Proposed Tax Reform Could Impact REIs

The proposed tax reform hit the internet last week. Though there are likely to be many changes and revisions, in its current form, there are many impacts to those who invest in real estate. Let’s explore these.

Changes in Deductions

The proposed tax reform has changed, reduced, and eliminated many deductions for the American taxpayer. Several of these changes will affect real estate investors. These include:

$10,000 deduction cap for state and local property taxes
Mortgage interest deductions will be limited to loans under $500,000 rather than $1 million
Eliminate interest deductions for second homes

Capital Gains

Originally, capital gains was only on your primary home $250K/$500K as long as you lived there 2 out of the last five years. The new proposal is more difficult for primary homes: You must now live in your primary residence for the past five of eight years with no transition period. If passed, any sale after January 1, 2018, must meet the new five-of-eight-years requirement. Taxpayer use of the exclusion would also be limited to one sale every five years, rather than one every two.

Some investors who wanted to avoid capital gains and couldn’t do a 1031, would sometimes convert their rental to the primary residence for two years and then sell. Now, they would have to live there for five. At this time, the 1031 exchange still exists, so investment properties can avoid the capital gains as long as they follow the 1031 rules.

Taxation of Business Entities

Most investors have formed an LLC in which to do business. This next section deals with changes to business entity taxation that could affect your company.

A 3-year holding requirement for carry or promote services to get long-term capital gain tax rates
Foreign investors, even those investing in LLCs, will be obligated to pay federal, state, and local income taxes

Benefits

However, the changes to the code are not all bad news. Here are some ways that real estate investors will benefit:

Maximum 25 percent pass-through business income rate
Only 30 percent of business income is subject to the 25 percent rate. The rest of the income is subject to regular income tax rates, which are also being revised
Repeal of the estate tax beginning in 2023 and reducing it in the meantime

What This Means as an Investor

If the proposed tax reform passes as it stands, there will be many homeownership tax benefits no longer available to the American public. Without these benefits, many Americans may decide not to own a home. Because of this, owning rental properties and multi-family properties may become more attractive.

However, I wouldn’t begin buying just yet. Since homeownership is a crucial piece of the American dream, it is likely that there will be opposition to the removal of these reductions.

Another thing to consider is the reduction of state and local tax deductions. This may make states with low or no income taxes, like Florida and Texas, more attractive. At the same time, states with high income taxes, like California and New York, may find themselves in a weaker market.

The point is to think about the taxation situation when buying investment properties on both the state and local level. In this new tax scenario, lower is better than ever.

Of course, with this tax reform just out, you can rest assured that this is not the final draft. Continue to watch as this tax reform makes its way through Congress so that you can capitalize on any tax changes made that affect real estate investing.