The new tax law gives rental property owners some breaks — and one important negative change
By BILL BISCHOFF, Market Watch
If you own rental real estate, the Tax Cuts and Jobs Act (TCJA) has changes that you need to know about. Most are in your favor. Here’s the story.
Lower ordinary income tax rates for 2018-2025
If you own property as an individual or via a pass-through entity (partnership, LLC treated as a partnership for tax purposes, or S corporation), net income from rental properties is taxed at your regular personal federal income tax rates. Here are the 2018 ordinary income rates and brackets under the TCJA.
Long-term capital gains tax rates are unchanged
The TCJA retains the 0%, 15%, and 20% federal income tax rates on long-term capital gains, including long-term gains from real estate. Here are the 2018 rates and brackets for LTCGs.
Exception: As under prior law, you still face a 25% maximum federal income tax rate (instead of the standard 20% maximum rate) on long-term real estate gains attributable to depreciation deductions.
What you can write off is mostly unchanged
As under prior law, you can still deduct mortgage interest and state and local real estate taxes on rental properties. While the TCJA imposes new limitations on deducting personal residence mortgage interest and state and local taxes (including personal residence real estate taxes), those limitations do not apply to rental properties unless you also use the property for personal purposes. In that case, the new limitations could affect deductions for mortgage interest and real estate taxes that are allocable to personal use.
You can still write off all the other garden-variety operating expenses for rental properties: depreciation, utilities, insurance, repairs and maintenance, yard care, association fees, and so forth.
New deduction for pass-through business income
Under prior law, if you had net taxable income from a pass-through business entity (meaning for this purpose a sole proprietorship, LLC treated as a sole proprietorship for tax purposes, partnership, LLC treated as a partnership for tax purposes, or S corporation), the net income was simply passed through to you and taxed at your personal rates.
For 2018 and beyond, the TCJA establishes a new deduction based on qualified business income (QBI) from a pass-through business entity. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels and a limitation based on your taxable income.
While it is not entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable rental real estate activity that you own via one of the aforementioned pass-through entities. The unanswered question is whether a rental real estate activity counts as a business for purposes of the QBI deduction. It probably does, but we await IRS guidance.
Liberalized first-year depreciation for some properties
For qualifying property placed in service in tax years beginning after 12/31/17, the TCJA increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017). The Section 179 deduction privilege potentially allows you to deduct the entire cost of eligible property in Year 1. For real estate owners, eligible property includes most improvements to the interior portion of a nonresidential building if the improvement is put to use after the date the building was put to use.
The TCJA also expands the definition of eligible property to include expenditures for nonresidential building roofs, HVAC equipment, fire protection and alarm systems, and security systems.
Finally, the TCJA expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples apparently include furniture, appliances, and other equipment used in the living quarters of a lodging facility such as an apartment house, dormitory, or other facility where sleeping accommodations are rented out.
Warning: Section 179 deductions cannot create or increase an overall tax loss from business activities. So you may need plenty of positive business taxable income to take full advantage of the Section 179 deduction privilege. Your tax adviser can help you assess this issue.
100% first-year bonus depreciation for qualified real property expenditures
For qualified property placed in service between 9/28/17 and 12/31/22, the TCJA increases the first-year bonus depreciation percentage to 100% (up from 50%). The 100% deduction is allowed for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.
New loss disallowance rule
If your rental property throws off a tax loss — and most do at least during the early years — things get complicated. The passive activity loss (PAL) rules will usually apply. In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources — like positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have sufficient passive income or sell the property or properties that produced the losses.
After you’ve successfully cleared the hurdles imposed by the PAL rules, the TCJA establishes a new hurdle. For tax years beginning in 2018-2025, you cannot deduct an excess business loss in the current year. An excess business loss is one that exceeds $250,000 or $500,000 if you are a married joint-filer. Any excess business loss is carried over to your next tax year and can be deducted under the rules for net operating loss (NOL) carryovers.
A key point: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental loss, you don’t get to the new loss limitation rule.
Example: You are unmarried. In 2018, you have a $300,000 allowable loss from rental real estate properties after considering the PAL rules. You have no other business or rental activities. Your excess business loss for the year is $50,000 ($300,000 loss minus $250,000 threshold for a single filer). You cannot deduct the $50,000 loss in 2018. Instead you must carry it forward to your 2019 tax year and treat it as part of an NOL carryover to that year.
Variation: If your rental loss is $250,000 or less, you will not have an excess business loss, and you will be unaffected by the new loss limitation rule.
The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers (like you) to use current-year business losses (including losses from rental real estate) to offset income from other sources — such as salary, self-employment income, interest, dividends, and capital gains. The practical result is that your allowable current-year business losses (after considering the PAL rules) cannot offset more than $250,000 of income from such other sources or more than $500,000 if you are a married joint-filer.
Like-kind exchanges still allowed for real estate
The TCJA still allows real estate owners to unload appreciated properties while deferring the federal income hit indefinitely by making like-kind exchanges, which are also known as Section 1031 exchanges. With a like-kind exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to put off paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange yet another like-kind exchange and continue to defer taxes. The TCJA doesn’t change any of this.
The bottom line
The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule, which will not affect very many folks). At this point, how to apply the TCJA changes to real-world situations is not always clear because we have nothing to rely upon except the statutory language. We await IRS guidance on the details and uncertainties. I will keep you up to date on developments.