With tax season just around the corner, we've had a number of clients call to ask how recent US Tax Law changes will impact them. The following article provides a good overview. We also highly recommend talking to a tax professional. Need a recommendation? We work with several top-notch CPA's and tax lawyers. Contact us for a referral.
How the New U.S. Tax Law Impacts Property Owners
Real estate investors and developers see a win, while individual homeowners face a loss of deductions
BY V.L. HENDRICKSON | ORIGINALLY PUBLISHED ON JANUARY 07, 2018 | MANSION GLOBAL |
Even before U.S. President Donald Trump signed new tax codes into law in December, many Americans had already been flocking to experts to help them navigate the sweeping changes. This, as many of those experts are still trying to fully understand it themselves.
“The biggest question is, ‘what does this mean for me?’” said Suzanne Shier, the chief tax strategist and tax counsel for wealth management at Northern Trust, a Chicago-based financial services company. “And then we have to ask, ‘well, who are you?’”
Which is to say, every client has different needs and goals, not to mention a different tax situation.
A conversation with an advisor should start with exploring what will be the same and what will be different under the new code starting in 2018, she said. Additionally, tax payers should look at short-, middle- and long-term goals, keeping in mind that many of the changes expire in 2025.
Ms. Shier is emphasising “flexibility in plans.” People should certainly be looking for ways to be tax efficient, but shouldn’t completely alter their plans and activities because of a change in the tax law.
Wins for real estate investors and landlords
Clients have “a ton of questions” about deductions for pass-through businesses, Ms. Shier said. Those are businesses where the entity itself does not pay taxes, but the tax is instead passed through to the owner. Sole proprietorships, partnerships, and S-corporations are examples of this kind of business, as are limited liability corporations.
LLCs are commonly used by real estate investors and landlords, making the new code very beneficial to them. It’s also a popular option to provide privacy and an additional level of asset protections, experts say. It’s also an option when buying a second home or vacation residence that will provide rental income.
Under the new law, there is now a deduction of 20% for qualified business income for pass-through businesses.
“Generally speaking, this special deduction is allowed against business profits, and does not apply to wages earned by the business owner,” according to a January report by Jay Messing and Chris Pegg of Wells Fargo Private Bank, which advises customers in wealth planning.
Owners get to deduct 20% of pass-through income, meaning only 80% is taxed. “They will be taxed 29.6% on income that would otherwise be taxed at 37%,” Mr. Pegg said on the call. The 6% difference could add up to some serious savings for real estate investors who buy under LLCs.
These changes, among others, are big wins for the real estate industry, said tax and estate attorney Bradford Cohen of Jeffer Mangels Butler & Mitchell in Los Angeles.
The change from paying 37% to 29.6% is “basically a huge incentive to organize your business that way,” he said. He thinks taxpayers will “absolutely” try to establish pass-through businesses to take advantage of the deductions, but that most real estate investors “are already there.” If they’ve been getting good advice, that is.
Taxpayers can also deduct 20% of income received as qualified Real Estate Investment Trust dividends, Mr. Cohen noted, so they may see savings there as well. And like-kind exchanges of property, also known as 1031 exchanges, will still be allowed. So if an investor sells a property and buys another qualifying property—be it “skyscraper or a piece of dirt,” Mr. Cohen said—he or she can defer paying tax on gains from the original property.
Worry over the housing market
Many taxpayers are lamenting the loss of deductions, including the lower mortgage deduction and the new cap on state and local tax write- offs. Although the standard deduction is doubled, many taxpayers who have had significant itemized deductions will see those drop.
Going forward, “the deduction for mortgage interest is limited to underlying indebtedness of up to $750,000, or $375,000 for married taxpayers filing separately,” explained Cindy Hockenberry, the director of tax research and government relations at the National Association of Tax Professionals. Previously, the upper limit had been $1 million.
Plus taxpayers can no longer deduct interest on home equity loans, unless the money was used for renovations or other home improvements.
Additionally, “the overall deduction limit on any state and local tax, a combination of income tax, real estate tax or sales tax, is capped at $10,000,” she said. Previously, there was no cap, and highly taxed residents of states like California, New York and Connecticut will be the most affected by this change.
Many Americans made a mad dash to prepay these taxes at the end of 2017, but found that they couldn’t.
“Many municipalities assess the tax at the end of the year and the tax payment is then due the following year,” Ms. Hockenberry said. “You can’t pay 2017’s taxes and 2018 taxes, not assessed yet, and get a larger deduction. You can, however, pay down debt to maximize your interest deduction. Some folks are allowed to make interest-only payments. That could be a viable strategy for some.”
Some economists think these tax changes will make home buyers skittish, and bring home prices down. Analysts at Goldman Sachs said Wednesday the changes could create a “headwind” for housing prices, according to MarketWatch.
They “should induce many homeowners to switch away from itemization,” analysts wrote. “Collectively, the changes are likely to reduce the utilization of the itemized mortgage interest and property tax deductions, and in turn reduce the value of owner-occupied housing as a tax shield.”
Without the deductions as incentives, potential buyers may decide to rent instead. New York-based real estate agent Donna Olshan thinks there will be an uptick in the rental market.
“If there’s no real benefit to the buyer, why not stay in a rental?” she said, adding that certain buyers, those with high mortgages, are losing “the benefit of ownership.”
Estate planning to think about
One area people should be reevaluating is estate planning. Up to $11.2 million per person ($22.4 million for a couple) of an estate can now be transferred without tax penalty, which is double the amount allowed in the previous code.
That means those with significant property holdings might want to gift some of the titles of that property to their beneficiaries now, rather than waiting, according to Ms. Shier. This, like many of the individual changes to the code, is set to expire in 2025.
Experts agree that revisiting all estate planning provisions is crucial under the new tax code.
“Estate plans created before 2013 should definitely be reviewed, and even recently created plans may need to be reconsidered in light of dramatically increased exclusions,” according to the Wells Fargo report.
And although taxpayers should be looking for new ways to save, it’s important to remember many of these changes are temporary, Ms. Shier said. Having an exit strategy is key.
“If you make changes now, what is it going to take to unwind those changes?” she said. “You need to take the immediate savings into account, but also the potential cost and inconvenience associated with unwinding any changes you’ve made.”