This guest post is from Onerent, a state of the art leasing & property management service.
Buying an investment property for rental under the new tax plan
Given the new proposed United States tax plan from the Trump administration, investing in real estate has some potential implications for a new investor. Most consider the changes extremely beneficial to first-time real estate investors in particular.
To cover the basics first, the existing tax structure allows for real estate investors to write-off all the expenses of owning and running a rental as those properties are considered a business operation. In addition, any interest on the mortgages for these investments along with any repair or management costs can be deducted pre-tax on the total income of the property so that the property owner is only taxed on the actual cash flow they’re earning from the investment.
None of these existing standards would change in the proposed tax-plan, but there are some new additions to look out for that could incentivize real estate investing and lower home sale prices.
Let’s take a look at how this plan can impact the industry and the externalities in the fine print.
Deductions for pass-through companies
Many experienced real estate investors will put the title of their investment property under a sole proprietorship, LLC, or S-corp for a variety of reasons including reduced risk in litigation, privacy, and tax benefits. These organizations are considered pass-through companies and they avoid double taxation rules of paying both individual and corporate taxes. Instead, taxes are just applied at the individual level.
The new tax plan proposes an additional deduction for pass-through companies. The plan adds a new 20% deduction on your net income after amortization and depreciation if you’re set up as a pass-through company. Alternatively, you may receive a 2.5% deduction on your property’s unadjusted basis–not including the value of the land.
To fully understand the value of the deduction, you need to understand the full amount of qualified business income and then consider the following breakdown. The deduction is the the sum of:
The lesser of:
- Combined Qualified Business Income, or
- 20% of the excess of: the taxable income divided by the sum of any net capital gain
And the lesser of:
- 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer, or
- taxable income reduced by the net capital gain
So what is combined qualified business income?
Combined qualified business income is the lesser of:
20% of the qualified business income with respect to the qualified trade or business; or the greater of:
50% of the W-2 wages with respect to the qualified trade or business, or
The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property
What does this all mean for someone looking to invest in real estate?
Well, it essentially means it’s now more profitable to own income-generating real estate assets such as single-family rentals, apartments, or condos. Instead of paying the regular income tax rate, you can create an LLC for $800-$1,500 and take advantage of the new 20% “freebie” deduction for pass-through companies.
Deductions for owner-occupied housing
With the new tax plan comes some rules that may create a negative incentive for owner-occupied housing. For example, mortgage interest is now only deductible on the first $750,000 of acquisition debt for primary and secondary residences. Anyone who previously purchased a property will be grandfathered in and can continue to deduct their interest on up to $1,000,000 of debt.
That grandfathering clause may incentivize primary residence homeowners to stay in their residence longer, which could in turn reduce the supply of available housing for sale and subsequently, increase sales prices.
The tax plan also removes the deduction on home equity debt, unless the proceeds are used in a trade or business acquisition or to make improvements on a rental property.
This might be a financial strain on some individuals who would need the extra tax deduction on interest and therefore might slow down home purchase numbers. Jerry Howard, CEO of the National Association of Home Builders, estimated that 7 million homes would be excluded from the mortgage interest deduction.
There is a proposed limit on aggregate deductions as well. In the new plan, state and local taxes are limited to a $10,000 deduction–this includes state income and property taxes. This change is most impactful for those living in high-income, high-property-tax states such as California, New Jersey, Washington, and New York. The impact will be negative for high-earners in these states. For example, if you’re state income tax is $15,000 and property tax is $9,000, you can only earn a maximum deduction of $10,000 event though your state and local taxes add up to $24,000.
These changes could negatively impact primary residence homeowners and create an incentive for owners to sell their primary residence, invest in out-of-state rentals instead, and just rent near their employer locally. These changes create a tax-shelter for single-family rental investors and thus may drive a swell of new real estate investment purchases.
Other changes in the tax plan
While we are not covering everything here, there are a multitude of other changes in the GOP’s proposed tax plan that may apply to you personally to consider as well before investing. These changes are covered in more detail by Brandon Hall, CPA on the popular real estate investing blog, BiggerPockets. We recommend reading through the changes in the new tax brackets, standard deductions, child tax credit, and alternative minimum tax in particular.