6 Ways the New Tax Cuts and Jobs Act Impacts Individual Real Estate Investors
Tax reform can have major ramifications on real estate investments. The last major tax reform to pass, the Tax Reform Act of 1986, was meant to simplify tax code and eliminate tax shelters. The 1986 tax reform lowered the top tax bracket for individuals from 50% to 38.5%, but also removed most tax savings opportunities and caused commercial real estate values to decline. The Tax Cuts and Jobs Act that was signed into law on December 22 will most likely have the opposite effect to commercial real estate.
The Tax Cuts and Jobs Act is meant to put more money back in the hands of individuals and corporations, stimulating the economy through investments and job creation. Real estate investors will receive a major benefit from the Tax Cuts and Jobs Act in the pass-through deduction legislation, making the after-tax return on investments even better than they are today. The end result is greater demand for commercial properties and more money in the pocket of investors.
Two of the biggest changes from the Tax Cuts and Jobs Act are to the federal corporate tax rate and the top income bracket for individuals. The federal corporate tax rate was cut from 35% to 21% and accounts for ~$1 trillion of the $1.5 trillion in tax cuts. $1 trillion is likely to flow back into the economy from increased corporate investment or dividends paid to shareholders. Additionally, the law has reduced the highest bracket for ordinary income from 39.6% to 37%. This would put billions of dollars back in the hands of individuals and would most likely be a bonus for the luxury goods and second home market.
Here are six key parts of the new tax law that will impact real estate and individual investors, along with our view:
1. Individual State Deductions – Negative. Currently, state and local property tax deductions are unlimited for individuals. Under the new tax law, these will be capped at $10,000. If your annual property tax bill exceeds this amount, you may want to consider pre-paying your 2017 first installment tax bill by the end of 2017. Paying in 2017 would allow you to deduct 100% of all real estate taxes as the new law won’t go into effect until 2018. This seems like an easy way to save on taxes, but please consult your own tax attorney for guidance here. Additionally, this may impact demographic shifts as people move away from high cost states to low cost states.
2. Pass-Through Deductions – Positive. Members, owners, or partners of pass-through entities will be able to deduct 20% of their taxable income earned from pass-through entities. This deduction represents a maximum effective tax rate of 29.6% for pass-through income.
LLC Profits: $100,000
20% Deduction: $20,000
LLC Taxable Profits: $80,000
New Tax Rate: 37%
Individual Investor Tax Bill: $29,600
Effective Tax Rate: 29.6%
This is a large benefit to real estate investors and will further strengthen the after-tax benefit of investing in the asset class. The pass-through deduction of 20% begins to phase out on income above $315,000 and disappears above $415,000.
3. Carried Interest/Capital Gains Taxes – Negative/Neutral. Under the 2017 law, long-term capital gains are available on investments held for longer than one year. There is no change to this rule under the new bill. However, capital gains on carried interest has been extended and redefined as investments held for longer than three years. This change may incentivize sponsors to hold assets longer and could reduce the transaction volume in commercial real estate. At Origin, we typically hold our properties for more than three years, so it won’t impact the way we do business.
4. Capital Expenditures – Positive. Code Section 179 of the new law will be expanded to include certain additional real property capital expenditures that will now be able to be 100% “written-off” in the year they are incurred, as opposed to the 2017 tax law where they are depreciated over their remaining useful life. This could be very beneficial for investors in commercial real estate as this would result in a significantly larger “paper loss,” which they would be able to use to offset non-real estate-related income from their taxes.
5. Interest Expense Deduction – Negative. If you take out a new mortgage on a primary or second home, you will now only be allowed to deduct the interest on debt up to a $750,000 principal balance, down from $1 million principal balance today. Homeowners who already have a mortgage would be unaffected by the change. On the flipside, there will be no caps in interest expense deductions for commercial real estate.
6. Tax Holiday for Cash Held Overseas by U.S. Companies – Positive. The new tax law lets U.S. corporations bring back an estimated $2.5 trillion to $3 trillion of foreign profits to the U.S. at a tax rate of 15.5%, versus the current corporate tax rate of 35%. Bringing this cash back to the U.S. will likely generate economic stimulus in every corner of America.
The newly signed tax law is expected to be beneficial for real estate investors and high-income earners in the short run. However, we don’t expect the effects of the new law to be felt until after 2018 as it generally takes time for tax cuts to trickle into the system and change behavior. Long term, we have to be concerned about adding $1.5 trillion to the deficit and the potential inflation it could invite into the system. Rising interest rates don’t bode well for property values. However, the stimulus will likely create demand for real estate, and property revenue growth could easily offset the risks of a rising rate environment. Lastly, we need to consider the fact that many of these new rules may be short lived and reversed by the next administration. At a minimum, the majority of the tax law changes, except for the corporate tax rate, are expected to be phased out at the end 2025.
This article was updated after the tax bill was signed into law.