The new federal tax law took away some benefits of homeownership but gave real estate investors a gift they might not be aware of yet.
Owners of investment property — from mom and pop landlords to big-time real estate moguls — could get a federal tax deduction of up to 20 percent of their net rental income for tax years 2018 through 2025. Most people who own shares in real estate investment trusts can also deduct up to 20 percent of their ordinary REIT dividends.
This tax break has been overshadowed by all the wailing over the law’s treatment of homeowners. It will reduce the mortgage interest and property tax deductions for some homeowners, but these new limits do not apply to interest and property taxes on income property.
More importantly, real estate investors get a potentially large tax break they didn’t have before.
It comes under the section of HR1 titled “Deduction for qualified business income of pass-thru entities.” Congress “used the Facebook spelling” of “through,” quipped Paul Bleeg, a partner with accounting firm EisnerAmper.
Bleeg said the new deduction could increase investor demand for real estate, offsetting any potential drop in demand from homeowners.
The pass-through provision is insanely complex, but it essentially lets owners of pass-through entities deduct up to 20 percent of their business income on their personal tax return, subject to certain limits.
Pass-through entities pay no business tax. Instead, their income passes through to their owners and is taxed at their personal tax rates. They include sole proprietorships, partnerships, limited liability companies and S corporations.
In the past, 100 percent of this income was taxed at the owner’s ordinary income tax rate. In the future, some owners can deduct up to 20 percent of it on their federal return (but not their California return unless the state conforms to this provision). Taxpayers won’t have to itemize to claim the new deduction, which will show up on a new line after adjusted gross income, said Mark Luscombe, principal tax and accounting analyst with Wolters Kluwer.
Congress put several limits on the new deduction, which differ depending on the type of business and the owner’s taxable income.
The first limit applies to everyone claiming the 20 percent pass-through deduction. It says your deduction generally cannot be more than 20 percent of your taxable income, excluding capital gains and the pass-through deduction itself. (Taxable income is your household income from all sources minus your deductions.)
If your taxable income is less than $157,500 (single) or $315,000 (married filing jointly), that is the only limit that applies. If your taxable income is above those amounts, then other limits apply, depending on the type of business.
If you are in a “specified service trade or business,” your deduction will be phased out between $157,500 and $207,500 in income (single) or between $315,000 and $415,000 (married filing jointly) according to a fairly simple formula. If your income exceeds the top of the phaseout range, you get no deduction.
Specified service professions include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial and brokerage services or any business where the principal asset “is the reputation or skill” of one or more employees. (Curiously, architects and engineers were excluded from the list.)
This income limit would apply to real estate agents but would not apply to real estate investors because their principal asset is their property, not their skill, said Kenneth Weissenberg, chair of real estate services at EisnerAmper.
If you are not a service professional and your taxable income exceeds $157,500/$315,000, then your pass-through deduction may be limited by a convoluted computation. It says: Your pass-through deduction can’t exceed the greater of either 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of the “unadjusted basis” of depreciable assets, which generally means what the owner paid for the assets, excluding land. Real estate investors would be subject to this nutty math if their income exceeds the limit.
To get the deduction, real estate investors must have net income from a property. Many real estate investors have net losses thanks to depreciation, interest, repairs and other expenses.
Suppose Donna is single, earns $100,000 a year working for a tech company, and owns a duplex that generates $20,000 a year in net income. Her taxable income, we’ll assume, is $108,000.
Under the new law, her pass-through deduction would be 20 percent of $20,000 or $4,000. It is not reduced because $4,000 is less than than 20 percent of her taxable income.
Now suppose she makes $200,000 at her tech job and her taxable income including the rental is $208,000. In this case she would have to do the complex computation.
We’ll assume she bought the duplex for $600,000 but $100,000 of that was land value. Her unadjusted basis is $500,000, and 2.5 percent of that is $12,500. She doesn’t pay anyone a salary, so her W-2 wages are zero. Her deduction still is not reduced because $4,000 is less than $12,500.
“The wages and depreciable property limits won’t impact most real investors,” said Stephen L. Nelson, a CPA in Redmond, Wash., who wrote a monograph on the new deduction.
One gray area is whether people who own real estate in their own names and file their rental income on Schedule E would qualify for the pass-through deduction.
“It’s not 100 percent clear,” said Jeff Levine, director of financial planning with Blueprint Wealth Alliance. To get the percent deduction, “it has to be a qualified trade or business.” The new law does not clearly define trade or business, and the term is defined differently in different parts of the tax code. “Depending on IRS interpretation, a taxpayer’s involvement in the rental property could be a factor” in whether he or she qualifies.
Luscombe said he believes Congress intended real estate investors who use Schedule E to qualify for the deduction, and a congressional committee report supports that idea.
Weissenberg said they clearly would qualify for the deduction.
Nelson also said they should qualify, “but we’ll have to see what the IRS says” when it issues regulations.
Real estate investors do not need to form a limited liability company to take this deduction, Nelson added. They can put property into an LLC (many do for liability reasons) as long as it’s not taxed as a corporation.
The law does state that people who own shares in a real estate investment trust can deduct 20 percent of their ordinary dividends (but not capital gains dividends) starting in 2018. This deduction cannot exceed 20 percent of their taxable income, but other limits do not apply.
“Real estate is a big-time winner” in the tax law, Weissenberg said, thanks to this and other provisions.
- Written by Kathleen Pender of the San Francisco Chronicle