The Tax Cuts and Jobs Act (also known as H.R. 1, or the TCJA) took effect on January 1, 2018. With the exception of bonus depreciation (described below), all of the act’s provisions apply to 2018 and later, not to 2017 taxes.
Overall, rental property owners win big under the new law. However, the new tax law does impose new restrictions on the deduction of interest and rental losses. Here’s how the new tax plan affects property owners and landlords.
Note: Are you a property manager? We have a separate version of this post just for you: How Does the New Tax Law Impact Property Managers? 9 Changes to Be Aware Of
New Passthrough Tax Deduction
The TCJA created a brand new tax deduction for income earned through passthrough entities. It just so happens that virtually all rental property is owned by passthroughs—that is, by individuals (or tenant in common owners), limited liability companies, partnerships, or (less often) S corporations. Thus, virtually all rental property owners can potentially benefit from this new deduction, so long as the rental activity qualifies as a business (as almost all do).
The amount of the deduction depends on a landlord’s total taxable income, and for most landlords, the value of their rental property. It can never exceed 20% of a taxpayer’s total taxable income for the year.
Income Below $315,000 ($157,500 for Singles)
The passthrough deduction is 20% of net passthrough income if total taxable income for the year from all sources after deductions is below $315,000 (if married filing jointly) or $157,500 (if single).
Income of $315,000 to $415,000 ($157,500 to $207,500 for Singles)
If total taxable income ranges from $315,00 to $415,000 for a couple filing jointly, or $157,500 to $207,500 for single filers, the W2 wages and depreciable property limit is phased in. At the end of the income range, the entire deduction cannot exceed the wages/property limit.
Income Above $415,000 ($207,500 for Singles)
20% of passthrough income remains the maximum limit for the deduction if annual taxable income is over $415,000 if married filing jointly, or $207,500 if single. However, the deduction cannot exceed the greater of:
- 50% of the landlord’s applicable share of the W-2 employee wages paid by the rental business, or
- 25% of the landlord’s share of W-2 wages paid by the business, plus 2.5% of the original purchase price of the depreciable long-term property used in the production of income—for example, the rental property (not counting the cost of the land).
Since most residential landlords have no (or few) employees, the 25% of wages plus 2.5% of property deduction will ordinarily apply. For landlords with no employees, the deduction will be limited to 2.5% of the original cost of their rental property.
This deduction takes effect for 2018 and is schedule to expire after 2025. Will it actually last that long? No one knows. However, if a Democrat is elected in 2020, along with Democratic majorities in Congress, it is quite possible that this deduction could be eliminated (or greatly altered) as early as 2021. So, rental property owners should enjoy it while they can.
New Limits on Deducting Rental Losses
Passive Activity Losses
The TCJA contains two new limitations on deducting business losses, including losses from rental properties. These limit deductions for any rental losses after the application of passive activity loss (PAL) rules, which restrict rental property owners’ ability to deduct rental (passive) losses from non-rental (active) income. These new limits are of particular importance to rental property owners who qualify as real estate professionals, since the PAL rules do not limit their ability to deduct losses from rental activities in which they materially participate. Thus, for 2018 and later, there are now limits on real estate professionals’ ability to deduct rental losses from their non-rental income.
Net Operating Losses
Under prior law, a net operating loss (NOL) could be carried back two years, resulting in a refund of all or part of the taxes paid in those years. The TCJA eliminates carrybacks of NOLs—that is, they may only be deducted in current and future years. Also, the TCJA permits taxpayers to deduct NOLs only up to 80% of taxable income for the year. Unused NOL amounts may be carried forward and deducted in any number of future years.
$250,000/$500,000 Annual Loss Limit
The TCJA also limits deductions of “excess business losses.” Married taxpayers filing jointly may deduct no more than $500,000 per year in total business losses, including rental business losses. Individual taxpayers may deduct no more than $250,000. If rental property is owned through a multi-member LLC taxed as a partnership or S corporation, the $250,000/$500,000 limit applies to each owner’s or member’s share of the passthrough’s losses. Unused losses are deducted in future years as part of the taxpayer’s net operating loss carry-forward.
New Limits on Interest Deduction
Starting in 2018, all businesses with average gross receipts of $25 million or more are allowed to deduct interest payments only up to 30% of their adjusted taxable income: Income including depreciation (until 2022), interest expenses, passthrough deduction, or NOLs. Interest that’s unable to be deducted must be carried forward to be deducted in any number of future years.
However, real property businesses may elect out of this prohibition, and thereby deduct 100% of their interest expenses each year. To do so, they must depreciate their real property under the longer periods required by the alternative depreciation system (ADS): 30 years (instead of 27.5) for residential property, and 40 years (instead of 39) for non-residential property. Also, such electing businesses may not use bonus depreciation. Real property trades or businesses include any real property development/redevelopment, construction/reconstruction, acquisition, conversion, rental, operations, management, leasing, or brokerage trade or business (including management and operation of lodging facilities).
First-Year Bonus Depreciation
Bonus depreciation permits a substantial portion of the cost of personal property used for business to be deducted in a single year. Prior to the enactment of the TCJA, the bonus depreciation amount was 50%—that is, 50% of the cost of an asset could be deducted the first year, with the remaining cost being depreciated over several years. The TCJA increases the bonus depreciation amount to 100%. The increase goes into effect for long-term tangible personal property acquired and placed in service after September 27, 2017. The 100% bonus amount is scheduled to remain in effect through 2022. It will be gradually phased down to 0% by 2027.
In addition, for the first time, bonus depreciation may be used for purchases of both used and new property. This permits rental property owners to use bonus depreciation to deduct 100% of the cost of used personal property included in rental units in a single year. Note that bonus depreciation may not be used for any property with a depreciation period of 20 years or more, which excludes real property and its components. It may be used for all types of personal property and real property improvements with a depreciation period of 15 years, such as landscaping and grading.
Expanded Section 179 Expensing
Section 179 of the Internal Revenue Code permits businesses to deduct the cost of personal property in one year. During 2017, the maximum amount that can be deducted under Section 179 is $500,000. Starting in 2018, the Section 179 maximum is increased to $1 million. The $1M amount is reduced by the amount by which the cost of property placed in service during the year exceeds $2.5M (but not below zero) .
One significant limitation on Section 179 is that rental property owners could not use it to deduct the cost of personal property used in residential rental units. The TCJA eliminates this restriction starting in 2018. Thus, starting in 2018, landlords may use Section 179 to deduct up to $1 million in personal property in rental units each year. For example, Section 179 may be used to deduct appliances and furniture in rental units. Section 179 may also be used to deduct improvements to non-residential building roofs; as well as HVAC, fire protection, alarm, and security systems added after the building was first placed in service. However, Section 179 may not be used to deduct the cost of such property in residential buildings.How does the new tax plan impact rental property owners? Find out on the #BuildiumBlog! Click To Tweet Read more on Accounting & Taxes
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