How the New Tax Laws Affect Smaller Real Estate Investors

The Tax Cuts and Jobs Act (TCJA) took affect the first of the year (2018) and is the biggest tax reform legislation since the Tax Reform Act of 1986. It has caused confusion in the real estate sector because it changes some tax deductions for homeowners. These should not be confused with the gains small real estate investors obtained.

For instance, although mortgage interest and property tax deductions were reduced for homeowners, these changes do not apply to interest and property taxes on income property (investors). It’s speculated that the reduced reductions for homeowners will result in fewer purchases of primary residences. However, this will be offset by an increase in investor purchases. The overall impact will be a healthy residential real estate market for at least several more years. People always need a place to call home.

Pass-through Entities

The investor in a 25-unit apartment complex and the investor in a single-family rental home are both small business owners. Every business entity, except C-corporations (large publically traded corporations), will benefit from tax changes that now apply to pass-through entities. These include sole proprietors, partnerships, LLCs, and S Corporations.

As with almost all tax code, the section HR1 titled “Deduction for qualified business income of pass-thru entities” is complicated with restrictions and conditions affecting specific businesses. You should always work with a tax professional to maximize the benefits for your specific situation. Here I highlight how tax laws affect smaller real estate investors to increase after tax pass-through income.

This change potentially offers a relatively large tax break that smaller real estate investors will benefit from. There is nothing new about you being able to pass through income from your investment business to your personal income tax return. Pass-through entities pay no business tax. However, previously you paid personal taxes on 100% of the pass-through income. The tax law change allows you to deduct up to 20% of your real estate pass-through income from your personal tax return. This deduction is subject to certain limits that are determined by your specific circumstances. Some of which you may be able to change to maximize your benefits under the new tax laws.

Pass-through Limits

The most notable limit is income above $157,500 (single) or $315,000 (married filing jointly). But it’s not that simple. People whose income is above those limits and from certain professions have additional restrictions. Those with additional restrictions probably include real estate agents and some investors working primarily in other specific professions. But not real estate investors directly.

The restrictions apply to a “specified service trade or business.” These specified trades and businesses include: accounting, actuarial science, athletics, brokerage services, consulting, financial, health, law, performing arts, and other businesses where the principal asset “is the reputation or skill” of one or more employees. The restriction should not apply to real estate investors with property as a principal asset rather than their skill.

Those with an income from a “specified service trade or business” will have their deduction phased out. For single people the phase out range is between $157,500 and $207,500. For married couples (filing jointly) the range is between $315,000 and $415,000. Incomes above the phase out ranges will not receive a deduction.

Another limit applies to everyone and is based on total taxable income. This restriction says your real estate pass-through income deduction cannot be more than 20% of your total taxable household income (excluding capital gains and the pass-through deduction itself).

There is one more complicated limit that applies if you are not a service professional (meaning many investors). This one applies if your income exceeds the $157,500/$315,000 (single/married) threshold. If it does, your pass-through deduction can’t exceed the greater of either 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the “unadjusted basis” of depreciable assets. Meaning the amount you paid for the assets (improvements) less the value of the land. An example follows.

Keep in mind that all of this only applies if you have net income from your real estate investments. Many investors show a net loss based on depreciation, interest, repairs, and other expenses. None of this applies if you show a net loss from your real estate investments.

You can see this gets rather convoluted. Only proceed if you have a net income from your real estate investment. Next, you must determine the source of your taxable income (asset or service/professional based). Then you figure out which of the limits apply. Then you do the math to figure out your deduction for up to 20% of your real estate pass-through income from your personal tax return. If you’re like most people, you’re going to need a tax professional.

Keep in mind that the discussed tax laws affect smaller real estate investors only. Big investors engaged in debt-financed real estate operations with more than $25 million in average annual gross revenue over the prior three years are subject to different regulations.

Two of Many Possible Examples

The new tax laws affecting smaller real estate investors aren’t always complicated. An example might be if you are single and earn $100,000 in retail sales (not a specified service trade or business). And you own two condos that contribute another $20,000 a year in net income. After other deductions your taxable income is $95,000.

Considering how tax laws affect smaller real estate investors, you would be able to take the full 20% deduction on the pass-through income. The math is: 20% of the $20,000 comes to $4,000. That $4,000 is less than 20% of your $95,000 taxable income (20% of $95,000 = $19,000).

Let’s hope your math situation is that simple.

However, if your income is $200,000 (exceeding the $157,500 threshold) the math is different. We use the same $20,000 a year in net income from the condos. Now it becomes based on the purchase cost of your real estate investment. The combined two condos cost $500,000 (if land is owned, that value is subtracted out). You now calculate 2.5% of the $500,000 unadjusted basis, which comes to $12,500. The 20% deduction on the pass-through income ($4,000) is below the $12,500. You still take the full 20% pass-through income deduction.

Temporary and New Depreciation Opportunities

This applies to qualified business property (generally machinery, equipment, and software) but not real property. For qualified property placed in service after Sept. 27, 2017 and before 2023, a 100% depreciation can be taken the year it is placed in service. Previously this was spread over multiple years. After 2022, the first year’s depreciation is incrementally decreased through 2026.

The definition of a qualified property has also loosened. It now includes new and used equipment as long as it isn’t purchased from a related party. Under Section 179, the purchase or financed cost of qualified equipment has also been increased. Previously the full deduction cap was a cost of $510,000. That has been increased to $1 million. The top end of the deduction phase-out has been increased from $2 million to $2.5 million. Another change is that after 2018, the limits will be indexed to inflation. These new limits may make it worthwhile to perform a cost audit to reclassify some business equipment that was previously categorized as real property for tax purposes.

Not Everything is Clear Yet

Major tax code changes come with multiple interpretations. Not even the lawmakers all agree on the meaning of the words they put into the legislation. And of course the IRS has to interpret it and convert it into instructions applying to every conceivable circumstance. You can believe there will be disagreement before it is all worked out.

One uncertainty about how new tax laws affect smaller real estate investors involves how the property is titled. Specifically, if it is titled in the investors name or that of an entity such as an LLC. The new language applies to a “qualified trade or business.” This brings up the question of whether individuals (or married couples) are able to claim the income pass-through deduction using IRS Schedule E. At the time this was written, there was no provision on Schedule E for the pass-through deduction. However, there is a congressional committee report supporting the use of Schedule E for the deduction.

Many people have other tax strategies that are comingled with how new tax laws affect smaller real estate investors. These include (but not limited to) interest income, carried tax credits, bad debt, as well as estate planning and gift exemptions.

Overall, real estate investing remains a great investment opportunity that is further enhanced by the changes in tax law. Most people agree that they are better off having enough money to warrant these tax complications rather than not having enough money. The bottom line is that the sooner you review your specific tax circumstances and consult with a tax professional, the sooner you will reap these new benefits available to small real estate investors. Or finally get into the real estate investing business because it only keeps getting better.

What you need to do now is TAKE ACTION!

By Wendy Patton

For more than 30 years, I've used the Sandwich Lease Option System to earn myself and my students millions of dollars. From my experience, I know there is plenty of room and opportunity in the real estate investment market for everyone wanting to participate to find profitable deals. It's because of that fact and my personal success that I share the Sandwich Lease Option System with others.

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