American’s don’t exactly have a love affair with taxes. Our current tax code has been called burdensome, unfair and overly complex. The thought of doing your tax return on a postcard sounds appealing to most; even if it is just a dream for many real estate investors.
The new plan just released includes numerous tax system reforms. These reforms impact individuals and corporations. Here are just a few highlights of the individual reforms under the proposal:
- Changes in tax brackets – from seven brackets (10 percent to 39.6 percent) to four brackets (12 percent to 39.6 percent);
- Doubling the standard deduction, but eliminating personal exemptions;
- Retaining the deductibility of 401(k) contributions;
- Increasing the child tax credit to $1,600;
- Allowing taxpayers to deduct property taxes up to $10,000; and
- Limiting the deduction of mortgage interest for newly acquired homes to $500,000.
But questions still remain. Will real estate investors benefit under tax reform? What tax strategies should real estate investors implement?
Let’s take a closer look at a few tax opportunities under the proposed reforms. Specifically, three areas could be game changers for the real estate community.
Many real estate brokers and agents use pass-through entities, such as partnerships, limited liability companies (LLCs) or S corporations. These entities do not pay income tax as any income, losses, deductions and credits “pass-through” to the individual owners and are taxed at their tax rate.
Partnerships are a favored tax structure for real estate investors and syndicators. They offer flexibility and favorable treatment when it comes to passive losses.
S corporations have become one of the more popular entity structures in recent years and are a favorite of many real estate agents, brokers, developers and wholesalers. Under the proposal, owners that conduct business as sole proprietorships, partnerships, and S corporations would face a tax rate of 25 percent.
Since the top tax rate is currently 39.6 percent, a reduction in rate to 25 percent would be a significant savings for many real estate professionals. However, this favorable rate does not apply to wages paid on form W-2. That would be subject to the owner’s marginal tax rate.
This change would give real estate professionals an incentive to reduce their compensation which would then increase the flow through income that would be allocated to them from the pass-through entity.
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But be careful. The tax reform framework claims that it would place into service controls to mitigate this issue. Make sure you are cautious when it comes to compensation. The IRS still requires that it be “reasonable.”
In either case, this could be a nice tax reduction for self-employed real estate folks.
Changes to the Estate Tax
This is a significant change. Since 1916, the United States has taxed the estates of deceased taxpayers. Under the new proposal, the exemption is doubled and the estate tax is repealed after six years.
The estate tax currently applies to the “gross estate.” This typically includes all the decedent’s assets, including real estate, investments (stocks, bonds, etc.) and other tangible property. It also consists of the value of the decedent’s business interests.
Estates can deduct specific items like debts, funeral expenses, legal costs, accounting fees, and estate taxes paid to states. The taxable estate is equal to the gross estate less any allowable deductions.
A credit is then applied that exempts a significant portion of the estate. For 2017, the effective exemption is $5.49 million for individuals. Any value of the estate over $5.49 million is taxed at the top rate of 40 percent. Under the new proposal, the exemption would be doubled to approximately $11 million for individuals and then be phased out after six years.
Because of the significant exemption applied, any decedent subject to the estate tax would likely have real estate holdings. For people with large estates, they often were able to get around the rules through quality estate planning. In either case, the revised exemption and ultimate repeal of the estate tax could result in a windfall for beneficiaries of large estates. Definitely a nice win for folks with large real estate holdings.
At the center of the proposal is a cut in the corporate tax rate to 20 percent from 35 percent. This is estimated to reduce federal tax revenues by $1.5 trillion over the next decade. However, it may give many companies the motivation to keep their profits in the U.S. and not have overseas tax havens.
It is too early to tell the impact in terms of tax revenues. But it certainly gives more incentive for real estate developers and certain other real estate firms to consider a C corporation structure. This structure also offer more flexible fringe benefits and can make a lot of sense. This could start a gradual shift.
One downside – limiting mortgage interest deduction
There has been talk of capping (or possibly eliminating) the mortgage interest deduction. Now we have the facts. The proposal limits the deduction of mortgage interest for newly acquired homes to $500,000. Previously, the limit was $1 million (plus $100,000 of home equity loans).
With the limiting of the mortgage interest deduction, I would expect it to impact the upper middle class. It could certainly dampen the purchase of high-end homes. In fact, for many areas across the country $500,000 of mortgage debt will barely get you a starter home.
Many believe that our tax code is broken and the debate over tax reform is not going away anytime soon. I suspect that even if tax reform passes, there will be some changes. But no one knows the outcome.
What we do know is that tax law is complex. We need more transparency. Taxpayers need to understand how the tax law impacts them.
While you may not be able to do your tax return on a postcard, one thing is for sure. Tax reform (in one form or another) is likely coming sooner rather than later. Your job is to pay the lowest amount of tax that you are legally required to under the law. Hopefully, you will find a few opportunities that can reduce your tax bill.