On Wednesday, Dec. 20, 2017, Congress passed a sweeping $1.5 trillion tax reform of the Internal Revenue Code of 1986. Dubbed the “Tax Cuts and Jobs Act,” the bill next heads to the President’s desk to be signed into law, which may occur in January 2018.
This bill has been characterized as the most significant overhaul of the U.S. tax code in more than 30 years. The Trump administration’s stated goals are to grow the economy, raise wages and promote economic competitiveness. While the corporate rate reduction and international reforms are proposed to be permanent, the tax bill sunsets nearly all individual tax provisions (including the new pass-through income deduction) at the end of 2025 in order to comply with Senate budget reconciliation rules. At that point, a future Congress would need to consider the extension of these provisions.
This article highlights some of the key tax reform provisions relevant to real estate owners, investors and developers.
- The corporate tax rate is slashed from 35% to 21% (effective in 2018). As a result, the current graduated corporate tax rate structure with its maximum rate of 35% will be replaced with a flat rate of 21%. Touted by many as the centerpiece of the legislation, this is a significant achievement, since the U.S. is considered to have the highest statutory corporate tax rate among advanced economies.
- The seven-bracket structure for individual tax rates is maintained with small reductions in the rates paid. The bottom rate remains at 10%, rising to 12%, 22%, 24%, 32%, 35% and finally 37% for taxable income above $500,000 for unmarried individuals and $600,000 for married, filing joint taxpayers. (The comparable current rates are 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.)
- The standard deduction is roughly doubled from $6,350 and $12,700 under current law to $12,000 and $24,000 for single filers and married couples, respectively.
- The alternative minimum tax (AMT) is retained for individuals (but with increased exemptions) and eliminated for corporations.
- The current estate (or death) tax exemption threshold is doubled from the $5 million base to a new $10 million base, which exemption is indexed for inflation.
- Like-kind (or 1031) exchanges are retained, but only for real property transfers beginning on Jan. 1, 2018. Taxpayers will be prohibited from deferring taxes from the sale of personal property (e.g., furniture and equipment) included with the like-kind exchange of real property.
- This result is a major relief for the real estate industry, as there was widespread concern that all aspects of this nearly 100-year-old reinvestment vehicle could be at risk under the bill.
- One of the biggest wins for the real estate industry is that certain property owners will now benefit from lower taxes on so-called pass-through income, which is income earned by pass-through entities (e.g., partnerships, S corporations and LLCs) whose income is passed through to its owner and taxed at the individual tax rate.
- Under the tax plan, owners of pass-through entities and sole proprietors (as written “taxpayers other than corporations”) will be allowed a deduction of up to 20% of domestic qualified business income, subject to certain limits. This deduction, which expires on Dec. 31, 2025, will have the effect of reducing the tax rate on pass-through income to less than 30% in many cases.
State and local tax (SALT) deductions
- State and local tax (SALT) deductions will remain in place, but will be capped at $10,000 for any combination of state and local income and property taxes. That means homeowners living in high-tax states like California, New Jersey and New York could see an increase in federal tax payments in coming years. This provision expires after 2025.
- Notably, while the provision prevents a taxpayer from prepaying 2018 state and local income taxes in 2017 to avoid the cap, a taxpayer may be able to prepay 2018 property taxes.
Mortgage interest deduction
- Under existing law, a taxpayer may claim an itemized deduction for mortgage interest paid with respect to one’s principal residence and a second qualifying residence. Itemizers may deduct interest payments on up to $1 million in acquisition indebtedness (for acquiring, constructing or substantially improving both residences).
- Under the new tax plan, mortgage interest on up to two personal residences can still be deducted for mortgage debt originating after Dec. 15, 2017, but only up to $750,000 in acquisition indebtedness for tax years 2018–2025.
- Any debt incurred before Dec. 15, 2017, would still be covered by the current law. Even if refinanced later, the debt would continue to be covered by the current law’s $1 million cap to the extent that the amount of the new loan does not exceed the amount refinanced. Beginning in 2026, the $1 million limitation would apply, irrespective of when the indebtedness was incurred.
- While a taxpayer can currently deduct interest payments on up to $100,000 in home equity indebtedness, this tax benefit is suspended for tax years 2018–2025.
Capital gains exclusion for sale of principal residence
- Taxpayers will still be able to exclude up to $500,000 (or $250,000 for single filers) from capital gains taxation when they sell their primary home, as long as they have lived there for at least two of the past five years.
Business interest deduction and property depreciation
- While the existing law generally allows a deduction for business interest expenses, the tax bill limits that deduction to the sum of business interest income plus 30% of adjusted taxable income.
- Notably, real estate businesses can elect out of the business interest deduction limitation, but at the cost of longer depreciation recovery periods—30 years for residential real property and 40 years for nonresidential real property.
- If a real estate business does not elect out of the interest deduction limitation, then residential and nonresidential real property depreciation recovery periods are maintained at 27.5 years and 39 years, respectively.
- The tax plan retains the Low-Income Housing Tax Credit (LIHTC) program, which encourages taxpayers to invest in affordable housing whereby owners of certain residential rental property may claim a low-income housing tax credit over a ten-year period.
- The tax plan also continues the new markets tax credit, which encourages investment in other developments in low-income areas.
- The bill also preserves tax-exempt private activity bonds (PABs), including multifamily bonds. PABs have traditionally funded a significant number of projects, and are estimated to finance more than half of all LIHTC-financed affordable homes annually.
Real estate implications of tax law changes
After many months of public speculation on tax reform, perhaps the prime benefit of the new tax regime to the real estate industry is its completion. The increased clarity could empower real estate investors who had cautiously moved to the sidelines beginning with the Trump/Clinton presidential campaign.
The preservation of 1031 tax-deferred exchanges for real property will provide a measure of relief to the real estate industry. Moreover, the favorable treatment of pass-through income may encourage additional capital to enter the commercial real estate market.
Once the President signs the bill into law, the Treasury Department and IRS will begin its implementation. We recommend that real estate investors take the time now to better understand how the new legislation will impact their tax liability and whether any changes should be made to real estate investments. We will monitor new developments and hope to provide updates on relevant provisions under this extensive rewrite of the U.S. tax code.