If you own commercial or residential real estate, you have likely been following the progress of tax reform. In December, the Senate and House reconciled their respective versions of tax reform bills, and the reconciled bill was signed into law by the President on December 22, 2017. The version of the bill that was signed into law (the “Act”) includes many provisions that will affect individuals, partnerships and corporations. This article will focus on the tax law changes that will affect real estate owners and investors, including taxpayers involved in 1031 exchanges, homeowners and commercial real estate investors.
1. 1031 Exchanges: The Act preserves the ability to defer tax through a 1031 exchange, but only for real estate. Starting in January of 2018, you won’t be able to exchange personal property, such as equipment and art, but no changes were made to the ability to exchange real property.
2. Capital Gains Rates: Although the law changes rates for ordinary income, it retains the same rates for long-term capital gains. The points at which the capital gains rate changes from 0 percent to 15 percent to 20 percent will be indexed for inflation.
3. Mortgage Interest Deduction: The mortgage interest deduction for your primary residence or a second home was largely preserved, but is now limited to interest on debt up to $750,000 (rather than $1 million under current law). The new rule applies to any new mortgage loans taken out after December 14, 2017. You will no longer be able to deduct interest on home equity loans, unless the proceeds are used to substantially improve the residence.
4. Exclusion of Gain Upon Sale of Primary Residence: No changes were made to current law in the final bill that was passed. Under current law, a homeowner who lives in his or her home as a primary residence any two of the past five years can exclude up to $250,000 in gain upon the sale of the home ($500,000 for married couples filing jointly). An earlier version of the tax reform bill would have extended the time required to live in a house as your primary residence in order to benefit from this tax break. In addition, an earlier proposal would have phased out this exclusion.
5. State and Local Tax Deduction: The Act limits the amount of state and local taxes, including property taxes, which can be deducted to no more than $10,000 each year. For residents of some states, this will limit the amount of property taxes that they will be able to deduct.
6. Estate Taxes: The Act increased the amount of transferred property that is not subject to estate tax from $5.6 million to approximately $11.2 million per person (the amount is subject to adjustment for inflation). The Act didn’t make changes to the step up in basis, which gives an heir a basis in inherited property equal to its fair market value at the time of the decedent’s death.
7. Business Interest Deduction: Although legislators considered eliminating the ability to deduct interest on debt incurred in connection with the acquisition of commercial real estate, the deduction survived tax reform with some limitations. For many businesses, net interest that exceeds 30% of earnings before interest, tax, depreciation and amortization cannot be deducted. Real estate owners can elect out of this limitation, but will then need to depreciate property based on a 40-year schedule for non-residential property and 20 years for qualified interior improvements.
8. Carried Interest: During the past several years, there was a lot of discussion in Washington about changing the way carried interest is taxed. Carried interest, which generally is the profits interest that a general partner gets, is taxed at a capital gains rate, rather than the higher ordinary income rate. Starting in 2018, there will be a three-year holding period required in order to get the long-term capital gains rate for carried interest.
9. Pass-Through Entity Income: The Act also creates a new deduction for certain pass-through entities, which include partnerships, S-corporations, sole proprietorships and limited liability companies. The deduction was created to give small businesses a tax break, since the corporate tax rate is going down. The basic deduction is 20 percent of qualifying income, but there are limits on the deduction depending on certain factors, such as income thresholds, wages and the capital of the business.
You may be affected by many other provisions of the Act, including changes to the standard deduction (doubling it), changes to rates (lowering the highest rate of individuals from 39.6% to 37%) and the removal of many itemized deductions. Some of the tax changes in the Act have a sunset date, so they will expire if they are not extended. Since each taxpayer is unique, we recommend you talk to your tax advisor about the details.
William Lopriore is the northeast regional manager and counsel for First American Exchange Company, LLC. Wayland, Mass.
Nothing contained in this article is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This article is intended for educational and informational purposes only. The views and opinions expressed in this article are solely those of this author, and do not necessarily reflect the views, opinions, or policies of this author’s employer.