Wealth Planning Update - Potential Effects of Tax Reform on Real Estate Investors - The Private Bank

In this Wealth Planning Update:

  • The Tax Cuts and Jobs Act removed uncertainty from the market and provided a significant reduction in the corporate tax rate, positively impacting investor confidence in the real estate market.
  • Real estate investors benefit from changes to bonus depreciation rules and Section 179 deductions and preservation of Section 1031 exchanges.
  • Owners of pass-through entities (any business other than a “C” corporation) benefit from an income tax deduction of up to 20% of qualified business income.
  • The newly introduced caps on state and local taxes and residential mortgages may give pause to homeownership, which could provide a boost for the rental apartment markets.
  • While there are many variables that go into an investment in real estate, these tax changes will likely have significant effects on the markets. It is important to meet with financial, planning or real estate professionals to address any changes that may need to be made as a result of tax reform.

The Tax Cuts and Jobs Act (TCJA) introduced the most comprehensive overhaul to the Internal Revenue Code since 1986, and it could serve as the framework for the U.S. tax system for the next 8 to 10 years. Real estate investors may be affected in a number of ways, including:

  • The effects of tax reform on investor confidence
  • The effects on previous tax incentives for real estate investors
  • New incentives for pass-through entities
  • The cap on state and local tax (SALT) and mortgage interest deductions

While the effects of these changes might be somewhat muted due to other market-driven factors, such as rising interest rates, they should help real estate maintain its place as a highly desirable investment vehicle for the foreseeable future. This Wealth Planning Update discusses the potential effects of these changes on real estate investors. Bear in mind, tax laws or regulations are subject to change at any time and can have a substantial impact on an individual’s situation. Wells Fargo and its affiliates are not legal or tax advisors. Be sure to consult your own tax advisor and investment professional before taking any action that may involve tax consequences.

Effects on investor confidence

Upon its passage, the TCJA removed a great deal of uncertainty from the marketplace. Investors spent much of 2017 contemplating the potential implications and effects of substantial tax reform. With many of the TCJA’s provisions scheduled to be in place for the next 8 to 10 years, investors can move forward with relative confidence knowing how the IRS will tax the vast majority of their investments during that time frame.

The reduction of the corporate income tax rate from 35% to 21% marks one of the more dramatic changes resulting from the TCJA. This reduction provides an opportunity to significantly boost corporate profits, which could be a main driver of the economy going forward. As a result, it is expected that many businesses will likely reinvest these profits into their own growth by:

  • Adding additional facilities and locations
  • Investing in those facilities and equipment
  • Creating jobs and boosting employee wages

Higher wages typically lead to increased consumer spending, which can benefit both manufacturers and retailers. The additional revenue this tax reduction generates should allow businesses to absorb rising rental rates.

Impact on previous tax incentives for real estate investors

The TCJA brought about several changes, including adjustments to the bonus depreciation rules, that should considerably benefit real estate investors. By taking advantage of bonus depreciation, real estate investors can deduct a certain percentage of the cost of qualified tangible business property when they acquire and place such property in service.

Changes to bonus depreciation rules:

  • First-year bonus depreciation is increased to 100% (previously 50%) for qualifying assets acquired and placed in service from September 28, 2017, through December 31, 2022.
  • After this time, the IRS will gradually phase out first-year bonus depreciation during the following five years.
  • Beginning in 2018, bonus depreciation applies to purchases of new and used property. (Previously, it applied only to purchases of new property.)

The TCJA also expanded and increased the benefits that Internal Revenue Code Section 179 provides taxpayers. Section 179 gives real estate investors the ability to deduct the cost of certain depreciable tangible personal property used in rental business as well as the costs of certain nonresidential real property improvements, subject to limitations.

Changes to Section 179 deductions:

  • Rental property owners can now deduct the cost of personal property used in residential rental units.
  • The definition of qualifying property is expanded to include certain nonresidential real property improvements, such as roofs, HVAC property, fire protection and alarm systems, and security systems.
  • The deduction limitation amount is increased to $1 million (from $510,000 in 2017) and the phase-out threshold amount to $2,500,000 (from $2,030,000 in 2017).

The TCJA’s preservation of tax-deferred exchanges under Internal Revenue Code Section 1031 is a significant development for real estate investors. In fact, real estate is the only asset class that retained tax deferral under Section 1031. Repealing 1031 exchanges for real estate likely would have had drastic effects on real estate markets. Sellers would have been subject to tax on all capital gains incurred upon the sale of real property. There continues to be discussion that 1031 exchanges for real estate may indeed go away, but for now they remain in place for the foreseeable future.

New incentives for pass-through entities

The TCJA created a new section (Section 199A) in the Internal Revenue Code. This section allows owners of pass-through entities (generally defined as any business other than a “C” corporation) to benefit from an income tax deduction of up to 20% of qualified business income. The deduction may be available to real estate investors whether they own the property personally or through a business entity. For a variety of tax and non-tax reasons, many real estate investors establish pass-through entities, such as limited liability companies (LLCs) or limited partnerships (LPs), to hold title to their investment properties. In addition to insulating the real estate investor’s liability exposure on the assets owned by such entities (typically an individual property), LLCs and LPs now have the potential to offer additional tax savings by deducting up to 20% of qualified business income, subject to certain limitations. This favorable tax treatment could encourage additional direct investment in real estate, particularly for those investors with a focus on after-tax returns.

Section 199A limitations:

  • An investor may deduct the lesser of: (a) 20% of qualified business income OR (b) 20% of the investor’s taxable income minus capital gains.
  • If an investor’s taxable income exceeds $157,500 for single filers or $315,000 for those married filing jointly, a “greater of” test is phased in to further limit the deduction. When an investor’s taxable income exceeds $207,500 for single filers or $415,000 for married filers, the test is fully applicable.
  • The 20% deduction cannot exceed the greater of: (a) 50% of the W-2 wages paid by the business OR (b) 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted (i.e., immediately after acquisition) income tax basis in qualified property.

Real estate investors should also consider the effects that taking deductions (i.e., mortgage pre-payment penalty as a business expense) have on maximizing the benefit of the 20% deduction.

Planning considerations with business expenses and pass-through entities:

  • Real estate investors should consider how they structure their entities to maximize the availability of this and other deductions.
  • Real estate investors should attempt to allocate their business expenses (including interest expenses) so that they do not miss out on certain deductions and can maximize the 20% pass-through entity business deduction.

Treatment of REITs:

  • Qualified REIT dividends are eligible for the 20% reduction without regard to wage and asset-based caps or qualified trade or business and qualified business-income limitations. This reduces the tax rate on qualified REIT dividends to 29.6% for those taxpayers whose top marginal rate is 37%.
  • Most REIT dividends qualify for this deduction because they are subject to ordinary income tax rates, but the deduction does not extend to dividends that qualify for reduced capital gains rates.
  • REITs should be able to attract new capital by increasing the after-tax returns to individual shareholders. Of course, REIT dividends are not guaranteed and may be reduced, changed or eliminated at any time.

For additional insight in to the TCJA’s effects on pass-through entities, please read the “Pass-Through Entity Taxation Deduction: What Does it Mean for You?” Wealth Planning Update (February 2018).

Cap on SALT and mortgage interest deductions

While the TCJA’s changes to SALT and mortgage interest deductions may adversely affect some homeowners, these changes could produce a positive effect on the residential rental market. Real estate investors, particularly those with vacation home properties, should be aware of these changes.

Changes to SALT and mortgage interest deductions expiring on December 31, 2025:

  • SALT deductions are limited to $10,000. However, the real estate tax deduction limit does not apply when a taxpayer uses the property in a trade or business.
  • The mortgage interest deduction on new mortgages for primary and secondary homes taken out after December 14, 2017, is limited to $750,000 (previously $1 million).
    • Taxpayers who took out mortgages prior to December 15, 2017, can continue to claim up to $1 million ($500,000 if married filing separately) in mortgage interest prospectively.
    • Business properties do not have a limitation on mortgage interest deductions.
  • Investors may no longer deduct interest on home equity loans, unless they use them to acquire or improve a qualified residence, subject to the limits above.

These changes, coupled with rising interest rates, could make homeownership less attractive, particularly at the higher end of the market. A change in sentiment toward home ownership could provide a tailwind for decelerating rent growth in certain apartment markets. This may be particularly evident in high-income-tax and high-property-tax states, such as New York and California, where the TCJA significantly modified previous tax benefits.

Impact on vacation homes and other secondary residences:

The IRS considers a vacation home a personal residence when personal use exceeds the greater of 14 days or 10% of the days the home is rented. Owners of vacation homes and other secondary residences might be able to minimize the impact of the new SALT and mortgage interest limitations by:

  • Limiting personal use to less than the greater of: (a) 14 days OR (b) 10% of the days the owner rents the house. This allows the taxpayer to allocate the property’s expenses between personal and business use.
  • Placing these properties in business entities; this may allow the taxpayer to avoid the limitations altogether.

Conclusion

When combined, the changes outlined above will likely have broad and significant effects on real estate markets. The majority of these changes should benefit real estate investors and developers. There remains uncertainty as to how these changes will affect home ownership trends throughout the country. Furthermore, changes in interest rates, national/regional markets, and the overall economy may mitigate some of the expected benefits from the TCJA for real estate investors.

All of these moving pieces require careful consideration as each individual’s situation is different. Contact your Relationship Manager and meet with Wealth Planners and the Wells Fargo Real Estate Asset Management team to assess considerations and options.

Authors: Scott Bennett, Real Estate Advisory Specialist; Scott Kapin, Real Estate Advisory Specialist; Kenan Peterson, Wealth Planner