With the election over, many of you may be wondering how the new changes in Washington impact those of us as real estate investors. Specifically, will we get to keep the wonderful tax breaks that we have enjoyed in the past as real estate investors? What potential pitfalls may come with some of the proposed changes from Washington?
The truth is that it is still anyone’s guess as to what the new tax changes will be. It is still too soon to tell what the final tax proposals will be and which ones will ultimately be signed into law. Will there be any significant changes to the tax law before the end of the year? If you ask me, it is very unlikely. We do, however, expect to see some major tax changes as early as 2017.
Let’s take a look at what the initial tax reform proposals may be and consider what that could mean to investors like us.
Income Tax Brackets for Individuals
The proposal cuts down the highest personal income tax rate from 39.6% down to 33%, so this is a benefit for those investors in the higher income brackets. However, for investors who may have been in the lower income tax brackets, it is possible that the lowest 10% bracket may be taken away and replaced instead by a 12% bracket.
Itemized and Standard Deductions
With the proposal to increase standard deductions and putting in place a cap on itemized deductions, the result is that the primary home interest deduction may be less impactful for many home owners. For example, if you are single, the current standard deduction for the 2016 year is $6,300; however, if you own your primary home and your mortgage interest and property taxes total $10,000, then you would itemize instead.
Under the proposed changes, the standard deduction would increase to $15,000 for single filers. Therefore, you would get a $15,000 deduction without even needing the mortgage interest or property taxes. Although this may not necessarily impact the taxes of real estate investors, what it could mean is that more people may decide to rent instead of purchasing a home since there would be decreased incentives to purchase. This can potentially mean higher demand for rental real estate, which can be a win for certain long-term hold investors, in my opinion.
We will likely get to keep the preferential capital gains tax rates when we sell rental properties, and that rate may even be lowered further. This is a win for real estate investors, especially if you are in a high tax bracket because for those in the highest 39.6% tax bracket, the sale of a long-term rental would only be subject to 20% tax.
Net Investment Income Tax
This is likely to go away. While this does not affect investors who make less than $250k, this can be helpful for higher income investors who have been paying the additional 3.8% tax on interest from note investments, capital gains on sale of rental real estate, and also rental income. This is a good thing for most investors since many real estate investments are subject to this additional tax.
Alternative Minimum Tax (AMT)
Many of you high earners have probably seen this pesky tax pop up now and again. AMT is an alternative tax calculation that adds back deductions such as state taxes, property taxes, net operating losses, investment interest expense, and depreciation and assesses an additional tax. Fortunately for high earners, this may be repealed as well.
Entity Structuring Considerations
There were many significant changes in the initial proposals with respect to the taxation of legal entities that we as investors need to be aware of. Let’s take a look at some of these and how they may impact us:
C Corporation Tax Rates
Tax rates for C Corporations may be lowered from 35% to 15%. Due to historical higher corporation rates and double taxation, few investors have benefited from C Corporations in the past when it comes to taxes. However, with the new proposals of lowering C Corporation taxes, it may make sense for certain higher income individuals to now consider C Corporations as part of their real estate entity structure.
For example, if you were flipping real estate in your personal name and your personal tax rate is 33%, it could make sense to shift your real estate into a C Corporation and pay 15% tax rate instead. Once we find out if there are changes to dividend tax rates, we will then be able to take a good look at whether it makes sense for certain active investors to consider entity changes in the coming years.
Currently, income earned in flow-through entities is not subject to income taxes at the entity level. Instead, the income flows through directly to the entity owners, and income taxes are assessed at the owner’s level. Under the new proposed tax changes, these flow-through entities may now be subject to taxation of 15%. Is this good for investors? Well, it depends.
Related: How Retirement Contributions Are Saving One Real Estate Investor $53K in Taxes
If the proposal indicates that the maximum rate at the entity level will be 15% and there will be zero taxes once the income flows through to the individual, it can be extremely beneficial for those investors who are in higher tax brackets personally. For example, if you are in the 33% bracket personally and you own your rental in an LLC, currently you would pay 33% taxes on your rental income. However, if the LLC will pay taxes at 15% and this income is not subject to double taxation, then your rental income now will be subject to only 15% taxes instead of the previously higher rate of 33%. This assumes, of course, that you personally do not need to pay any taxes on this rental income at the time you take distributions from your LLC.
If estate taxes are repealed, that could be good for those investors with higher net worth. If you are hanging onto real estate and other assets to pass onto your kids, you may now be able to escape the 40% tax that comes along with transferring these assets. One of the pitfalls, however, is the proposal to potentially take away the step-up tax basis. Many people use 1031 exchanges to defer taxes on capital gains. With step-up tax basis, you can potentially pass it on to heirs at stepped up basis so that the heirs can sell it the very next day and pay zero cap gains taxes. If the step-up basis is taken away, we may need to do some additional planning on those with highly appreciated real estate. Heirs may want to hang onto some of those properties instead of selling them in that case to avoid taxation personally.
You may already know that one of the best ways to protect ourselves from taxes is with proactive tax planning. Over the next year, we should all stay on top of the new tax changes as they take shape, so that we can take advantage of the good ones and avoid any costly mistakes.
What do you think about proposed tax changes? How do you think your investing business will be impacted?
Let me know with a comment!