Tax Reform Was Passed, Signed & Delivered
Congress Says It’s a Christmas Gift for us….But, is it?
As there has been a great deal of hype on all sides of tax reform, let’s see if we can dig into the issues with more light and less heat. Hopefully you find this helpful and instructive on items that will no doubt have lasting ramifications and unintentional consequences for many years. The summary: The reforms should be good for real estate, with tax advantages for pass-through entities improving. Before making decisions based on tax reform, please be sure to speak with a tax accountant up to date on the all real estate rules, as those will be coming fast and furiously from the IRS! To start, let’s get a quick understanding about “the process” and how we got here:
The rules in the Senate, specifically those about budget reconciliation drove the GOP Tax Reform process; or more perhaps accurately, hemmed it in. The Senate rules would not allow not budgetary items to be included in the bill, though somehow the opening of the ANWR for oil drilling was deemed appropriate. I say that not to be tongue in cheek or sarcastic, but to highlight that the rules of the Senate can be rather extensive and somewhat archaic. Nothing illustrates that more the Byrd Bath, or Byrd Rule, named after Sen. Byrd of WV, who was prolific in his ability to ear mark projects (and have them named for him throughout the state). This provision limits a budgetary item from being either “extraneous” to the budget or would significantly increase the federal deficit beyond a ten-year term. Those definitions, and the reference to the 10-year life span of legislation for the Senate, are key.
Second Amendment advocates may remember that the “Assault Weapon Ban” approved by the Senate had a 10-year life, as do many bills passed they pass. This is especially true of bills that would expand the deficit beyond the 10-year time frame. So…a budget item must have sufficient financial offsets, per the Senate’s staff accountants, The Congressional Budget Office. Which then leads to a trade-off of budget items.
Think of it this way, your budget includes travel, car payments, shelter, clothing, school fees, etc. In December you decide to set your car payments & mortgage/rent for 12 monthly payments, but you’re only going to spend on travel for the first 3 months, clothing once a quarter, and lastly school fees only twice a year. If you increased any of those, your budget goes out of whack – ignoring that the US is already deficit spending 30%+ of its budget. So you may make the trade-off (gamble?) that spending for travel will drop to the first two months and you will increase the mortgage/rent – permanently. That works for this year, budget-wise, but next year (or the next ten-year Senate cycle) you still have to live with that “new” base-line expense.
With that understanding, it is important to note that the deficit restriction, self-imposed by the GOP, was $1.5 Trillion. Each tax cut has its own “expense” or cost to the budget. As the dust settled, some were set to start immediately, others like the quarterly clothing expenses in our example above, start at different dates. Additionally, some of the items, like the travel allowance, are set to expire or sunset on specific dates. Is your head spinning yet?
Now that we know those details…let’s dig into the specific details of the bill.
The flagship piece of the puzzle is the reduction in corporate tax rate. This rate was reduced from 35% to 21% – and it is permanent. This reduction moves the US from one of the highest rates in the world to among the lowest. The Trump Administration’s goal, in sync with Congressional GOP leaders, is to make the US a haven for Corporations world-wide. (click here for more details charts – prefer table #1.)
The next key item is that of the Individual tax rates lowered for 80% of tax payers. There are 7 tax brackets (listed below)
2018 Income Tax Brackets
The goal was to simplify the system so that with standard deductions, which were nearly doubled: Singles from $6,500 to $12,000 and for Couples from $13,000 to $24,000. Part of the reason for the increase was to remove the personal exemption line item and consolidate the process. Ideally, most taxpayers will be able to use a post card format to submit their taxes…needless to say, we are still always away from that goal.
The child tax credit was doubled to $2k and a non-child dependent was added for elderly parents, but then only at $500. Additionally, these tax reforms are to sunset in 2025. The goal of the current Administration and Congress is to make these permanent and even improve on them, but alas that will need to wait for the next bill.
The State and Local Tax deduction (SALT) was one of the most hotly contested and philosophically charged issues. The argument is that if those deductions are allowed, then low tax areas are subsidizing high tax areas, because people in high tax areas don’t pay as much to the federal government due to local and state taxes creating such a large deduction. Most of the Republicans come from low-tax areas and Democrats from high-tax urban areas, so the political divide was substantial. However, there were some Republicans from high tax states, and a concern for low-income workers who would be harmed by the elimination of the deduction. So, a $10K cap on deductions was implemented. For comparison, the average New York City tax payer deduction exceeds $50K. The cap helps low income workers, but doesn’t soften the blow very much for those in areas that have decided to tax, tax and tax again! Corporations are still allowed to deduct SALT, while individuals with pass through entities are capped at $10K.
Pass through entities – Where Real Estate Investors Live!
The vast majority of real estate investors utilize pass through entities like Limited Liability Companies. There was a lot of hype on these entities, the rates and various proposed modifications. In general, Pass Through Entities received a tax cut as well. The details are a bit more complicated. Bloomberg News, stated it this way,
“The bill sets several restrictions for the type of pass-throughs eligible for the deduction and how much they’re allowed to claim, based on the wages the entity pays, the amount of equipment the entity purchases, and how much the owner earns. It excludes many service businesses from the tax break.”
During the tax reform debate, there was significant concern that if the separation between corporate rates/benefits and pass through entities became too great there would be a mass conversion from pass through entities to corporations. Experts (economists) do not believe that is the case presently, though as numerous wealth, finance and business outlets have noted, this will be a conversation to have with your CPA, as there are still significant benefits to the flexibility of pass through entities, especially with the capturing of depreciation, expanded expensing provisions and the lack of corporate tax layering.
While there is a 20% tax reduction in the reform for pass through entities, there are provisions to limit active owners who receive a salary from re-characterizing their income so as to avoid taxes. Passive investors are treated a bit more friendly – and in this area more than any other, they will need to have a specific conversation about their situation with an up to date tax consultant. Click here for more information from Alistair Nevius and The Journal of Accountancy.
Pass-through income deduction
For tax years after 2017 and before 2026, individuals will be allowed to deduct 20% of “qualified business income” from a partnership, S corporation, or sole proprietorship, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. (Special rules would apply to specified agricultural or horticultural cooperatives.)
A limitation on the deduction is phased in based on W-2 wages above a threshold amount of taxable income. The deduction is disallowed for specified service trades or businesses with income above a threshold.
For these purposes, “qualified business income” means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.
“Qualified business income” does not include an S corporation shareholder’s reasonable compensation, guaranteed payments, or — to the extent provided in regulations — payments to a partner who is acting in a capacity other than his or her capacity as a partner.
“Specified service trades or businesses” include any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.
The exclusion from the definition of a qualified business for specified service trades or businesses phases out for a taxpayer with taxable income in excess of $157,500, or $315,000 in the case of a joint return.
For each qualified trade or business, the taxpayer is allowed to deduct 20% of the qualified business income for that trade or business. Generally, the deduction is limited to 50% of the W-2 wages paid with respect to the business. Alternatively, capital-intensive businesses may get a higher benefit under a rule that takes into consideration 25% of wages paid plus a portion of the business’s basis in its tangible assets. However, if the taxpayer’s income is below the threshold amount, the deductible amount for each qualified trade or business is equal to 20% of the qualified business income for each respective trade or business.
An article on CNN-Money also points out that, “The 20% deduction would be prohibited for anyone in a service business — unless their taxable income is less than $315,000 if married ($157,500 if single).” So, if you separate the service, maintenance, or management company responsibilities, a global review may be in order.
Live-in Home remodeling? If you and your spouse take on the task as a daily effort, or they put up with your ongoing renovations, please know that this tax reform still has a carve out to protect up to $250K for Singles and $500K for Couples in capital gains from selling a house, as long as it was a primary residence for two of the last five years.
Landlords were thrown a bone in that moving expenses are no longer tax deductible, except for certain military exemptions. One less incentive for renters to move about and cause turn-over costs. Why moving expenses were ever deductible in the first place is the real question!
A couple of final items worth noting for investors, if your lofty goals of becoming a wealthy land baron come true, know the new estate tax exemption has been raised to approximately $10M for singles and $20M for couples. Additionally, if you are on your own for insurance you will no longer be penalized for not purchasing a federally approved plan – the ACA mandate (aka Obamacare) was removed.
There will be plenty more written about this as the accountants breakdown each phrase, the IRS issues regulations and “clarifications” and of course the occasional tax precedent via the courts. In the meantime, enjoy a rousing conversation with your partners and adapt to the new tax scheme.
Charles Tassell is the Chief Operating Officer of National REIA.