Toward the end of 2017 congress approved a new tax bill that was signed into law and became effective as of January 1, 2018. If you own real estate, there are several thinks you need to know so that you can make educated decisions regarding buying, selling, and holding real estate. I’ll start of with the impact on people who own primary residences.
The Impact of Owners of Primary Residences
One of the biggest tax deductions for most real estate owners is the mortgage interest deduction. When added with property tax and other write-offs, it was often bigger than the standard deduction so it made sense for people in this situation to itemize their deductions and pay less in taxes. Under the new tax law (formally named “The Tax Cuts and Jobs Act”), the standard deduction was increased to $12,000 for people filing individually and $24,000 for joint filers. Moody’s Analytics estimates that about 38 million Americans who own homes and would otherwise itemize will now probably get a bigger benefit by taking the standard deduction. BONUS: tax returns are easier to fill out when you don’t itemize. As interest rates continue to rise along with home prices, mortgages will get bigger and the amount of tax-deductible interest that people pay will also grow which will increase the likelihood of people having deductions beyond the limit of the standard deduction and, thus, benefiting from itemizing. The new tax law limits the size of the mortgage for tax-deductible interest at $750,000, down from $1,000,000 under the previous tax law. Additionally, interest on HELOCs (Home Equity Line of Credit) will no longer be tax deductible regardless of purpose.
Another key change in the new tax law is how state, local, property and sales taxes are handled. State and local taxes (SALT) are still deductible but there is a cap of $10,000 and that includes property taxes and either income or sales taxes. Hence, if you pay $6,000 in property taxes between your house and cars and another $6,000 in income taxes for a total of $12,000, you will only be able to deduct $10,000 of that amount. The impact in states with no income tax will likely be minimal at worst and in many cases will have no impact at all. For those who live in states with high income and property taxes, the $10,000 cap could be fairly significant hit to the bottom line.
The Impact on Real Estate Investors
The 2-in-5 home sale gain exclusion rule was in jeopardy for a while as it was looking like the law might be changed to 5-in-8. This would likely have had fairly significant impact on real estate investors who purchased a move-up home and converted there current primary residence to a rental property. Thanks to the good lobbying job of the National Association of Realtors, congress came to their senses and left the rule as it was.
Another key benefit of real estate investing was also left unchanged – the 1031 exchange rule that allows investors to defer capital gains on the sale of their investment real estate if they purchase real estate of equal or greater value (can be one or more properties) and invest all of the proceeds of the sale of the investment property they are selling remains intact. The rule was changed in the fact that it no longer applies to non-real properties such as aircraft, heavy equipment, franchise rights and other things that used to also benefit from the rule.
Interest expense deductions are limited to 30% of the adjusted taxable income (ATI) of a business. There is a formula for calculating the ATI and you should consult your accountant for help with this in addition to seeing how any of the other tax changes will impact your specific situation. That said, a taxpayer can elect to exclude this limitation for real estate investing purposes. If this election is made, then the recovery periods for depreciation purposes become slightly longer: 40 years for non-residential property, 30 years for residential property, and 20 years for qualified interior improvements. As a side note, business interest expenses that exceed 30% may be carried forward to future years when a taxpayer’s situation is such that they can be used.
Finally, the limitation on deductible taxes discussed in the section above is not applicable to real estate investors. An investor can deduct the full amount of property taxes on his investment property under the new law without regard for the $10,000 cap.
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