The biggest tax reform in the last thirty years was signed this past December and took effect in January of 2018. It has some positive and negative impacts to your current investment strategy, but let’s make it a great thing for your future strategy. Here is how this tax reform affects real estate investors.
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Changes to How you Borrow Money
Many real estate investors focused on single family rentals utilize their own home residence as a way to finance their rental portfolio. This will be the first major change, as the interest you can deduct is now limited in both the dollar amount and the type of loan. Borrowing money for new rentals will now be less from your home equity and more from the equity in your rentals.
Mortgage interest tax deduction remains in place with a change of the limit from $1 million to $750,000. It’s important to mention that real estate investors won’t have the option of deducting interest from home equity lines. They won’t be able to claim this tax deduction if they had interest on home equity lines before the tax reform.
This means your real estate loans will need to be with the rental properties themselves instead of your home residence. By borrowing against the rental property (which many do already), you can use the interest as a deduction. However, if you do this, you will also have to change your depreciation schedule to thirty years instead of the current 27.5 years (twenty years for improvements).
Changes to Where you Personally Live
Having a primary residence became less beneficial, because you now get a standard deduction that is most likely greater than if you had a large loan on your home with a large interest expense and high property taxes. In cities with high property taxes, it will make more financial sense to rent than own, and in cities with low property taxes, it will be better to own.
Itemized deductions are a thing of the past. Before the tax reform, the standard tax deduction was set at $6,350 for a single tax filer and $12,700 for a married couple, so itemizing expenses was often worthwhile. The tax reform of 2018 nearly doubled those amounts: $12,000 and $24,000, respectively. In addition to the increased standard deduction, many itemized deductions no longer qualify, so the standard will most likely bring you a higher return. This means more people will probably be opting for a standard tax deduction, as it will end up amounting to more.
This does mean you may want to become a renter yourself but still own your rentals:) Of course, if you can move easily, you could always find a city where property taxes are low, and thus have the benefit of both owning and receiving the larger deduction. Selling your home isn’t an easy decision, but there are some things to help. You can still get up to $500,000 in non-taxable capital gains if you have lived in your home for two of the last five years ($250,000 if you’re single). You can also still move from a residence to a rental (and vice versa) with the 1031 exchange.
The decision to move or not can be aided by knowing whether you pay more or less than $10,000 now. State and Local Tax (SALT) deductions will still apply under the new tax reforms. However, there is now a set maximum of $10,000 for the combination of state and local property taxes. In Texas, California, New York, and Florida, $10,000 doesn’t come close to covering your home property tax bill.
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Changes to Your Lifestyle
It’s important to mention that the tax rates have been reduced, even though the structure of tax brackets remains the same under the new tax reform. The highest tax rate has been changed from 39.6% to 37%. The amount of taxable income for each bracket has also been raised slightly, allowing taxpayers to possibly move down to lower brackets. This means that whoever you are, you’re probably going to have a little more money in your pocket.
Other ways your lifestyle might change? For those who are small business owners (farmers, ranchers, real estate investors, etc.), you can now deduct 100% of new and personal property (and “new” now means new to you, so used items are allowed). Expensing the full amount of a new piece of equipment can lower your overall tax liability for purchases you are thinking of making anyway. It’s currently planned to expire in five years, but for now this provision means you can say yes to the new Model X Tesla. Equipment over 6,000 pounds and used for your business does qualify :)
For years I’ve heard arguments for creating LLCs for my rental business, but have only heard the benefits from lawyers. I’ve avoided doing so, but given the new change, I may start considering it. Putting your rental business into an LLC allows for an opportunity to have a 20% deduction of the “pass-through” income. This is limited to those with under $315,000 ($157,000 for singles) of taxable income. If your income level fits, then the 20% works by looking at your LLC’s income compared to your other income. (If one spouse works and the other does the rentals, then it is rentals compared to spouse's AGI from salary.) Whichever is lower, you get a deduction of 20% of the AGI. Not bad, seeing how the LLC income is after all the normal rental expenses like interest and property taxes.
The 2018 tax reform has positive and negative sides to real estate investors and their markets. You may want to read some tax stuff to make sure you've done everything right to close your tax season. But even if you are aware of the current situation, we would still suggest you consult a tax advisor to know how the new tax reform will affect your return on investment.
Good luck with your investment strategy, and hope this helps!