Posted on Mar 5, 2018

Do you own residential or commercial rental real estate? The New Tax Law – Tax Cuts and Jobs Act (TCJA) brings several important changes that owners of rental properties should understand.

In general, rental property owners will enjoy lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025. In addition, the new tax law retains the existing tax rates for long-term capital gains. (See “Close-Up on Tax Rates” in the right-hand box.)

Close-Up on Tax Rates

If you own property as an individual or via a pass-through entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation — net income from rental properties is taxed at your personal federal income tax rates.

For 2018 through 2025, the TCJA retains seven tax rate brackets, but six of the rates are lower than before. The 2018 ordinary income rates and tax brackets are as follows:

Bracket Single Married, Filing Jointly Head of Household
10% tax bracket $0 – $9,525 $0 – $19,050 $0 – $13,600
Beginning of 12% bracket $9,526 $19,051 $13,601
Beginning of 22% bracket $38,701 $77,401 $51,801
Beginning of 24% bracket $82,501 $165,001 $82,501
Beginning of 32% bracket $157,501 $315,001 $157,501
Beginning of 35% bracket $200,001 $400,001 $200,001
Beginning of 37% bracket $500,001 $600,001 $500,001

In 2026, the rates and brackets that were in place for 2017 are scheduled to return.

In addition, the new law retains the current tax rates on long-term capital gains and qualified dividends. For 2018, the rate brackets are:

Bracket Single Married, Filing Jointly Head of Household
0% tax bracket $ 0 – $38,600 $0 – $77,200 $0 – $51,700
Beginning of 15% bracket $38,601 $77,201 $51,701
Beginning of 20% bracket $425,801 $479,001 $452,401

These brackets are almost the same as what they would have been under prior law. The only change is the way the 2018 inflation adjustments are calculated.

Additionally, 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.

Unchanged Write-Offs

Consistent with 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 property taxes on personal residences), those limitations do not apply to rental properties, unless you also use the property for personal purposes. In that case, the new limitations could apply to mortgage interest and real estate taxes that are allocable to your personal use.

In addition, you can still write off all the other standard operating expenses for rental properties. Examples include depreciation, utilities, insurance, repairs and maintenance, yard care and association fees.

Possible Deduction for Pass-Through Entities

For 2018 and beyond, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.

While it isn’t 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 through a pass-through entity. The unanswered question is: Does rental real estate activity count as a business for purposes of the QBI deduction? According to one definition, a real property business includes any real property rental, development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing or brokerage business.

Liberalized Section 179 Deduction Rules

For qualifying property placed in service in tax years beginning after December 31, 2017, the TCJA increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017). Sec. 179 allows you to deduct the entire cost of eligible property in the first year it is placed into service.

For real estate owners, eligible property includes improvements to an interior portion of a nonresidential building if the improvements are placed in service after the date the building was placed in service. The TCJA also expands the definition of eligible property to include the expenditures for nonresidential buildings:

  • Roofs,
  • HVAC equipment,
  • Fire protection and alarm systems, and
    Security systems.

Finally, the new law expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples of such property include:

  • Beds and other 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 provided and rented out.

Important: Sec. 179 deductions can’t create or increase an overall tax loss from business activities. So, you need plenty of positive business taxable income to take full advantage of this break.

Expanded Bonus Depreciation Deductions

For qualified property placed in service between September 28, 2017, and December 31, 2022, the TCJA increases the first-year bonus depreciation percentage to 100% (up from 50%). The 100% deduction is allowed for both new and used qualified property.

For this purpose, qualified property includes qualified improvement property, meaning:

  • Qualified leasehold improvement property,
  • Qualified restaurant property, and
  • Qualified retail improvement property.

These types of property are eligible for 15-year straight-line depreciation and are, therefore, also eligible for the alternative of 100% first-year bonus depreciation.

New Loss Disallowance Rule

If your rental property generates a tax loss — and most properties 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, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you 1) have sufficient passive income or gains, or 2) sell the property or properties that produced the losses.

To complicate matters further, the TCJA establishes another hurdle for you to pass beyond the PAL rules: For tax years beginning in 2018 through 2025, you can’t deduct an excess business loss in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:

  1. Your aggregate business income and gains for the tax year, plus
  2. $250,000 or $500,000 if you are a married joint-filer.

The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.

Important: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental real estate loss, you don’t get to the new loss limitation rule.

The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers 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 the taxpayer’s allowable current-year business losses (after considering the PAL rules) can’t offset more than $250,000 of income from such other sources or more than $500,000 for a married joint-filing couple.

Loss Limitation Rules in the Real World

Dave is an unmarried individual who owns two strip malls. In 2018, he has $500,000 of allowable deductions and losses from the rental properties (after considering the PAL rules) and only $200,000 of gross income. So he has a $300,000 loss. He has no other business or rental activities.

Dave’s excess business loss for the year is $50,000 ($300,000 – the $250,000 excess business loss threshold for an unmarried taxpayer). The $50,000 excess business loss must be carried forward to Dave’s 2019 tax year and treated as part of an NOL carryfoward to that year. Under the TCJA’s revised NOL rules for 2018 and beyond, Dave can use the NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.

Important: If Dave’s real estate loss is $250,000 or less, he won’t have an excess business loss, and he would be unaffected by the new loss limitation rule.

Like-Kind Exchanges

The TCJA still allows real estate owners to sell appreciated properties while deferring the federal income hit indefinitely by making like-kind exchanges under Section 1031. 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 you can arrange yet another like-kind exchange and continue deferring taxes.

Important: For 2018 and beyond, the TCJA eliminates tax-deferred like-kind exchange treatment for exchanges of personal property. However, prior-law rules that allow like-kind exchanges of personal property still apply if one leg of a personal property exchange was completed as of December 31, 2017, but one leg remained open on that date.

Need Help?

The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule). At this point, how to apply the TCJA changes to real-world situations isn’t always clear, based solely on the language of the new law.

In the coming months, the IRS is expected to publish additional guidance on the details and uncertainties. Your tax advisor can keep you up to date on developments.


Posted on Jan 15, 2018

The most immediate concrete change the Tax Cuts and Jobs Act (TCJA) will bring about for employers is new payroll tax withholding rates. Here’s the latest word from the IRS: “We anticipate issuing the initial withholding guidance in January reflecting the new legislation, which would allow taxpayers to begin seeing the benefits of the change as early as February. The IRS will be working closely with the nation’s payroll and tax professional community during this process.”

Under the new law, the tax rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Under prior law, the tax rates were 10%, 15%, 25%, 28%, 33%, 35% and 39.6%

Sexual Harassment Subject to Nondisclosure Agreement

Under the new law, effective for amounts  paid or incurred after December 22, 2017, no tax deduction is allowed for settlements, payouts, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.

In general, a taxpayer generally is allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business. However, among other exceptions, there’s no deduction for: illegal bribes, illegal kickbacks or other illegal payments; certain lobbying and political expenses; fines or similar penalties paid to a government for the violation of any law; and two-thirds of treble damage payments under the antitrust laws.

Family and Medical Leave

Another change involves tax incentives to encourage employers to pay employees — though not necessarily their full salaries — when they’re absent due to their own sickness or that of a family member. (Employers in several areas are already required to do so by  their own state laws.)

To receive a general business tax credit in 2018 and 2019, employers must grant full-time employees a minimum of two weeks of annual family and medical leave during which they receive at least half of their normal wages. Ordinary paid leave that employees are already entitled to, such as vacation or personal leave, or any form of leave already required by state and local laws, doesn’t qualify for the tax credit.

Employees whose paid family and medical leave is covered by this provision must have worked for the employer for a year or more, and not had pay in the preceding year exceeding 60% of the highly compensated employee threshold, set at $120,000 for 2018 (which works out to $72,000).

The minimum credit equals 12.5% of the eligible employee’s wages paid during that leave, up to a maximum of 25%. Within that range, the amount of the credit rises as employees are paid more than the minimum of half their normal compensation during their leave period. Employers that qualify may claim the tax credit for a maximum of 12 days per year of family and medical leave.

Save the Savings?

While most authors of the TCJA are probably hoping employees who will see a higher paycheck will use the difference to stimulate the economy by spending it immediately, there’s another scenario employers might consider: Employers that are concerned their employees aren’t saving enough for retirement could suggest that some might elect to “bank” their tax cut “raise” in the form of an increased 401(k) contribution.

One tool for motivating employees to save more for the future is to provide some illustrations of the long-term impact of a higher savings rate. For example, a $50 increase in 401(k) savings deducted from a biweekly paycheck would accumulate around $50,000 in greater savings over a 20-year period, assuming a 6% annual growth rate.

It’s also noteworthy that early versions of the TCJA would have drastically reduced employee opportunities to save for retirement in a 401(k) using pre-tax dollars. One proposal that would’ve hit many taxpayers hard would have limited contributions by requiring them to combine participation in multiple plans, including mandatory employee contributions to defined benefit pensions.

Those ideas were dropped.

401(k) Loan Rule Change

The TCJA did, however, make some technical changes in the retirement plan arena. Most notable is that the new law gives a break to plan participants that have outstanding 401(k) loan  balances when they leave their employers. Under current law, a participant with such a loan who fails to make timely payments due to his or her separation from the employer is deemed to have received a distribution in the amount of that outstanding balance, triggering adverse tax consequences. The participant, however, is permitted to roll that amount — assuming he or she has sufficient funds available — into an IRA without tax penalty if he or she does so within 60 days.

Under the new law, former employees in that situation have until the due date of their tax returns to move funds equal to the outstanding loan balances into IRAs without penalty. The same opportunity would apply if they were unable to repay their loans due to their plans’ termination.

Taxing Employee Awards

Some TCJA provisions affecting employee benefits seek to recoup tax relief granted in other parts of the law. For example, the TCJA tightens up the definition of employee achievement awards eligible for tax deductions on the part of employers, and exclusion from income taxation for the employees.

“Tangible” achievement awards still qualify, but the following award categories are no longer considered tangible: cash and cash equivalents, gift cards, gift coupons, gift certificates, vacations, meals, lodging, tickets to theater or sporting events, stocks and bonds.

The Inflation Effect and Other Changes

Another section of the law alters the inflation index used to periodically adjust the limits on contributions to health flexible spending accounts, health savings accounts, and the threshold for the value of health benefits subject to the 40% “Cadillac tax” (currently scheduled to take effect in 2020).

Instead of using the regular consumer price index (also known as the CPI-U), annual limit adjustments will be set using the “chained CPI-U.” That “chained” version tends to rise at a slower rate than the unchained index. The same formula change was made applicable to IRA contribution limits.

Finally, here are three other changes affecting employee benefits:

  • Employees’ ability to exclude the value of employer-provided reimbursements for moving expenses has been taken away. (An exception is made for active-duty military personnel, however.)
  • Employers can no longer deduct the cost of qualified transportation fringe benefits granted to employees, such as reimbursement for commuting expenses. And, similarly:
  • Employers can no longer deduct payments to employees who commute to work by bicycle.

When you add it all up, many employers and employees are likely to be happy with the overall effects of the TCJA. The task of digesting all the changes might cause a few headaches in the short run, however.