In part one, Lawrence Fassler discusses proposed changes to the tax code, including limitations on sponsored business interest deductions, changes to 1031 Exchange program and carried interest taxation. To read part one click here.
Lowered Business Income Rates for Investors in Pass-Through Entities
The change that might affect investors and sponsoring real estate companies. Most directly is the proposed reduction of the tax rate applicable to business income received from pass-through entities, such as the limited liability companies and partnerships utilized by RealtyShares and most project companies formed by sponsoring real estate companies. This rate on pass-through business income would be dropped from 39.6 percent to 25% percent.
For many investors in real estate projects, the lower rate for pass-through business income could be a boon. This is because the proposal aims to encourage investment by small businesses through a formula targeting tax revenue that is applied to capital expenditures. Real estate projects should benefit from that “capital expenditure” test. And the current proposal allows “passive” owners in such pass-through entities to benefit from 25 percent top rate as well, according to the legislation. The provision would thus likely work to the advantage of RealtyShares investors who invest in real estate projects
The proposal faces much criticism, however. The bill would make it very difficult for lawyers, engineers, doctors, consultants, and other personal service providers, who make up a good share of small businesses, to qualify for the 25 percent rate. Since their services do not involve capital expenditures. And since the change only effectively lowers taxes for persons whose income tax rate is above 25 percent, the change wouldn’t help everyone. Couples earning less than $260,000 and singles earning less than $200,000 wouldn’t be able to take advantage of it. Some observers claim that about 86 percent of these pass-through business owners aren’t paying individual rates greater than 25 percent anyway. Critics thus argue that the “small-business tax cut” label the House is applying to this proposed change mischaracterizes the situation.
Additionally, the change’s applicability to persons who are “passive” owners, while potentially beneficial to investors in real estate projects, strikes many as counter to previous IRS rules. The rules generally try to avoid providing special tax breaks to non-active investors, which earlier efforts aimed (for example) at preventing people from falsely claiming to be active in order to claim tax losses.
Individual Mortgage Deductions May Be Capped
The tax plan would reduce the maximum available interest deduction available on owner-occupied mortgage debt from $1 million cap to $500,000. It would also make that deduction less relevant, by implementing a big increase in the standard deduction (the amount that can be earned before paying tax). Which would greatly reduce the incentive to take advantage of itemized deductions in the first place (Americans must pick one or the other).
For most of America, the impact will be minimal, since the $500,000 figure is still more than double the median home price in the United States of roughly $200,000. Fewer than three percent of home mortgages involve principal balances of more than $500,000, according to CoreLogic.
But more expensive areas along the coasts will feel the pinch. While in the Houston metropolitan area only about 6.5 percent of homes are valued at more than $500,000, in San Jose, California, more than 90 percent are, and in San Diego, California, it is 63 percent, according to Zillow. The move will thus serve to raise the overall cost of buying a home in those areas, and perhaps discourage existing homeowners in those regions from moving.
For the single-family or condominium sectors of the housing market, these changes will generally not help transaction activity in the high end of the market. The U.S. homeownership rate has already fallen to about 64 percent from its pre-recession peak of around 69 percent, and the whittling away of the mortgage interest deduction gives homeowners one more reason to stay put, said Svenja Gudell, chief economist at Zillow.
The House plan would also cap the deductibility of property taxes at $10,000, another provision that could weigh on the construction and resale of more expensive homes. Moreover, the proposed elimination of deductions for state and local income taxes would adversely affect itemizing households in high-tax states like California and New York.
But if the changes do continue or accelerate the shift from home owners to renters, the commercial property sector that focuses on rental units may well benefit. The market for value-add multifamily apartment complex projects often featured by many online marketplaces (including the one I work for), for example, may actually see increased interest if the proposed changes are enacted into law.
Things Are Moving Fast
The residential real estate industry, including mortgage bankers, will be pushing back hard on Congress in the weeks to come with respect to the new limits on the mortgage interest deduction and other proposals considered damaging to the single-family housing industry. The House seems intent on speeding the plan to a vote, though – Republicans are attempting to get the plan to President Trump’s desk by Christmas – so lobbying efforts may be less effectual than in the past.
Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.