The Latest Tax Reform Update and What It Means for Real Estate Investors

by | BiggerPockets.com

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.

Flippers/Wholesalers

Flipping and wholesaling income is generally eligible for the 20% tax-free treatment.

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.

tax-consultant

Related: PSA: Taxes Are the Biggest Cashflow Killer (With Examples)

Private Lenders

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.

Landlords

Prior to the release of the temporary regulations, most tax advisors were fairly certain that the 20% tax-free treatment would be applicable to rental income. One of the most disappointing things that came out as part of the temporary regulations is that the IRS issued confusing language surrounding this area. Instead of clearly stating all rental income would qualify for this tax break, the IRS instead made references to other code sections that create further mystery on exactly when rental income may qualify for this tax break. Currently, there are many debates in the tax world on what type of rental income may qualify for this tax break:

  • Do you need to own a lot of rental properties to qualify? If so, how many?
  • Do you need to be the property manager of your rentals to qualify?
  • Do you need to spend a certain number of hours in your rentals to qualify?

The bad news is that if you asked these questions to three different tax advisors, you would likely get three very different answers. The reason is because each tax advisor may have their own interpretations of the tax law and their own risk/tolerance level. What we are all hoping for is a more definitive language in the final regulations from the IRS that clearly indicates what type of rental income may qualify for this 20% tax-free treatment. When will the final regulations be released? That is anyone’s guess. Will the final regulations clearly tell us if all rental income qualifies for this tax break? Nobody knows at this time.

So what does this mean for us as real estate investors? It means now is a good time to discuss your rental business with your tax advisor. Find out what their interpretation of the law is, and determine whether there are things you can do to ensure that your rentals qualify for this tax break. My personal opinion on this topic is that all rental income may be eligible for the 20% tax-free treatment. There are many court cases in the past where the tax court affirms the definition of rental income to be “trade or business” income. This can change, of course, pending any final IRS regulations or further updates from the IRS. For now, I see the temporary regulations as favorable to those of us earning rental income with respect to the tax break.

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 rental income is eligible for the tax break. From a tax perspective, BRRRR is just like any other rental, so it is treated the same as a regular buy and hold transaction. If your tax advisor interprets that regular rental income meets the definition for the 20% tax-free treatment, then the rental income from the BRRRR transactions will qualify as well.

4 Tax Tips for Rental Property Owners

Related: The Tax Implications You MUST Understand Before House Hacking

Short-Term Rentals

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 on your tax advisor’s interpretation of the eligibility of rental income.

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.

Any questions about this recent update?

Leave them below!

About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

24 Comments

    • Shane Benner

      I posed this this question to my accountant today…I wanted to get your thoughts on one of the major tax breaks under tax reform, the Section 199A deduction. They way I interpret this is that this tax break provides certain flow-through business income with a 20% deduction, which essentially makes 20% of the profit tax-free. I wanted to get your thoughts, as this would make the first $20k of our rental property income tax-free for our 2018 filing?

      My accountant’s response…Based on what I have read, you will not be able to deduct the 20% since it is limited to W-2 wages. The majority of my rental clients do not incur any employee wages therefore will not be able to use the Section 199A.

      This deduction is geared towards small business with employees. I will keep you posted if I hear anything different. I am going to a few seminars on this in next few months.

      • Amanda Han

        Hi Shane: Although there are limitations to how much of the benefit a taxpayer may receive, the calculations on based on depreciable basis of rentals in addition to wages. So just because you do not pay wages on your rentals (which most investors do not), that fact alone does not mean you cannot get any of the benefits. Hopefully your tax advisor will work with you on the updated info after his seminars. Thanks for reading!

  1. Eli Ren

    As a CPA with experience in Real Estate and Financial Services-borrowing from what a US Trade or Business means for a hedge fund, if you are frequently involved and have numerous rental properties it seems to me that you should qualify for the 20% deduction…The example in the Proposed Regs which states if there is common ownership between landlord and tenant is an example (frankly not sure what the logic is in that) and does not mean to exclude every other type of real estate….As a tax professional and an investor I would sit down and explain the rules, case law to my client and guide them to a decision which makes sense…I don’t think we are going to get 100% clarity on this before next filing season

  2. Brian Levredge

    Tangentially, is there any change to passive loss limitations? For instance if I employed cost seg on a commercial rental and between that and the mortgage interest deduction for business could I still take an extra 20% on top of it all assuming I had already effectively reduced my adjusted gross down to zero or less with other paper losses? Sounds pretty sweet if so.

  3. Joshua Mou

    Hi Amanda,
    This may not pertain to many on BP, but there are certain dividends that will be eligible for the 20% deduction: REIT dividends.

    “Eligible taxpayers may also be entitled to a deduction of up to 20 percent of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. This component of the section 199A deduction is not limited by W-2 wages or the UBIA of qualified property.”

    This is exciting to those who own individual REIT stocks. Qualified REIT dividends used to be called ordinary REIT dividends—very confusing change. These make up the bulk of dividends paid out by REITs—at least publicly-traded ones—which used to be taxed at ordinary income rates. Now it looks like these dividends will be 20% deductible. Plus, no income restrictions if I read that correctly! They did not specify if the deduction can be taken by people who use mutual funds to own REITS & PTPs.

    Interestingly, the new guidance included publicly traded partnerships, which wasn’t in the original tax law.

    By the way, your tax strategies book has been very helpful to me. Thank you for sharing your knowledge and experience.

  4. Derek Schlicker

    Thank you for the article. Has there been any updates as to the treatment of HELOC interest expense? That seemed like another opaque area in terms of tax treatment (specifically around whether certain uses of HELOC funds are used for improvement of a property vs using a HELOC as a down payment on an investment).

  5. Chris Nelson

    Thank you for this info. And I had the same question asked above regarding the deduction of HELOC interest. It was my understanding, early on, that HELOC interest would no longer be deductible. I know that for some of us, a HELOC is a great way to finance a down payment for an investment property, and whether or not the interest is going to be deductible, is not a reason not to use a HELOC, but, it sure would be nice if that interest expense would still provide a tax benefit.

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here