Real Estate and the 2017 Tax Act
On December 20, 2017, President Trump signed the Tax Cuts and Jobs Act of 2017 (“Tax Act”), ushering in an extensive array of new tax laws. Among them were some fundamental changes that affect primary residence homeowners as well as owners of investment real estate.
Primary Residence Homeowners
Mortgage Interest Deduction. Prior to 2018, individuals could deduct interest on a home mortgage (or second home mortgage) that was less than $1,000,000. As of January 1, 2018, individuals can only deduct interest on a home mortgage that is less than $750,000. However, individuals who purchased a home prior to 2018 or who were under contract before December 15, 2017, will continue to be able to deduct interest on their mortgages up to $1,000,000. This provision in the Tax Act expires at the end of 2025 and the mortgage interest deduction will revert back to the pre-2018 rules.
Home Equity Line of Credit Interest Deduction. Prior to 2018, individuals could deduct interest on a home equity line of credit (HELOC) that was up to $100,000. As of January 1, 2018, the deduction for interest on a HELOC is eliminated until the new Tax Act sunsets at the end of 2025.
State and Local Taxes. Prior to 2018, individuals could deduct state and local taxes (referred to collectively as “SALT”). These taxes included income tax paid to the state (or sales tax if you lived in a state that did not have a state income tax), property tax, and transit tax. As of January 1, 2018, the deduction for these taxes is capped at $10,000 (the same cap for individuals and married couples). High income individuals who live in states with a high state income tax (i.e., California, Connecticut, Oregon, Massachusetts, New Jersey, and New York) will be the most negatively affected by the loss of the full federal deduction. A study done by the National Association of REALTORS™ found that this could result in a drop in home prices up to 10% percent in these states.
Capital Gains Exclusion upon Sale. Prior to 2018, Internal Revenue Code (IRC) §121 allowed homeowners to exclude $250,000 (single) or $500,000 (married) from capital gains upon sale of their primary residence if they owned and lived in the residence as their primary residence for a certain period of time before sale. The ownership requirement was 5 years and the residency requirement was 2 years. Both the House and Senate tax bills had proposed changes to IRC §121 to increase the ownership requirement to 8 years and the residency requirements to five years. Fortunately, the proposed change did not become a part of the 2018 Tax Act and homeowners will continue be able to exclude amounts from capital gain if they own the residence for 5 years and live in it as their primary residence for at least 2 of the 5 years prior to sale.
Moreover, property owners will still have the ability to convert a personal residence into a rental property or convert a rental property into a personal residence and qualify for tax exclusion under IRC §121 and potentially also qualify for tax deferral on the rental property under IRC §1031.
Investment Property Owners
Tax Deferred Exchanges. Since 1921, investment property owners have been able to defer capital gains by swapping one investment property for another (typically known as “1031 tax-deferred exchanges”). These 1031 tax-deferred exchanges were available for both real and personal property, allowing investment owners to exchange investment real estate, aircraft, franchise rights, heavy equipment and machinery, rental cars, and trucks. As of 2018, the new Tax Act limits 1031 tax-deferred exchanges to exchanges of investment real estate, eliminating 1031 tax-deferred exchanges for personal property investments.
Carried Interest. Carried Interest is the share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership. This is specifically seen in alternative investments such as hedge funds, where the General Partner who manages money on behalf of his/her Limited Partner client may receive a 20% share of profits from the investment gain on stocks, bonds, real estate, or other securities held for more than one year. The IRC treats the share of profits paid to the General Partner (“Carried Interest”) as long-term capital gain, which is taxed at a lower rate than ordinary income. Over the years, and especially during the last presidential debate, there was a lot of discussion about changing the Carried Interest rules, but in the past, the private equity and hedge fund industries have fought to keep the Carried Interest rules in place. Under the new Tax Act, Carried Interest will not need to be reported as ordinary income. However, to qualify for the lower capital gain tax rate on Carried Interest, investors will now have to hold these assets for 3 years instead of the pre-2018 1 year holding period.
Immediate Expensing. A business owner may elect to deduct the cost of certain business assets immediately when they are purchased and put into service, rather than over their depreciable life (“Immediate Expensing”). Prior to 2018, property owners including farmers and ranchers, could immediately expense up to $500,000 (adjusted for inflation – $510,000 for 2017) of the cost of certain property each year, subject to limitations: (a) if the cost of assets placed into service that year were more than $2 million (adjusted for inflation – $2,030,000 for 2017) or (b) if the business’s taxable income for the year exceeded a certain threshold. Under the new Tax Act, the amount a business can immediately expense is increased to $1,000,000 and the phaseout limitation is increased to $2,500,000 (indexed for inflation after 2018). The Tax Act also expands the definition of qualified real property which is eligible for immediate expensing to include all qualified improvement property and certain improvements (roofs, heating, ventilation, and air-conditioning, fire protection and alarm systems, and security systems) made to nonresidential real property.
Business Interest Expense Deduction. Prior to the new Tax Act, certain business interest expenses were deductible. As of 2018, these expenses are limited to 30% of the taxpayer’s earnings before interest, tax, depreciation, and amortization (EBITDA) for taxable years 2018-2021. In 2022 and thereafter, the deduction is limited to 30% of a taxpayer’s earnings before interest and tax (EBIT). The limitation does not apply to regulated public utilities, certain electric cooperatives or taxpayers with average annual gross receipts for the current and prior two taxable years under $25 million. Further, at the taxpayer’s election, the limitation does not apply to interest incurred by the taxpayer in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Depreciable Lives for Certain Depreciable Real Property. If a taxpayer elects to be excluded from the business interest expense deductibility limitations described above, the taxpayer must use the alternative depreciation system to depreciate its real property. Pursuant to the new rules, the recovery periods under the alternative depreciation system for nonresidential depreciable real property, residential depreciable real property, and qualified improvements are 40 years, 30 years, and 20 years, respectively. These longer depreciation schedules can have a negative impact on the return on investment and property owners will need to weigh the benefit of the interest expense deduction against the longer depreciation schedules.
State and Local Taxes. Prior to 2018, a business owner could deduct state and local taxes incurred in (a) carrying on a trade or business, or (b) in an activity related to the production of income. Under the new Tax Act, these taxes remain deductible. While individuals are limited in the amount of property tax they can deduct on their personal residences, rental property owners can deduct the full amount of the property taxes on their rental properties. This may lead to more people purchasing single family residences as investment properties than as personal residences.
Preservation of the Historic Tax Credit. The new tax law retains the 20% tax credit for the rehabilitation of historically certified structures, but taxpayers must claim the credit over a 5 year time period. Much-loved by preservationists, these credits help restore and renovate historic structures and have been a boon for urban development. For example, The Trump Organization is currently seeking those credits to offset $40 million in costs for the transformation of Washington, D.C.’s post office into a Trump Hotel.
The new Tax Act has a wide ranging effect on individuals and businesses. For more information regarding the new Tax Act, contact any of the attorneys in Helsell Fetterman’s Taxation Group.