How Will the New Tax Law Affect My Real Estate Investments?
Updated: Sep 20, 2023
Sweeping changes will create some big winners, big losers and mixed results for others. Understand what's coming so you can strategize for 2018.
(Disclaimer: I'm an investor and not an accountant, a financial advisor or attorney. Consult your own financial and/or legal advisors before making any investment or legal decisions.) (Update: December 28, 2017. Some financial advisors (and the financial press) have been recommending that homeowners in high tax states prepay future property taxes in 2017 to get an extra deduction (since the since removal of the deduction doesn't occur until the first day of 2018).
However, the IRS has posted additional guidance clarifying that this will not work for most people. You cannot get a deduction if the taxes have not yet been assessed. And no jurisdictions have assessed them yet. Simply guessing at the amount in the future will not get you a deduction. More information here.)
The Winds of Change
Hours ago, the president signed into law a sweeping overhaul of US tax law, which will affect virtually every person in the country.
A new 20% deduction for real estate investment income will be hugely beneficial to many income-oriented real estate investors. Other portions of the law will create losers in high tax markets and affordable housing. Additionally, the law will cause changes to the national debt, interest rates and healthcare that will affect all investors.
Before talking about those specifics, here's a quick summary of the major changes.
What Changed
The standard deduction increased to $12,000 for single and $24,000 for MFJ (married and filing jointly).
Deductions for state and local income and sales tax (including property taxes) are now limited to $10,000 a year.
Eliminated: personal exemptions, miscellaneous itemized deductions. Also, home equity loans are no longer deductible.
Increased: medical expense floor reduced from 10% to 7.5% of AGI.
Mortgage interest is deductible on up to $750,000 of new acquisition debt.
Qualified income from sole proprietorship's, LLCs and S Corp. gets an additional 20% deduction (with some limitations by wages)
Expensing:
Bonus depreciation: Can expense certain business assets (with recovery period less than 20 years) 100% instead of 50%.
Can now expense up to $1 million instead of $500,000.
Expenses now allowed for roofs, heating, ventilation, air conditioning, fire protection alarm systems, security systems.
C Corporation tax rates reduced to 21%
Estate tax exclusion increased from $5 million-$10 million
529 plans funds can be used to pay for public, private and religious elementary and secondary education
Penalty from Obama care individual mandate was eliminated
Medical expense floor reduced from 10% to 7.5% of AGI
Child tax credit increased from $1000-$2000.
A very detailed breakdown of the above is available from Hall CPA: the real estate CPA. So what does this mean for real estate?
Show me the "20% deduction"!
The good news for income-oriented real estate investors is that many of us will see a large reduction in taxes in 2018. 20% of all real estate income that comes through pass-through entities (LLCs, S Corp.'s, etc.) will be deductible. This will boost returns for many income-based real estate crowdfunding and syndication investments (core/core plus strategies and real estate debt), as well as REITs.
Note that this only applies to income and not to capital gains. So value-added and opportunistic strategies which depend mostly or all on price appreciation are out of luck and will see less or almost no tax sheltering.
Also, if you make too much money (more than $207,500 single or $315,000 MFJ), the deduction may be limited. (More information on those fairly complicated limitations are here.)
So in 2018, you may wish to prioritize more favorable income-producing strategies, if you've been putting them off. (Information on the top core/core plus funds and top hard money loan options are here). And the same for your REIT allocation as well (as described in this Wall Street Journal article).
Get it back to me faster!
Also positive news for almost all real estate investors are the more favorable rules for expensing when acquiring new properties. This will allow investments to recover costs quicker, which gets investors money back faster than before. This is unlikely to make a very large or noticeable difference on many investments, but it still will be a welcome small net positive.
Bonus depreciation: Can expense certain business assets (with recovery period less than 20 years) 100% instead of 50%. Note that depreciation has to be paid back to the IRS when you sell a property. So this will have less effect for short-term investments, and more effect on longer-term buy-and-holds.
Can now expense up to $1 million instead of $500,000.
Expenses now allowed for roofs, heating, ventilation, air conditioning, fire protection alarm systems, security systems.
That's the good news for all. Now the bad and mixed news…
The Homeowner Triple Whammy
Owning a home in many high tax markets will get much more expensive and become unaffordable for some. The doubling of the standard deduction will mean that many people will not be getting a tax break for their mortgage like they do now. Then the capping of the state and local tax deductions to just $10,000, means everyone will have to pay significantly more in taxes to own a home instead of rent. And the elimination of the ability to deduct property taxes will make this even worse.
Together, these 3 things will cause significant lowered demand, net selling of residential properties in these areas and home prices to fall. This will negatively affect investors who own properties in these areas that depend on growing price appreciation.
On the positive side, multifamily investors in these areas should see increased demand as more people are forced to rent. This will decrease vacancies and perhaps allow rents to be raised higher than they would have been before. Also, the price drops could provide an opportunity for income-based residential property investors to pick up rental properties at a lower price.
(Update: December 28, 2017. Some financial advisors (and the financial press) have been recommending that homeowners in high tax states prepay future property taxes in 2017 to get an extra deduction (since the since removal of the deduction doesn't occur until the first day of 2018). However, the IRS has posted additional guidance clarifying that this will not work for most people. You cannot get a deduction if the taxes have not yet been assessed. And no jurisdictions have assessed them yet. Simply guessing at the amount in the future will not get you a deduction. More information here.)
"So I Guess You're Paying This Bill?"
The other bad news for all real estate investors is that the government will have to raise a significant amount of new debt to pay for the tax breaks.
The political party that passed this law only has a simple majority in the Senate. And Senate rules say that no bill can be passed with a simple majority, unless it "only" increases national debt by $1.5 trillion over the next 10 years. This bill was successful in sneaking under that threshold and only increasing the debt by $1.456 trillion. So that got it through the Senate, but now that it signed, the bill will be coming due.
The immediate issue is that this increase means the US will have to finance and sell twice as much debt to investors in 2018 as it did in 2017. (See Bloomberg news for more details). And the problem is that the Federal Reserve is no longer buying debt as it did during the recession (via quantitative easing to keep interest rates low and stimulate investment and the economy). This increase in supply and reduction of demand will cause interest rates to rise. Real estate mortgages are tied to the 10 year treasury. So when treasuries increase, so do mortgages and the cost of owning real estate. This reduces profitability (as well as increases the chance of default).
So if you have the chance to lock in a rate now, you might want to do it.
The longer-term effects of this debt increase are more difficult to predict. The tax cuts could be rescinded by the opposing political party if they take control sometime in the next several years. If so, the bulk of the debt required to pay for the cuts might not be needed.
But if that doesn't happen, then something else has to give. Since the largest expense of the federal government comes from paying Social Security, Medicare and Medicaid, these are prime targets for reductions. In fact, some members of the political party in control are floating trial balloons on this already. Reductions to these government programs would have significant effects on the elderly as well as the economy at large, and thus on certain real estate investments. Certain senior care and assisted living facilities would expect to be hit the hardest. But on this, we can only wait and see how things develop.
Hope You Didn't Need That Healthcare
This law also eliminates the Obama care requirement that everyone purchase health insurance. This former requirement was hated by some. At the same time, all health insurance works by having healthy people subsidize and bring down the cost of the health care for the sick, to lower costs for all. So this will effectively sabotage the insurance marketplace.
The American Medical Association says taxpayers can expect prices to skyrocket in 2019. More than 11 million people are projected to be unable to afford health insurance, which will cause a significant increase in medical bankruptcies, broken leases and foreclosures. Additionally, the insurance increases will take a bite of taxpayer incomes, reducing income available to service a mortgage or pay rent. Investors in working-class neighborhoods and affordable housing can expect the most disruption and drops in net operating income and profitability.
More Affordable Housing Woes
Most of affordable housing wouldn't be profitable to build without federal tax credits. These are called the LIHTC (Low Income Housing Tax Credit). The lowering of the corporate tax rate from 35% to 21%, makes these credits less valuable, and reduces the incentive to build this type of housing. Developer Bart Mitchell estimates this means 200,000 fewer units will be built over the next decade.
If you are invested in affordable housing are considering investing, you'll want to consult with your accountant and other advisors to see the effect this will have on you.
The Truly Big Winners
The Tax Reform Act of 1986, took two years for Congress to publicly consult with tax experts and finally pass after much bipartisan deliberation. This law was passed by politicians in secret closed-door sessions, and in less than six weeks. Many parts of the original proposal were passed with handwritten text in the margins. Accountants, lawyers and tax attorneys have already pointed out numerous gray areas and potential loopholes to exploit, and the ink isn't even dry yet on the law. They will be having a field day in 2018, and will be the biggest winners of all with the huge increases in business. And I strongly recommend that you "help them" with that by consulting your own advisors. That's the best way to help you best navigate the changing landscape of 2018.
