Real estate investors may have never had it so good. A classic alternative investment in a volatile stock market, real estate also just got a boost from the Tax Cuts and Jobs Act, with landlords among the biggest winners.
The law’s new provisions especially favor rental properties. “Real estate investors have historically been given preferential treatment by the tax code,” says Nick Sher, founder of New York-based Sher & Associates. “All things being equal, 2018 tax reform only enhanced that preferential treatment.”
And there’s no shortage of tenants. While the housing boom and bust of a decade ago hurt a lot of overleveraged buyers, we’re facing a housing shortage right now, and that scarcity could mean higher rents.
Other tax changes that have created disincentives for home ownership could push more consumers into the rental market. New limits on deductions for mortgage interest and state and local property taxes mean there’s less of a tax advantage to owning a home. The higher standard deduction may also have a chilling effect on a taxpayers’ ability to benefit from itemizing and deducting mortgage interest.
If you’re considering wading into the rental property investing waters, here’s what the changes mean from a tax perspective.
Pass-through entities get a tax break. One of the most significant provisions of the tax bill affecting real estate investors is the 199A pass-through deduction. This allows residential landlords who operate as pass-through entities to deduct 20 percent of net rental income right off the top. The new deduction will allow many individuals at the highest tax brackets to effectively reduce their tax rate from 37 percent to 29.6 percent.
But there are some exceptions for who can claim this deduction. New qualified business income rules do not permit the full deduction for high-income specified service businesses, which includes lawyers, accountants, doctors, consultants and financial advisors.
Claiming the full deduction also depends on income. For pass-through entities to qualify, total annual income must be less than $157,500 for single filers and $315,000 for those who are married and file jointly.
Rental property investors should also keep in mind that the 20 percent deduction of rental income is capped by whichever is greater: 50 percent of wages or 25 percent of wages plus 2.5 percent of the unadjusted basis of qualified property held by the business. Qualified property is any rental property you own that’s subject to depreciation, and the unadjusted basis is the property’s original cost, without depreciation.
For an idea of how much the pass-through deduction could be worth to a rental property investor, assume you own a 10-unit apartment building through a limited liability company, with no employee wages. The building was constructed in 2012, with land costing $100,000 and the building costing $800,000. In 2018, your LLC has a taxable profit of $300,000. In that case, the potential 20 percent pass-through deduction is $60,000 or 20 percent of $300,000; however, it’s limited to 2.5 percent of the $800,000 building or $20,000.
Investors just entering the rental property arena should fully understand the tax implications of the deduction. Your financial advisor or accountant can help with determining whether you qualify for the deduction.
New Section 179 rules yield additional tax savings. The tax bill preserves and expands some existing tax benefits for rental property owners, including the Section 179 deduction. It allows business owners to deduct the cost of qualifying equipment or software purchased or financed in that tax year.
Beginning in 2018, the deduction is extended to rental property business owners, allowing them to deduct the cost of personal property, such as appliances or furniture used in rental units. The deduction has also been expanded to include investments in certain improvements, such as a new roof, an upgraded heating and air system or new fire protections and security systems.
By having a firm grasp of Section 179, investors can realize some meaningful reductions to taxable income. It’s important to be familiar with what assets and improvements qualify for the depreciation allowance to take full advantage of the change.
In addition to widening the scope of deductible expenses, the tax bill also raises the Section 179 deduction limit from $500,000 to $1 million, with a phaseout limit of $2.5 million. This represents the amount you can spend on rental property assets or improvements before the deduction begins to be reduced on a dollar-for-dollar basis.
Additionally, the new 100 percent bonus depreciation allowance lets landlords deduct the entire personal property for rental units, instead of the previous limitation of $2,500 or less.
Keep in mind also that these tax breaks won’t last forever. The pass-through deduction ends Jan. 1, 2026, and the 100 percent bonus depreciation deduction only lasts through 2022. Before adding rental property to your portfolio, consider whether the investment can still meet your goals and objectives after these tax benefits expire. -Rebecca Lake
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