Watch out for Trump’s Tax Adjustments
Unfortunately, a new year brings new tax changes. This article appeared in the Wall Street Journal and has implications for real estate investors. As always, the views presented here are my own. I am a licensed Real Estate Broker, not an accountant, tax preparer, or attorney. Absolutely nothing in this email is legal advice.
While Trump’s tax reforms will be beneficial, there is potential for trouble in the real estate investment world. I’d like to call your attention to the following paragraphs:
Among other things, the GOP blueprint calls for the elimination of the deduction for state and local property tax. Industry executives also worry the plan could severely cripple the mortgage interest deduction—long considered a sacred cow of U.S. tax policy.
The upshot, real-estate industry leaders worry, would be that fewer people would be incentivized to purchase homes, which would weigh on demand and possibly the broader economy.
While the loss of this deduction could negatively affect us, it also works against fence-sitting potential buyers who may want to purchase their own home. This change may encourage them to continue renting, which is good for apartment investors. How good depends upon your own tax situation and existing deductions. Will any potential increase in rental demand offset these proposed deduction changes?
Another sea change in commercial real estate would be in the way the House blueprint would affect depreciation. Tax law currently allows buyers of rental apartment buildings to depreciate the cost over 27.5 years and other commercial real estate over 39 years.
The House plan would eliminate depreciation for real-estate companies as well as other businesses. Instead, buyers of real estate would be able to treat the entire cost of buying a property—excluding land—as a business expense that could be used to reduce income. If a buyer didn’t have enough income in the year they bought the building, they could be able to carry the expense forward into future years as a net operating loss.
This proposed change eliminates our 27.5 or 39.0 year constant depreciation deduction. It should also eliminate recapture provisions going forward, as there is nothing to recapture without depreciation. (How the law will address past depreciation benefits is still unknown.) This doesn’t automatically seem bad. Owners of more profitable properties will enjoy some years of tax-freedom, but will pay more tax down the road when their purchase price (business expense) runs out. Those with less profitable properties will enjoy longer periods of freedom from tax gains.
I potentially foresee more importance being applied to ownership vehicles in relation to taxation. Consider an investor with a sole proprietorship (owned in their own name) rental property. Let’s assume it’s a $115,000 property. The house earns a profit of $15,000 and the investor earns $100,000 from their day job.
Does this mean our investor has $100,000 in additional expenses to carry over to the next tax year for the house’s future income? Or does it mean that their $100,000 in day job income is sheltered by house’s purchase price but leaving no coverage for future years?
I suspect the former if the house is owned by a separate entity (LLC, Inc., IRA account, Trust, etc). But what about sole proprietorships? Is this the creation of a new tax mitigation strategy for high income earners? Assuming this change also operates as a shelter, I foresee an active new market opening for high income earners to trade properties among themselves. Some will need to change ownership yearly to keep their income sheltered if the tax mitigation strategy is to work properly. However, if the tax code allows for this sort of mitigation strategy, high income earners must employ multiple heavy legal peril/risk mitigation strategies because they must own these properties as a sole proprietorships.
Another thought. Could this lead to investors purchasing properties with leverage essentially for free? For example, will a 25% down payment be less than the potential year 1 tax savings?
“We’re advocates for job creation and economic stimulation,” said William Rudin, a major New York landlord and chairman of the Real Estate Roundtable. “We don’t want to provide tax shelters.”
Of course, someone always has to spoil the fun.
Still, officials said they are concerned about how such changes as the elimination of depreciation would be phased in. Investors who bought properties recently on the assumption that current law would apply might face big losses if all of a sudden they lost their depreciation tax benefits, industry officials said.
“The transition rules are really, really critical,” Mr. DeBoer said.
That final sentence is the understatement of 2016. The real estate crash of 1986 was partially brought about by how the Tax Reform Act of 1986 changed passive loss rules and depreciation schedules. Some economists believe that these changes directly contributed to or even caused the Savings & Loan Crisis as well. Avoiding similar ham-fisted changes are absolutely vital.
If you have opinions relating to potential changes, I strongly suggest you contact your federal elected officials immediately. Remember that phone calls and emails are less effective; elected officials have no idea whether you are a constituent or some random person in a faraway state who may be safely ignored. Hand-signed letters which contain your full name and address, whether faxed or sent through the mail, are always your best option.
Here’s to a happy and prosperous 2017 for us all!