these deductions do not limit ability to claim expenses on rental property. These changes are related to your itemized deductions (Schedule A).
Standard Deduction and Personal Exemptions
The standard deduction will now be $12,000 for those filing single, and $24,000 for those who are married and filing joint. Personal exemptions have been eliminated.
Previously, a family of five would get a standard deduction of $12,700, and total personal exemptions of $20,250. Combined, this family received a total deduction of $32,950. Now their total deduction is only $24,000.
Child Tax Credit
To avoid mutiny from the above family of five above, 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.
If you’ve read my prior articles, you likely know my stance on 529 plans. With the passing of this bill, I dislike them a little less.
You can now use 529 plans to pay for private, public, and religious elementary and secondary schools, plus qualified education expenses.
Alternative Minimum Tax (AMT)
Unfortunately for high-income earners and their tax preparers, the AMT is still in existence. The good news is that the exemption amounts have increased to $109,400 for married filing joint and $70,300 for all other taxpayers. Additionally, 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.
Obamacare Penalty Eliminated
The penalty for not having health care has been eliminated beginning in 2019. Healthy millennials who don’t want/need health insurance are high-fiving. Their parents are upset that their premiums will likely increase in 2019.
A new “freebie” deduction has been granted to 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 appears to be on an aggregated basis for rental properties but on a business-by-business basis for businesses.
The deduction is the the sum of:
The lesser of:
Combined Qualified Business Income, or
20% of the excess of: the taxable income divided by 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
In order to figure the above, we must know what combined qualified business income is.
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
Let’s assume that you don’t have any capital gain or qualified cooperative dividends. We’ll also assume you own a rental property you purchased for $120,000, of which $100,000 was allocated to the building and $20,000 was allocated to the land. Furthermore, let’s assume that your rental property generated $5,000 in net taxable income after deprecation and amortization.
Your deduction calculation will be the lesser of:
20% of the qualified business income ($1,000; figured by multiplying $5,000 by 20%); or
The greater of:
50% of the W-2 wages ($0; you didn’t pay yourself W-2 wages); or
The sum of 25% of the W-2 wages ($0) plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property ($2,500; figured by multiplying the unadjusted (unadjusted basis does not include land) basis of $100,000 by 2.5%).
In this example, your deduction will be the lesser of $1,000 or $2,500, so your deduction is $1,000.
This is a freebie deduction. All you have to do in order to claim it is make more money. It’s a deduction that’s figured after the calculation of your AGI though, so it’s being referred to as a “below the line” deduction.
There is another twist though. If your total taxable income is less than $157,500 (if single) or $315,000 (if married filing jointly), then you are excluded from the having to go through the wage and basis calculation. Instead, you will automatically qualify for a 20% deduction on your combined qualified business income.
Service businesses will not receive a deduction at all, unless the taxpayers who own the service businesses fall below the $157,500 (if single) and $315,000 (if married filing jointly). If they can accomplish this, then they too will qualify for the 20% deduction.
Per the new law, service businesses are “any trade or business where the principal asset is the reputation or skill,” except for engineers and architects.
I was sad when I read this because, you know, I run a service business. Maybe our lawmakers know that CPAs will game the system as much as possible, and they just wanted to make it harder for us.
C corporation Rates
If you own a C corporation, you will now see a flat tax of 21%. This is great for C corporations that have large amounts of net income. Generally though, the majority of BiggerPockets readers will not be directly affected.
Will you be indirectly affected via trickle down economics? Who knows.
The new law increases bonus depreciation from 50% to 100% for assets with useful lives of less than 20 years. What does that mean, exactly?
If you buy personal property (carpet, appliances, tools, equipment, etc) or if you make land improvements (landscaping, driveways, parking, etc) you can now immediately write off the entire cost of these assets.
You cannot write off the cost of buying a rental property and the property’s key components because they have useful lives of 27.5 years.
It is important to note that this is bonus depreciation. That means that when you sell the assets, you will pay depreciation recapture tax. Keep that in mind.
Bonus depreciation is retroactive to start in September 2017. So if you are making any year-end purchases/improvements, they will be 100% written off.
Lifetime Gift Exclusion
Every year, you are allowed to gift another person $14,000 without having to fill out a gift-tax form. If you gift any one person over $14,000, you must fill out a gift tax form that then reduces your lifetime gift exclusion.
That lifetime exclusion has been increased to $10,000,000 and will be indexed for inflation. This is on a per-person basis and will reduce the number of estates subject to federal estate taxes.
Rehabilitation Tax Credit
The rehabilitation tax credit has been reduced in scope.
1031 exchanges allow you to exchange like-kind property and roll your gain forward without having to pay tax.
The new rules modified 1031 exchanges to include only real property. The intention was to eliminate exchanges of vehicles, planes, and equipment. But will it affect people who need to 1031 a building that has undergone a cost segregation study? After all, the point of a cost segregation study is to identify personal property assets.
Frankly, we’re not yet sure.
Domestic Production Activity Deduction (DPAD)
DPAD has been eliminated. This will negatively affect flippers, developers, and builders.
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What Didn’t Change
Section 121 Exclusion
This is commonly referred to as the $250,000 ($500,000 if married) exclusion on gain from the sale of a qualified residence. In order to claim the exclusion, you must have lived in the property for the past two of five years.
Earlier renditions of this bill had proposed making the exclusion harder to claim. They had modified the rules to make you live in the property for the past five of eight years, and they included a phase-out for high income earners.
I’m happy to report that there was no change here. You can now sleep stress free.
The senate had proposed moving the useful life of both residential and commercial property to 25 years. This would have been a huge boon to owners of commercial property, as the useful life is currently 39 years.
But this did not make it in the final bill.
Rental income being subject to SE tax
In my previous article on the bill, I reported a three-sentence line in the House bill that would have made rental income subject to self-employment taxes of 15.3%. Luckily, the House admitted this was a “mistake” and removed the provision.
So rental income is still taxed as it is currently. No self-employment taxes.
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What Should You Do Before Year-End?
Pre-Pay 2018 State Property Tax
Everyone should look at pre-paying their 2018 state property tax bill by the end of the year. If you are subject to AMT, you should factor that into your consideration as to whether or not you should pre-pay.
The reason we want to pre-pay state property tax bills is due to the $10,000 aggregate limit on all state and local taxes beginning in 2018. So we shift property taxes from 2018 into 2017 where we can deduct them.
This does not apply to state income taxes. There is a provision in the bill that specifically disallows pre-payment of 2018 state income taxes.
Pay Your Q4 2017 State Income Tax
Though we can’t pre-pay 2018 state income taxes, we can pay our Q4 2017 state income tax bill by the end of this year. Instead of waiting until April 15th, 2018 to pay your 2017 state income tax bill, cut a check to the state by the end of the year. That will allow you to deduct the taxes in 2017 as itemized deductions rather than deducting them in 2018, which will make them subject to the $10,000 aggregate limit.
Next year, you will most likely see tax savings. If you have control over your income, push revenue into January 2018.
Because you will most likely see tax savings next year, go ahead and pre-pay for expenses before the end of the year to reduce your 2017 tax bill. You can pre-pay for trips, conferences, membership dues, and subscriptions. You can also buy tools, equipment, and make repairs before the end of 2017. All of these acts will move more expenses into 2017 and will reduce your 2017 tax bill.
The caveat is that if you consistently have passive losses and cannot claim them due to the passive loss rules, pre-paying won’t help.
This is a huge tax bill. Because it was pushed into law so quickly, there will be tons of loopholes to exposure. Our firm has already identified quite a few strategies that real estate investors can use. I’ll be writing about those strategies over the coming months, so stay tuned!
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.