Remember towards the end of 2017 when everyone was talking about tax reform? While many thought it was a done deal, those of us in the tax profession knew that the tax changes were far from being finalized.
Without too much media buzz, the IRS has recently issued some temporary guidance on what tax reform may mean for taxpayers. The key word here is “may” because what we received recently in August 2018 are “temporary” regulations and not “final” regulations. This means that the law is still not finalized and is subject to additional changes and clarifications.
Before these temporary regulations came out, the tax reform bill left many questions unanswered. This included who got certain new tax breaks, who might be excluded from certain tax breaks, how the new tax breaks would be calculated, etc. The newly released temporary regulations provide us with some guidance on how the tax law may ultimately read. Although these are still subject to changes, we now have a little more information than we had before, and that can prove to be a very powerful tool for those of us who want to get ahead of the game to take advantage of tax reform.
As you already know, there were many changes that took place as part of tax reform. You can read more about those changes here. Today, however, I want to focus mainly on the important updates from the latest temporary regulations and their impact on real estate investors. We will discuss the tax reform’s impact on flippers/wholesalers, private lenders, landlords, BRRRR property owners, short-term rental owners, and real estate agents.
One of the major tax breaks under tax reform was the Section 199A deduction. Simply put, this tax break provides certain flow-through business income with a 20% deduction, which essentially makes 20% of the profit tax-free. Currently, this deduction does not apply to W-2 wages, interest, dividends, and capital gains income.
Let’s take the example of James, who is a fix-and-flip investor. If James made $100k in flip profit, the first $20,000 of that would be at zero tax. Assuming he would otherwise be in the 24% tax bracket, this new tax break saves him up to $4,800 in federal income taxes.
$100,000 x 20% = $20,000 tax-free income
$20,000 x 24% = $4,800 tax savings under Section 199A
It is important to note that the Section 199A benefit is available for certain types of income generated through LLCs, S corporations, partnerships, and sole proprietorships. This means that having a legal entity is not a requirement to receiving this tax benefit. As such, James is potentially eligible for this tax break regardless of whether he is conducting his flip through an S corp, LLC, or simply as a sole proprietorship.
It is also important to note that simply having a legal entity does not automatically mean that the income earned in the entity would be eligible for the 20% tax-free treatment. Ultimately, it is the type of income that determines whether it is eligible for the tax-free treatment—irrespective of whether it is earned by the flow-through entity or in the individual taxpayer’s name. Let’s go over an example of how this works.
Lisa is a private lender and lends her money to other investors who flip real estate. As a private lender, Lisa earned interest income of $10k. Since interest income is not eligible under Section 199A, Lisa would need to pay taxes on this entire amount, and none of that will be tax-free. This is the case even if Lisa were to put her money in an LLC and then have the LLC lend out to flippers. The reason is because in both scenarios, Lisa is generating interest income.
Alternatively, what if Lisa was not a lender and was actually the person flipping the property? In that scenario, Lisa is earning active income from flipping real estate (just like James), and thus up to 20% of her flip profit may be tax-free under Section 199A. This is the case regardless of whether Lisa flips in her personal name or in an LLC or S Corp. As you can see from this example, earning interest income versus flip income can have a notable impact on whether this income is eligible for the 20% tax-free treatment.
The IRS recently released new information with some safe harbor rules that help landlords to qualify for the 20% tax-free treatment. To qualify for the safe-harbor rules, the taxpayer must meet all four of the following requirements:
- Have separate books and records for the rental real estate activities
- Have over 250 hours of rental service activities
- Have contemporaneous records to document these hours and services, and
- Attach a signed statement to the tax return to indicate the safe harbor requirement has been met.
The 250 hours of rental service activities may be aggregated amongst your eligible properties so that you may not need to meet the hours requirement for every single rental property separately. Eligible services include time spent on maintenance, repairs, rent collection, payment of expenses, and activities in order to rent the property.
The IRS also indicated that the eligible services do not need to be performed only by you as the property owner and can include services performed by employees, agents, and independent contractors as well. Better yet, an investor may be able to qualify for this regardless of whether or not they claim real estate professional status.
Also, it is important to keep in mind that just because the safe harbor rules are not met, it does not automatically mean the tax benefit is not applicable to rental income. There may be other ways to demonstrate eligibility outside of these safe-harbor rules as well.
Buy, Renovate, Rent, Refinance, Repeat (BRRRR)
What about investors involved in the BRRRR strategies? Do they get the tax break? The answer is easy: it depends on your view of whether your regular rental income is eligible for the tax break. From the tax perspective, BRRR is just like any other rental so it is treated the same as a regular buy and hold transaction. So, if your regular rental income meets the eligibility requirements for the tax break, your BRRRR properties should as well.
We have seen a significant increase in the number of investors involved in the short-term rental business. For the most part, we are also seeing significantly higher profits in short-term rentals as compared to traditional long-term rentals. In the short-term rental space, there are two potential tax treatments. If hotel-type services are provided to the guests (i.e. room service, food and beverage, daily cleaning, etc.), these may be treated as ordinary income for tax purposes. In this scenario, the income may generally qualify for the 20% tax-break. Most of the short-term rentals we see, however, do not provide these hotel-type services. In these cases, the income is treated the same way as regular long-term rentals. As such, whether it is eligible for the new tax break will just depend again on whether your regular rental income would qualify.
Real Estate Agents & Brokers
Real estate brokers and agents who earn commissions income are generally eligible for the 20% tax-break. This applies to such income earned in a flow-through entity, as well as income earned as a sole proprietorship. Please note that real estate agent income earned as W-2 income is not eligible for the 20% tax break. As such, if you are able to earn your income as a 1099, you may get significantly more tax savings as compared to a W-2 realtor.
Prior to the release of the temporary regulations, most tax advisors were under the impression that those higher income taxpayers who earn commissions income from real estate may lose out on the Section 199A tax break. In one of the largest welcome surprises to the temporary regulations, the IRS has indicated that even higher income taxpayers with real estate agent commissions income may be eligible for a full or partial benefit under the tax break.
As you can see, there are many changes that will be impacting real estate investors’ taxes for 2018 and potentially more changes to come before the year is over. Make sure to take advantage of these tax breaks and meet with your tax-advisor to do some proactive tax planning. Do not fall behind by waiting until next April because chances are, that may be too little too late to reap the potential tax savings.
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