Real Estate Winners and Losers Under Federal Tax Overhaul
David J. Petersen
In a prior post, I highlighted the effect the December 2017 Tax Cuts and Jobs Act has on Section 1031 tax deferred exchanges. While those changes affected investors in everything but real estate, other provisions of the Act will have a profound effect on both residential and commercial real estate.
Home Ownership The Act doubles the standard deduction to $12,000 for single filers and $24,000 for married couples filing jointly. This is expected to reduce the number of taxpayers who itemize deductions, which will reduce use of the mortgage interest deduction. Also, the cap on the mortgage interest deduction is reduced from $1 million to $750,000, and now excludes interest on a home equity line of credit. Accordingly, we can expect to see fewer renters motivated to become homeowners for the tax benefits, which may have a significant downward impact on new home construction.
The Act also caps the deductions for other taxes at $10,000. This can be expected to have a negative impact on property values in high-tax states, or in higher-tax areas of certain states (like Multnomah County). The National Association of Realtors predicts a resulting drop in home prices everywhere, and in high tax areas by as much as 10 percent.
Investment Property The Act is a mixed bag for real estate investors, depending on the type of investment. Landlords and farmers are excited by a doubling of the bonus for depreciation expenses, which will make it easier to write off more (or even all) of the cost of tenant or farm improvements. However, other limits on interest deductions take some of the shine off this benefit, since landlords with high interest deductions must choose between the deductions or the bonus depreciation.
Other developers who do not operate as a C corporation may stand to benefit from a new 20 percent deduction on certain "qualified business income," which consists mostly of wages and certain expenses to acquire depreciable property. The deduction reduces taxable income rather than adjusted gross income. Net losses in business income can be carried forward to future tax years. The business must be conducted within the U.S. to qualify. The deduction phases out at higher income levels, and also is not available to professionals in health, law, consulting, athletic, financial or brokerage services. Expect this last exclusion to be the subject of clarifying rules and/or litigation, given the broad and vague terms used in the exclusion.
At this point, it appears that homeowners (particularly those who pay high state and local taxes) are the losers, and businesses with real estate holdings and high wage expenses are the winners, as long as they are in not in one of the disfavored professions. But much about the impact of the Act remains unknown, and a lot will depend on implementing rules to be developed by the IRS. This is perhaps no surprise given the way the Act was put together at the 59th minute of the 11th hour and no doubt voted on by people who hadn't read it.
This blog is not tax advice. You should consult with your tax advisor regarding the potential advantages and disadvantages under the new tax law as it relates to any real estate investment.