Individual Real Estate Investors Are Affected by the New Tax Cuts and Jobs Act in Six Different Ways.
Tax reform might have significant effects on real estate investments. The Tax Reform Act of 1986, the last major tax reform, was intended to streamline the tax law and remove tax shelters. The 1986 tax reform reduced the highest tax band for individuals from 50% to 38.5% but also eliminated most tax savings options and caused a drop in the value of the commercial real estate. Commercial real estate is anticipated to see the opposite effects of the Tax Reform law, passed into law on December 22.
The Tax Reform act aims to return more money to individuals and companies, stimulating the economy via investments and job creation. Real estate investors will benefit from the Tax Cuts and Jobs Act’s pass-through deduction law, increasing the after-tax asset return. The final outcome is a more significant demand for commercial real estate and increased profits for investors.
The Tax Reform act contains two of the most substantial changes to the federal corporate tax rate and the highest individual income bracket. The reduction of the national corporation tax rate from 35% to 21% accounted for $1 trillion of the $1.5 trillion tax cuts. Increased business investment or dividends are given to shareholders are anticipated to return $1 trillion to the economy. In addition, the measure has lowered the highest tax level for regular income from 39.6% to 37%. This would return billions of dollars to people and undoubtedly benefit the luxury goods and vacation home markets.
Here are six significant provisions of the new tax legislation that will affect real estate and individual investors, as well as our opinion on each.
- Negative Individual State Deductions.
State and municipal property tax deductions for individuals are now limitless. The new tax legislation caps these deductions at $10,000. If your yearly property tax payment exceeds this amount, you may choose to prepay the first installment of your 2017 property tax bill before the end of 2017. As the new rule does not take effect until 2018, you may deduct 100 percent of any real estate taxes if you paid them in 2017. This seems to be a simple approach to saving on taxes, but you should contact your own tax attorney for advice. Additionally, this may influence demographic changes when individuals relocate from high-cost to low-cost jurisdictions.
- Positive Pass-Through Deductions
Members, proprietors, and partners of pass-through businesses will be eligible to deduct 20% of their pass-through firms’ taxable income. This deduction results in a maximum effective tax rate for pass-through income of 29.6 percent.
Example
- Profits of a Corporation: $100,000
- Twenty percent Subtraction: $20,000
- Profits taxable of an LLC: $80,000
- The new tax rate is 37%
- Individual Tax Liability: $29,000
- The effective tax rate is 29.6%
This is a substantial advantage for real estate investors and will increase the after-tax benefit of investing in the asset class. The 20 percent pass-through deduction starts to taper down at $315,000 and is eliminated at $440,000.
- Taxes on Carried Interest and Capital Gains – Negative/Neutral.
Long-term capital gains are attainable for assets held for more than one year under the 2017 legislation. This regulation remains unchanged under the new law. However, carried interest capital gains have been broadened and reinterpreted to include assets held for over three years. This adjustment might motivate sponsors to maintain support for a more extended period and limit the amount of commercial real estate transactions. We usually keep our properties for more than three years; therefore, it will not affect how we do business.
- Capital Expenditures – Positive.
Code Section 179 of the new legislation will be enlarged to encompass certain additional actual property capital expenditures that may now be “written off” in full in the year they are spent, while under the 2017 tax code, they are depreciated over their remaining useful life. This might be particularly advantageous for commercial real estate investors since it would result in a considerably higher “paper loss” that they could use to offset non-real estate-related profits.
- Negative Interest Expense Deduction.
If you take up a new mortgage on a primary or secondary residence, you can only deduct interest on debt up to a principal sum of $750,000, down from $1 million today. Existing homeowners with a mortgage would be unaffected by the change. On the other hand, there will be no limits on commercial real estate interest cost deductions.
- Tax Holiday for Foreign Cash Held by U.S. Corporations – Positive.
Compared to the current corporation tax rate of 35.5 percent, the new tax law enables U.S. businesses to return an estimated $2.5 trillion to $3 trillion in offshore profits to the United States at a tax rate of 15.5 percent. Returning this cash to the United States will undoubtedly stimulate the economy in every region.
In the near term, the newly enacted tax reform is anticipated to benefit real estate investors and high-income earners. However, we do not expect the new law’s benefits to be realized until 2018 since it often takes time for tax cuts to permeate the system and alter behavior. Long-term, we must be cautious about adding $1.5 trillion to the deficit and the inflation that might result from it.
Rising interest rates are not favorable for real estate prices. However, the stimulus is anticipated to increase demand for real estate, and property income growth might easily outweigh the concerns of an environment with rising interest rates. Finally, we must consider the possibility that many of these new regulations may be repealed by the next government. Most tax law modifications, except the corporate tax rate, are predicted to be abolished by 2025.
This page was revised after the passage of the tax package into law.
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