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Tax Reduction but Not Reform

By: Marty Rueter, Executive Vice President

As every political pundit, tax preparer, business owner, and “ordinary” wage earner knows by now, there’s a new tax law starting this year. In last month’s Commercial Chronicle, I speculated about varying proposals in the two, widely differing House and Senate tax bills hovering the chilled holiday season – and the most challenging reconciliation of these into a final bill that displeased the fewest. Which deductions and cuts would survive? Which “reforms” would crash into the black hole of nice but naïve ideas?

AT LAST…with President Trump’s signature scrawl, what’s been hypothecated is now set in IRS stone (actually soggy cement until guidelines are written, and then challenged in the Tax Courts).

Immediate observations:

  1. The new law simplifies very little. The volumes of re-definitions, exemptions, and “safe harbors” remain as obscure, even thicker, as the result of strong-arming by lobbyists and big state bureaucrats (including our own real estate trade association).
  1. What HAS changed are lower tax rates for most individuals and businesses, including multinationals that may finally bring offshore profits back into the American economy.
  1. Also seen as overdue is the ability for more taxpayers to file “short forms” (standard deduction) returns – versus having to hoard receipts for every questionable, “itemized” deduction.

SO… here’s a less speculative, factual summary of how this generous, not-so-“reforming” new tax law affects homeowners, investors, and real estate professionals, like you and me.

Effective Date

Individual provisions are effective after December 31, 2017 for the 2018 tax filing year. The new provisions do not affect tax filings for 2017. Unlike those nestling in cushy congressional seats, however, the new Tax Law has term limits – reverting after 2025 to pre-2018 tax rules, absent any extensions.

Tax Rate Reductions

The new law provides lower tax rates for individual filers. While this does not mean every American will pay lower taxes under these changes, most will. The total size of the tax cut from the rate reductions exceeds $1.2 trillion over ten years.

  • The tax rate schedule retains seven brackets, but with slightly lower marginal rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
  • The final bill retains the current rates on net capital gains – a 15% maximum rate (20% for those in the highest tax bracket); 25% rate on recaptured depreciation from real property, and continuation of the Medicare Tax on capital gains partially funding Obamacare.

Major Provisions Affecting Homeownership

Exclusion of Gain on Sale of a Principal Residence

Retains current law – homeowner must live in their primary home two out of the past five years to qualify for the capital gains exclusion of $250,000 for single taxpayers, and $500,000 for those filing jointly.

Mortgage Interest Deduction

The new law reduces the limit on deductible mortgage debt to $750,000 for new loans taken out after 12/14/17. Current loans of up to $1 million are grandfathered, not subject to the new $750,000 cap. Neither limit, however, is indexed for inflation.

  • Homeowners may refinance mortgage debts existing on 12/14/17 up to $1 million and still deduct the interest so long as the new loan does not exceed the amount of the mortgage being refinanced. 
  • The final bill repeals the deduction for interest paid on home equity debt through 12/31/25. Interest is still deductible on home equity loans (or second mortgages) if the proceeds are used to substantially improve the residence.
  • Interest remains deductible on second homes, but subject to the $1 million / $750,000 limits (NAR squeezed very hard on this one). 

Deduction for State and Local Taxes

Taxpayers and lawmakers in “big tax” states screamed LOUDEST on the near elimination entirely of sales taxes, property taxes, and state income taxes. The new tax law ultimately gave some relief – allowing an itemized deduction of up to $10,000 for the total of state and local property taxes and income or sales taxes. This $10,000 limit applies for both single and married filers and is not indexed for inflation.

  • Note that real estate taxes are still deductible on income or business properties.
  • The final bill specifically precludes the deduction of 2018 state and local income taxes prepaid in 2017.

Standard Deduction

Many more middle-income wage earners will be filing “short forms” next year, since the final tax bill provides a standard deduction of $12,000 for single individuals and $24,000 for joint returns. The new standard deduction IS indexed for inflation.

  • By doubling the standard deduction, Congress reduced the value of the mortgage interest and property tax deductions as incentives for homeownership. Congressional estimates indicate that only 5% to 8% of filers will now be eligible to claim these deductions by itemizing, meaning there will be no tax differential between renting and owning for more than 90% of taxpayers.
  • This should spur on real estate investment sales, however, as residential rents will continue to rise with ever increasing demand.

Repeal of Personal Exemptions

Under prior law, tax filers could deduct $4,150 for the filer and each dependent. These exemptions were completely repealed in the new law, mitigating the positive aspects of the higher standard deduction for larger families.

Child Credit

The new law increases the child tax credit to $2,000 from $1,000 and keeps the age limit at 16 and younger. The income phase-out to claim the child credit was increased significantly from $55,000 single/$110,000 married under current law, to $500,000 for all filers in the final bill.

Student Loan Interest Deduction

The final bill retains current law, allowing deductions of student loan debt up to $2,500, subject to income phase-outs.

Deduction for Casualty Losses

Deduction is allowable only if a loss is attributable to a presidentially-declared disaster.

Moving Expenses

The final bill repeals moving expense deduction and exclusion, except for members of the Armed Forces (this could affect employee relocation).

Major Provisions Affecting Commercial Real Estate

Like-Kind Exchanges

The final bill retains the current Section 1031 Like Kind Exchange rules for real property. It repeals the use of Section 1031 for personal property, such as art work, auto fleets, heavy equipment, etc.

Cost Recovery (Depreciation)

Contrary to previous hype, the new law retains the current recovery periods for nonresidential real property (39 years), residential rental property (27.5 years) and qualified improvements (15 years).

Qualified Private Activity Bonds

The final bill retains the deductibility of qualified private activity bonds used in constructing affordable housing, local transportation and infrastructure projects and for state and local mortgage bond programs.

Low Income Housing Tax Credit

The final bill retains current law. However, a lower corporate rate will negatively impact the value of the credits in the future, and may result in less low-income housing being developed.

Rehabilitation Credit (Historic Tax Credit)

The final bill repeals the 10% credit for pre-1936 buildings, but retains the current 20% credit for certified historic structures (but modified so the credit is allowable over a 5-year period based on a ratable share (20%) each year).

Major Provisions Affecting Real Estate Professionals

Deduction for Qualified Business Income

Because the new tax bill greatly decreases the tax rate for corporations (from the prior law’s 35% to just 21%), many members of Congress believed that business income earned by sole proprietors, independent contractors, as well as “pass-through” businesses (partnerships, limited liability companies, and S corporations), should also receive tax rate reductions. In addition to lower marginal tax rates, the final bill provides a significant upfront deduction of 20% for business income earned by many of these businesses, but with certain conditions.

Specifically, the bill limits the 20% deduction to non-personal service businesses. Essentially, a personal service business is one involving the performance of services in the following fields: Health, Law, Consulting, Athletics, Financial Services, Brokerage Services (not real estate), and “any business where the main asset of the business is the reputation or skill of one or more of its employees or owners.”

It seemed clear that most real estate agents and brokers will be considered in a personal service business, and would thus not normally qualify for the 20% deduction. However, NAR was able to help secure a major exception (the personal service income exception) in the final bill that will make it possible for many real estate professionals to be able to take advantage of the deduction.

  • This exception provides that if the business owner has taxable income (after deducting expenses) of less than $157,500 (for single taxpayers) or $315,000 (for couples filing jointly), then the personal service restriction will not apply. 
  • Above this level of income, the benefit of the 20% deduction is phased out over an income range of $50,000 for singles and an income range of $100,000 for couples.
  • For those with non-personal service income above these thresholds, the bill provides a second exception that may still allow a full or limited 20% deduction. This second exception (the wage and capital limit exception) places a limit on the deduction of the greater of:
  • 50% of the W-2 wages paid by the business, or
  • The total of 25% of the W-2 wages paid by the business plus 2.5% of the cost basis of the tangible depreciable property of the business at the end of the year.

Bottom Line: Independent contractors and pass-through business owners with personal service income, including real estate agents and brokers, with taxable income below the $157,500 or $315,000 thresholds may generally claim the full 20% deduction under the personal service income exception. Independent contractors and pass-through business owners with non-personal service income and total taxable income below these thresholds may also claim the full 20% qualified business income deduction.

In addition, independent contractors (or other sole proprietors) with non-personal service incomes above these thresholds may also be able to claim a 20% deduction, but that deduction may be limited by the wage and capital limit exception.

Section 179 Expensing

The final bill increases the amount of qualified property eligible for immediate expensing from $500,000 (current law) to $1 million. The phase-out limitations are increased from $2 million to $2.5 million.

  • The final bill expands the definition of qualified real property eligible for section 179 expensing to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
  • The bill also significantly increases the amount of first-year depreciation that may be claimed on passenger automobiles used in business to $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period.

Denial of Deductibility of Entertainment Expenses

No deduction is allowed with respect to an activity considered to be entertainment, amusement, or recreation; membership dues for any club organized for business, pleasure, recreation or other social purpose; or a facility or portion of a facility used in connection with the above items.

  • The provision thus repeals the present-law deduction for entertainment, amusement or recreational expenses directly related to the active conduct of the taxpayer’s trade or business.
  • Taxpayers may still generally deduct 50 percent of food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).