As I write this on New Year’s Eve, I join the rest of the tax professionals trying to fully understand exactly how the 494 page TCJA will affect my clients.
The TCJA represents the product of work begun by the GOP years ago, and refined (in mostly closed door discussions thru 2017 among the GOP legislators), with no input from the Democrats.
However, I want to give you a 30,000 foot overview of the impacts I now believe are likely to flow from the TCJA for rental property owners, so you can begin planning for them.
After reviewing some of the most significant changes, this article will briefly discuss a few planning implications most relevant to income property owners (I have ignored a bunch of provisions that seem more general). But, be sure to check with your tax advisers before acting on this summary, as understanding of the details of the bill is sure to change and the way these provisions will work depends on your individual situation.
First, The Bad And Ugly Parts of the TCJA
California rental property owners are going to take a few BIG hits to their pocketbooks.
By now, you probably know that you are going to lose the ability to take an itemized deduction for all of your state and local taxes (“SALT”).
Under the TCJA, the total SALT deductions will be limited to $10,000 beginning in 2018.
[Even this limited SALT deduction may have little effect on those without a lot of state income taxes, or a lot of property taxes, as the “standard deduction” doubles to $24,000 for a married couple filing jointly (“MFJ”), and $12,000 for a single person. But, the increase in the standard deduction is offset by the loss of personal exemptions of about $4,000 per person.]
Fortunately, you dodged a bullet (maybe a 155 mm cannon shell!) when the Conference Committee Report clarified that “in the case of property taxes, an individual may deduct such items [independent of the SALT limitation] only if these taxes were imposed on business assets (such as residential rental property)” as reported on Schedule C or E.
Home Mortgage Interest
The TCJA also limited the deduction for home mortgage acquisition interest to the interest on no more than $750,000 of encumbrances. Fortunately, that limitation will not apply to encumbrances in place on or before December 15, 2016, or incurred in relation to certain binding contracts entered into on or before such date to purchase a personal residence if the purchase is completed by April 18, 2018. Some refinancing of residential acquisition debt will also be exempt from the new rules.
Limit on Business Interest Deduction
The TCJA introduced a new rule generally limiting deduction of business interest expenses to the sum of business interest income, plus 30% of adjusted taxable income. This rule will not affect most property owners, as it applies only to affiliated groups with more than $25 million in average annual gross receipts.
No More 1031 Exchanges for Personal Property
This may limit the benefit of some cost segregation.
Now For Some Good News
The mainstream press has characterized the TCJA as one of the most unpopular tax cut bills in history. But, it will save a LOT of money for some and if the GOP is correct about the “Laffer Curve,” it will help “raise all boats” by turbocharging growth in employment and in the economy.
Rate Reduction for Nearly Everyone
Every tax bracket (except the lowest) got a reduced rate, and all tax brackets now start at a higher level and apply to higher levels. Rate reductions will have the greatest impact on those with higher income levels, consistent with GOP orthodoxy on the beneficial impact of “trickle down” economics.
If you are lucky, rate reductions (and maybe the pass-thru deduction discussed below) will be more important for you than the loss of SALT and other itemized deductions.
Reduction in C-Corporation Rates
One of the major goals of the TCJA was to lower the rates paid by corporations. The top rate on corporations was reduced from 35% to 21%, and the Alternative Minimum Tax (“AMT”) was eliminated for corporations.
Despite these reductions, it will rarely make sense for income property owners to transfer their property to a C-Corporation (one that pays taxes itself, instead of passing its income through to be taxed to its shareholders). However, you may still want to discuss how this will work for your individual situation with your tax advisor.
Still, many “perks” get better deduction treatment in a C-Corporation, which might make it rational to use a C-Corp as a management entity. On the other hand, that might reduce your ability to get the benefit of the pass-thru deduction discussed below.
§ 179 Deduction
The amount of the 179 deduction which allows you to immediately write off the cost of acquiring certain business property (but not RE) increased from $500,000 to $1 million, with more liberal phase-outs, and it can be taken for used property.
Pass-Thru Business Deduction for Qualified Business Income (“QBI”)
The GOP did not want to ignore businesses that were not organized as C-Corps. We call these “pass-thru” businesses (partnerships, LLCs, sole proprietorships and S-Corps), where income is generally taxed to the owners of the business, rather than the business entity itself.
The House and Senate had different ideas on how to do this. After all the horse trading was done, the Conference Committee adopted a plan patterned on the Senate’s proposal to give these businesses a special deduction, rather than the House plan to roughly reduce the pass-thru rate to 25%.
The bills originally passed by both the House and Senate DID NOT allow this benefit for real estate rental businesses.
Fortunately, at the last minute, the Conference Committee adopted an amendment to let real estate rental businesses benefit from the special deduction.
Under the new rules, most pass-thru businesses will be able to give their owners a limited Qualified Business Income (“QBI”) Deduction. The final version of the law (though not the versions originally passed by the House and Senate) also permits estates and trusts to also use the deduction.
The pass-thru deduction unfortunately “sunsets” for taxable years beginning after 12/31/2025, unlike the reduced rate for C-Corps, which is “permanent” (although a future law could change the latter).The calculation of the QBI Deduction is extremely complicated, and space limitations requires oversimplification in this article.
Some elements are calculated at the taxpayer level (owner by owner), while others are calculated at the filer level (each LLC, partnership, S-Corp separately) level.
If the taxpayer (owner) does not have taxable income over the threshold ($157,500 for a single person, $315,000 for an MFJ), the QBI Deduction simply equals the lesser of 20% of the QBI from the business or 100% of taxable income. At a marginal rate of 24%, that can mean a reduction in Federal income tax of about $15,000 (depending on other limitations), potentially reducing the effective marginal rate to about 19.2%. At the top marginal rate of 37%, the QBI Deduction can potentially reduce the effective rate on such business income to 29.6%, though other limitations will apply. QBI is generally reduced by depreciation and by deductible interest. Net operating loss carryforwards from the qualified business will reduce QBI in subsequent years.
In all cases, the QBI Deduction cannot exceed the lesser of the combined QBI Amount (which includes the deduction for each qualified trade or business plus 20% of certain REIT dividends and income from publicly traded partnerships. The QBI deduction is not adjusted for the Alternative Minimum Tax.
Generally, if the taxpayer has income over the threshold ($315,000 for MFJ, and $157,500 for singles), and the income is from a real estate rental business, the QBI Deduction is reduced. If taxable income is over $415,000 for MFJs ($207,500 for others), the QBI Deduction is limited to the greater of: (i) 50% of W-2 wages; or (ii) 25% of W-2 wages, plus 2.5% of “unadjusted basis” in the real estate rental business. Unadjusted basis is equal to cost basis of qualified property without reduction for accumulated depreciation.
But, “qualified property” only includes tangible property that (i) is being depreciated, (ii) which is held for use in the business at the end of the year, and (iii) was actually used in the business at some point during the year. It does not include land, and does not include tangible property for which the depreciation period ended before the end of the tax able year (either due to being fully depreciated or having been subject to a § 179 deduction for the full value in the year of purchase). This limitation may make the QBI deduction of little value for property owners who have held property for many years if such owners have income over the threshold. Note: property being depreciated over a period of less than 10 years will still be included in “qualified property” until expiration of the 10-year period.
For those over the threshold, property with a high original cost basis, even if substantially (but not completely) depreciated, may allow use of most of the potential QBI deduction. If your unadjusted basis is not sufficient, most planners believe that the step-up in basis at death can increase unadjusted basis to a level that may enable full use of the QBI deduction. Unused QBI Deductions can carry forward to future years.
Note that QBI must be reduced by reasonable compensation paid to owners of the business who work in the business, which may generate other costs for FICA and other employment taxes.
For owners who are over the threshold, the calculation of the QBI will be very complicated. To give you incentive to do it correctly, the accuracy penalty for improper claims of the QBI Deduction increases to 10%.
However, there are planning opportunities with regard to timing of income and deductions if you are over the threshold. Maybe timing issues can allow the deduction in alternate years. If you have multiple entities, interest on intercompany or other debt may reduce the QBI, so you may want to eliminate it from high debt entities. Or, some entities may want to pay more in salaries, while others may be paying more in salaries than they need to in order to get the full QBI benefit. All of this requires careful modeling and planning.
We have software that can allow us to project your QBI Deduction and to model changes that might increase or decrease it.
Expanded Estate Tax Exclusion
While the GOP wanted to abolish the “death tax,” fiscal reality prevented Congress from getting there.
However, the GOP DOUBLED the lifetime exclusion from estate taxes, gift taxes and generation skipping taxes. For 2018, it will be $11.2 million per person, or $22.4 million per couple.
This exclusion will continue to grow with inflation, although the index picked to measure inflation will probably understate the real impact of inflation.
The same exclusion will apply to gifts and for generation skipping tax purposes.
Unfortunately, however, this expansion of the exclusion is one of the many provisions that sunsets at the beginning of 2025. So, for those of you who do not die before then, you and your heirs will face the 2017 exclusion (with slight inflationary increases), unless a future Congress extends the doubling or repeals the death tax. In the political climate we face today, I doubt that anyone can rely on Congress to bail us out. Because the expanded transfer tax exclusion sunsets, you may want to use it (with high basis property or strategies that make it possible to still get the step-up in basis at death on low basis property) before it sunsets.
Net Operating Losses (“NOLs”)
Effective in 2018, new rules will apply to NOLs – no more carrybacks, but unlimited carryforwards, usable to offset 80% of taxable income (90% of AMT income) in any year.
Preliminary Thoughts on Planning Implications
- 1. It will rarely make sense to convert your real property ownership to a C-Corp, given the two layers of tax, reduced ability to use step-ups in basis at death, and the double tax when property is sold.
- 2. Maximize your ability to use the pass-thru QBI Deduction. Model changes to your property and business to see which produce the best results.
- 3. Think twice before you use cost segregation to increase depreciation. It may limit your ability to take advantage of 1031 Exchanges.
- 4. Integrated Estate Planning has become more important than ever, to maximize step-ups in basis, minimize property tax reassessments AND meet important family non-tax goals and protect the inheritance you leave behind. If the QBI Deduction survives long-term, the step-up will be even more valuable than it was prior to 2018, as it increases the amount of QBI Deduction that can be used.
- 5. Estate planning designed to reduce death taxes must still be evaluated against the possible cost of reducing step-ups in basis. If you expect to have estate tax exposure, we may be able to both reduce estate taxes and preserve step-ups in basis.
- 6. While we think charitable deductions are now LESS valuable given the limits on itemized deductions and lower rates, charitable remainder trusts may be more valuable as a way to increase the effective QBI Deduction. We are still evaluating the merits of this strategy under the TCJA.
The bottom line motto remains: “If you fail to plan WELL, plan to FAIL!”
Upcoming Estate and Tax Planning Seminars for Apartment Owners
In conjunction with AOA, we have scheduled the following seminars:
- March 15 – Buena Park
- March 22 – Van Nuys
- March 27 – Torrance
Each seminar will begin at 10 AM and run until noon, with Q&A to follow. We will try to arrange an extended Q&A period (up to 1 PM) to deal with questions related to the TCJA and give examples of the QBI Deduction. Call your local AOA office to register or register online at www.discoversuccess.com. (For Northern California members: Watch for upcoming seminars in your area in May or June.)
Estate planning attorney, Kenneth Ziskin, focuses on integrated estate planning for apartment owners to save income, property, gift and estate taxes. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, a perfect 10 out of 10 rating from legal website AVVO.Com, and is multiple winner of AVVO’s Client Choice Award. This article is general in nature and not intended as advice for clients. Please get advice from counsel you retain for your own planning.
Ken also offers FREE consultations for AOA members. You can call him at (818) 988-0949. See Ken’s website at www.ZiskinLaw.com.