2017 Tax Act’s Effect on the Residential Rental Property Owner
As you know, Congress enacted tax legislation at the end of 2017. The changes are effective primarily for transactions occurring after December 31, 2017, thus affecting your 2018 income tax return.
From a rental property owner’s perspective, we are going to highlight:
- State income taxes and real estate taxes
- Interest expense limitation
- A newly created 20% business deduction
- Immediate tangible property expensing
- Depreciation expense
- Use of net operating losses
- Like-kind exchanges
- A few miscellaneous individual income and estate tax law changes
- A reminder of the real estate professional rules
This is not an exhaustive list of the changes and you should discuss with your tax advisor how they affect your specific situation. Please note that the IRS needs to issue guidance that interprets these law changes.
Real Estate Taxes and State Income Taxes
By now you have heard that your personal real estate tax and state income tax that you have claimed in the past on Form 1040 Schedule A as itemized deductions will be limited to $10,000. That limitation does not apply to real estate taxes associated with a rental real estate business reported on your Form 1040 Schedule E. Those real estate taxes will still be fully deductible given there is a bona fide business purpose and there is no personal use limitation.
Unfortunately, your state income tax deduction will be subject to the combined $10,000 limitation, regardless that the state tax is generated in part by your rental business.
There is a new limitation on the number of business interest expenses that you can deduct in any one year. However, this limitation only applies if your aggregate gross receipts exceed $25 million.
Qualified Business Income Deduction
This is a newly created income tax deduction for qualified businesses, which includes residential real estate rental. What is nice about this deduction is you do not have to pay for the deduction; it is “free” and effectively reduces your overall income tax rate.
In general, you may deduct 20% of your net rental income from your overall personal taxable income. If your overall taxable income is less than $157,500 ($315,000 if you are married and file a joint return) then this amount will not be subject to further limitations. If your taxable income is over the above- mentioned thresholds, then you have to calculate two limitations on your 20% deduction:
- The first limitation is 50% of the rental activity’s taxable wages. Congress realized that wages paid in a rental business are generally negligible.
Luckily, the second limitation is 25% of business wages plus 2.5% of the business’s unadjusted basis in depreciable property (including the building) – subject to certain limits and timeframes. You are allowed to use the higher of the two calculated limitations to compare to the overall 20% deduction. You then claim the lower of 20% of business net income or the limitation amount.
As an example, you rent a house that costs $500,000 and you pay an employee $500 per month to manage it. The two limitations are $3,000 ($500 wages X 12 months X 50%); or $14,000 ($500 wages X 12 months X 25%) plus (2.5% X $500,000 building cost). This would allow you to claim the full 20% deduction if your net income from the property were $70,000. If you are paying tax at the highest 37% marginal rate, the $14,000 deduction saves you approximately $5,180.
Bonus depreciation is expanded to 100% of the property’s cost, regardless if it is new or used, for property placed in service after September 27, 2017. Bonus depreciation applies only to personal property (not the building) with a useful life of less than 20 years. Section 179 expensing, which also allows for immediate expensing of capital improvements, has been expanded both through limit increases and by what types of property qualifies for the deduction.
Previously, personal property used in rental properties such as furniture, refrigerators, ranges, and other equipment used in living quarters were ineligible for the Section 179 deduction. Under the new law, these assets are eligible for the deduction.
One tax planning strategy to consider is a cost segregation study (cost seg). In essence, a cost seg is performed by an engineer to “break down” the building into its separate parts and allocate the cost between the building, and the personal property included in the building’s cost. Cost segs have been available for some time, but now that you can include the acquisition of used property and immediately expense it, it will be critical to determine what benefit there could be in accelerating some of those deductions.
Net Operating Loss
Before the law change, if you had an overall loss on your personal income tax return, you may have been able to carry such loss back to your prior two years’ returns and claim a refund for taxes paid in those earlier years. If you decided not to carry back the loss, you could carry forward the loss to future years (not beyond 20 years). For years starting after December 31, 2017, you cannot carry back your net operating loss; you can only carry it forward to offset future years’ taxable income.
Related to the cost segregation opportunities available, if you are eligible to accelerate your 2017 depreciation deductions you may create a net operating loss and carry back the loss to 2015 and 2016. You have time to complete the 2017 cost seg until the extended due date of your return, October 2018.
Congress had discussed eliminating the like-kind exchange rules, whereby a taxpayer can defer the gain on a property sale if he or she exchanges or purchases another similar property within a set period. The new law keeps in place the like-kind exchange rules for real estate, but eliminates the deferral on personal property exchanges.
Miscellaneous Individual Tax Changes
A few other tax law changes are worth mentioning. The top individual income tax rate will be 37%, rather than 39.6%. The tax brackets have also widened providing lower effective tax rates.
The alternative minimum tax (AMT) was not repealed for individual taxpayers; however, the exemption and exemption phase-out limits have been increased.
Also, an individual’s gift and estate tax lifetime exemption has doubled to approximately $11.2 million for 2018. Now, a married couple can gift or pass through an estate with a combined $22.4 million of value.
Please keep in mind that each state has their own rules regarding estate taxes.
Real Estate Professional
Even though it was not a part of the new legislation, it is critical to understand the real estate professional designation that is available to taxpayers involved in real estate. The main tests are whether more than half of your personal services performed during the year are within the real estate industry and whether you spend more than 750 hours in such service.
A real property business includes development, construction, acquisition, rental, management, brokerage, etc. If you own multiple properties and spend 750 hours in total on all the properties, you should consider the election to aggregate the activities on your income tax return. The real estate professional status allows you to deduct the rental losses without being limited by the passive activity rules, as well as avoid the additional 3.8% net investment income tax on net rental income.
The new tax legislation will benefit residential rental property owners. Here’s a recap of some of the biggest wins:
- Deduct 20% of your net rental income from your overall personal taxable income
- Lower effective tax rates
- Bonus depreciation is expanded to 100% of the property’s cost
At Rentalutions, we’re building a community of responsible DIY landlords and tenants by providing them end-to-end tools, education, and customer service to support them in their rental experience.
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This publication contains general information only and Miller Cooper & Co., Ltd. is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Miller Cooper & Co., Ltd. shall not be responsible for any loss sustained by any person who relies on this publication.