It’s more than half way through the tax year and this is the year that the Tax Cuts and Jobs Act (TCJA) took affect. These tax code changes affect just about everyone and for the most part real estate investors will see a positive affect – if you make changes to your strategy. One possible odd tax strategy for real estate investors is renting out their own primary residence.
This certainly isn’t for everyone but because of the new limits on mortgage interest and property tax deductions, renting out your own home can convert it into a business investment that is still fully tax deductible. And since you’ll have to move, consider relocating to a low income tax state if you’ll exceed the new federal deduction limit in your current state. Dramatic but a good strategy for wealthy and savvy investors.
Probably the biggest new tax benefit to most real estate investors is the 20% deduction of your real estate pass-through income from your personal tax return. The key here is income that comes from pass-through entities. The most common pass-through entities are sole proprietors, partnerships, LLCs, and S Corporations. This deduction does not apply to C-corporations (large publicly traded corporations) that have an entirely different tax structure.
You may still have investment properties titled in your own name and be operating as a sole proprietor. This may still work for you as a pass-through entity but there is a question whether individuals (or married couples) are able to claim the income pass-through deduction using IRS Schedule E. As with any tax code change, there are still unanswered questions. Many of those that wrote the legislation don’t agree on exactly what was intended and the IRS is still in the process of writing instructions that apply to every possible situation. At this moment, there is no provision on Schedule E for this deduction. This is just another of many reasons why you should title your properties as a separate entity such as a LLC.
Additionally, there are restrictions, limits, and phase out schedules that apply to the 20% pass-through deduction. These mostly apply to your primary business income when real estate investing is not your main source of income. Different rules, limits, and restrictions apply if your primary income doesn’t come for a “qualified trade or business.” This restriction commonly applies to service professionals such as doctors, lawyers, accountants, and others that often invest in real estate as a side business. There are also income limits that apply all investors.
You really need to be talking to a tax professional about how these changes affect you. Every investor’s situation is unique. Most likely, you have multiple tax strategies across multiple income streams that need to be blended together for maximum benefit.
There are changes in depreciation of personal (business) property that real estate investors will benefit from. For qualified property placed in service after Sept. 27, 2017 and before 2023, a 100% depreciation can be taken the year it is placed in service. Previously this was spread over multiple years. After 2022, the first year’s depreciation is incrementally decreased through 2026.
The definition of a qualified property has also loosened. It now includes new and used equipment as long as it isn’t purchased from a related party. Under Section 179, the purchase or financed cost of qualified equipment has also been increased. Previously the full deduction cap was a cost of $510,000. That has been increased to $1 million. The top end of the deduction phase-out has been increased from $2 million to $2.5 million. Another change is that after 2018, the limits will be indexed to inflation. Among the many other types of equipment and costs, these include: roofs, air conditioning, furnaces, alarm systems, and fire systems.
Tax code changes are a time to reevaluate your strategy. For instance, you probably no longer want you use the equity in your primary residence to finance investments because this is no longer deductible. Instead, your strategy becomes borrowing against the rental property itself although at a higher (deductible) mortgage rate. Fortunately, by taking advantage of these tax breaks, you’ll have more discretionary income. Your ultimate strategy should be upgrading your lifestyle.
What tips do you offer investors reviewing their tax strategy? Please comment below.
Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for seven years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. In the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.