Key Changes in the Trump Tax Plan That Will Affect Real Estate Investors

by | dolinsksite.ru

On November 2, 2017, the U.S. House of Representatives released its proposal for tax reform called the Tax Cuts and Jobs Act (H.R.1). Though lacking a creative title, the 429 page bill proposes sweeping changes that will affect how you invest in the future.

Our firm tediously analyzed each page of the bill to compile and condense the key items you must pay attention to. Today’s post will touch on a few of the bigger finds.

Keep in mind that we don’t know what parts of this bill (if any) will actually pass. It’s important for you to read through this post and the bill itself in order to understand the potential affect on real estate investors. However, take a deep breath as this bill still has a long way to go to meet the standards of a few GOP fiscal hawks in the senate.

Biggest Loser: Rental Income Subject to Self-Employment Tax

We couldn’t believe it when we found this one short sentence on the 51st page of the bill “(3) APPLICATION TO RENTAL INCOME.—Section 1402(a) is amended by striking paragraph (1).”

This was found in the section where the bill defines “net earnings from self-employment.” Let’s break this down.

The bill is amending IRC Section 1402(a) by removing paragraph one (aka IRC 1402(a)(1)). If you were to type “IRC 1402(a)” into a Google search, the first link will take you to the current definition of “net earnings from self-employment.” If you look at paragraph one (IRC 1402(a)(1)) as it’s currently written, you’ll see that the paragraph provides an exclusion of rental income from the calculation of self-employment income. This paragraph, which the bill proposes should be removed, saves you from paying Social Security and Medicare taxes, a total tax of 15.3%, on your net rental income.

So if paragraph one is removed as the bill proposes, your rental income may be subject to an additional 15.3% tax.

However, it’s not as simple as saying all rental income is subject to self-employment taxes. First, you’d actually have to show net positive taxable rental income in order for the self-employment taxes to apply. Assuming you do have net positive taxable rental income, you’d also have to be conducting a “trade or business.”

What type of landlords are running a “trade or business” is where it gets murky.

The IRC does not define “trade or business” anywhere in the tax code. Instead, we have to look to tax court cases to understand what “trade or business” means. To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit (Commissioner v. Groetzinger, 480 U.S. 23 (1987)). Profit motive factors are defined in the IRC and there are other Tax Court cases we can look to in order to better define a trade or business.

Your rental income may be subject to self-employment taxes if you:

  • Qualify as a real estate professional
  • Materially participate in your rental activities
  • Invest in short-term rentals

Holding rentals passively will not likely subject your rental income to self-employment tax. So if your rentals house long-term tenants and you have a day job (or business), you will likely avoid qualifying your rental income for self-employment taxes.

Regardless, should this one sentence go unnoticed and pass, it will have hugely negative implications for real estate investors.

Related: 7 Common Tax Mistakes of New Real Estate Investors

Second Biggest Loser: Loss of Itemized Deductions

What you will be able to write off as an itemized deduction on Schedule A will change drastically.

First, you will no longer be able to deduct state and local income taxes paid during the tax year. That tends to be one of the biggest itemized deductions for our clients in high-tax states. The elimination of state and local income taxes as itemized deductions will be costly for those in high-tax states. For folks in low-tax (or no-tax) states, the impact will be less noticeable.

Real estate property taxes are now capped at $10,000 on Schedule A. This will hurt people who own a primary residence or a second home of high value, or own in a locality with high property taxes.

Personal property taxes are no longer deductible.

Mortgage interest on new loans is now deductible only on the first $500,000. I have seen mass hysteria in the real estate investment community with this new limit. However, keep in mind that this limit applies to your primary residence and a second home. Your rental properties will not be subject to this limit as it’s written.

Third Biggest Loser: The Section 121 Exclusion is Harder to Claim

Currently, the IRC Section 121 allows you to exclude $250,000 ($500,000 if married) of capital gains on the sale of your primary residence, as long as you’ve lived in the property for the past two out of five years. The new bill states that you must now live in your primary residence for the past five of eight years in order to qualify for the gain exclusion. The real bummer here is that there is no transition period as currently written in the bill. This means that any sale after January 1, 2018, must meet the new five-of-eight-years requirement.

So if you were planning to sell your primary residence and cash out the capital gains tax-free, you had better get moving on listing the property and hope that either (1) you sell before the end of the year or (2) this measure does not pass.

Other Losers: Elimination of DPAD and Rehabilitation Tax Credits

The Domestic Production Activity Deduction (DPAD) is a nice boon that rehabbers, developers, and builders can claim to further reduce their tax liabilities. You can only claim DPAD if you combine raw materials into an inventory item and then hold them out for sale. The bill currently proposes to eliminate the DPAD.

The Rehabilitation Tax Credit is also on the chopping block. This credit helps investors who fix up decrepit parts of cities and towns and hold the properties for a number of years. The proposed bill will eliminate this credit.

Biggest Winner: Elimination of Alternative Minimum Tax

We jumped for joy when we found out that the Alternative Minimum Tax (AMT) was proposed to be eliminated with this bill. The AMT is an attempt by congress to make sure that rich Americans pay at least a 28% tax on all of their income. The problem is that the AMT negatively impacts the middle class, probably more so than it does the rich. Additionally, it can be insanely difficult to calculate, adding to processing time and professional fees incurred. Basically, it doesn’t serve its purpose and it’s inefficient and rightly being eliminated.

Second Biggest Winner: 25% Entity Pass-Through Tax and 20% Corporate Tax

Some LLCs and S corporations will now enjoy a 25% tax rate on their pass-through income. I say “some” because the calculation on the 25% pass-through rate is complicated, and businesses such as service businesses have been specifically excluded from qualifying for a 25% rate.

The calculation that was created leaves some S corporation owners out to dry. You will now use a “capital percentage” to calculate how much of your net income will be taxed at a 25% rate and how much will be taxed at rates above 25%. Businesses that are capital intensive, such as flippers, developers, and builders, may be able to justify high capital percentages. Otherwise, your capital percentage is 30%, meaning that only 30% of your net income from your business operations is subject to a 25% tax. The remaining 70% could be subject to your marginal tax rate if higher than 25%.

This is a huge bummer, especially considering C corporations now have a 20% tax rate. We are hoping that the calculation for the 25% tax on pass-through income will change as the bill moves through the senate.

Related: The Ultimate Guide to Real Estate Investment Tax Benefits

Other Winners: 100% Bonus Depreciation and a $10 Million Threshold for Lifetime Gift Exclusion

Currently, the tax code allows for a 50% bonus depreciation on personal property purchases. So if you were to buy carpet that cost you $5,000, you could write off $2,500 today via the 50% bonus depreciation and then you’d depreciate the remaining $2,500 over a five year period.

With this new bill, you will be able to write off the entire amount of the personal property item as long as it has a useful life of less than 20 years.

Another win is the fact that you will now have a $10 million threshold for your lifetime gift exclusion amount. Previously, the amount was $5 million, which was adjusted for inflation giving us a $5.45 million in 2017. This means that each person can now give their heirs up to $10 million in wealth without being subject to taxes.

Conclusion

There are many changes in H.R.1 and we except to see push back from the senate. We’re not sure what will and will not pass, only time will tell. Our firm put together a public Google doc which you can find here. The link will not take you to our website, just to a document where we’ve compiled our detailed findings of this bill.

Are you concerned about how the new tax code may affect your business? Ask me your questions in the comments below.

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients.

87 Comments

  1. Thomas Phelan

    Great article and it show you, “Desperate men do desperate things” or should I say, ““Desperate Congressmen and Congresswomen do desperate things” ???

    Nothing is sacred and that includes Social Security, the almighty ROTH IRA and perhaps even Life Insurance death benefits that are usually Tax Free.

    I’m amazed the Feds didn’t come up with a 1% sale tax when homes are sold …???

  2. Wilson Churchill

    If somehow rental income were to become subject to SE tax, S-corporations might look a lot more attractive, especially considering the lower top rate, provided there aren’t a lot of transfers between the scorp and individuals that trigger gains without an actual sale. If all else fails, I may have to become Amish and claim the exclusion from SS and Medicare.

  3. This is a royal screwing for RE Investors, and the 25% rate does not help… if you are already in the 25% bracket. Additionally, the benefit of being a “Real Estate Professional” is perhaps no longer a benefit. WOW. Even as these “reforms” pertain to non-investors, it seems that the so-called middle class is again getting the shaft. More give aways on the low end, more TAX on the middle, in order to cut the corporate rate to 20%. So, big business gets 20%, small business gets 25%… that does not seem right. We are paying more to keep this bill revenue neutral.

    TELL YOUR CONGRESSMAN NO!

    I have.

    • christina trexler

      I’ve been thinking similar things about this. Big investment firms get benefited, while “small time” investors get hit harder. Real Estate is a great vehicle for those struggling financially to “pull themselves up by thier bootstraps” like the republicans always want them to do, but now they tax it more to make it more difficult. Smh.

        • Well, that is exactly the problem. Many of us became brokers so RE would not be passive… and many brokers who work with clients for some extra cash flow are already hit with SE tax on that portion of their income. Now, our rental properties may be hit with it as well.

          It really is going to cause many to consider other options, or at least reevaluate. The extra tax burden we will carry may make mutual funds or dividend paying blue chips far more attractive… as much as I HATE the idea of giving up that much control.

          Question Brandon: For a married couple, do you get the sense that filing separately will be more important to consider, and placing rental properties under the ownership of the spouse who is NOT a RE professional?

  4. Curt Smith

    No self employment taxes if…

    – you are NOT full time investor
    – are NOT a real estate professional

    Sure +/- re the above but many will get caught up in this new source of taxation.

    Sounds to me like quiting your day job now is being heavily taxed.

    Nice the additional expensible $$ amounts vs the $2500 per invoice limits. Small potatoes!

    Thanks Brandon.

      • Curt Smith

        “Our interpretation is that if you are investing passively, you’ll be fine.”

        Meaning deligating management to a property management co?

        So if you don’t use a prop man co and you don’t have a day job (me) Then I’m in a “trade or business”? And now (if this goes through) subject to SE tax?

        I can see their logic, same logic is applied to flippers and we don’t scream. Guess the issue is the shock.

        But we are ok, we formed our own LLC taxed as an S corp last year and we are definately passive behind our PM co.

        What this brings up: I check the box “active participation” in the past. Where now I will need to NOT check active participatoin. Now what does this change else where in Sched E / 1040?

        tnx

        • david neese

          If you work over 1040 hours per year in a real estate related occupation and claim yourself to be a real estate professional. This has generally been considered advantageous as you could claim larger depreciation losses against other non real estate income. This could be you or your spouse as the “pro”. You could be an investor as your primary occupation. This generally applies to folks to full time wholesale, flip, or agents and brokers.

    • Michael McFarland

      I am almost 60, was laid off from the oil field because of oil prices, and haven’t been able to find work, so I am flipping and buy/hold. So if you are young and employed, doing exactly the same work as me, I’ll be singled out for self-employment tax while the younger won’t because he has a job?

  5. Curt Smith

    To move our SD-IRAs from the worst custodian on Earth, Equity Trust, we setup our own Prop Managment Co, LLC so as to setup a solo-401k to move our SD-IRA titled rentals to (all done now whew!) and now that tactic is paying MORE value to shield us from this self employment tax since we are truely passive using a Prop Management co… 🙂

  6. Tim Sabo

    Great article Brandon, as is your standard. Everyone needs to read this and identify if-and how-this bill will impact them if it becomes the law. Before we allow Congress to enact new legislation, the people need to review and respond; for far too long, Americans have forgotten to pay attention to legislation until AFTER it impacts them. As for Trump, love him or hate him, people ARE paying more attention to what Congress is trying to do these days, and that is a plus. Thank you for helping us understand it.

  7. Tyson Cox

    Thanks Brandon for the detailed information on H.R. 1. This is definitely something that could change how RE investors do business. I’m sure we would all appreciate any new information/insights you may have as this continues through the senate. Thanks in advance 🙂

  8. I was expecting to see all kinds of items we would loose in the new tax bill. The only item mentioned that would apply is if we have to pay SS tax on the rental income. All the other items have noting to do with rentals.

    Yes you may no longer be allowed to deduct state and local income taxes paid. But landlords do not Itemize rental state and local income taxes, at least none that I know. We list rental state and local income taxes as an expense on schedule E not schedule A.

    Also, excluding $250,000 ($500,000 if married) of capital gains on the sale of your primary residence has nothing to do with rental properties.

    Thanks for the heads up on the possible SS tax on rental income if it passes.

  9. Alik Levin

    Brandon, outstanding article!
    I can tell you I actually was sitting on the edge of the seat and waiting for it from you posted on BP.
    Huge disappointment with the section 121, HUGE!
    What a massive work – looked at Google doc as well.
    Thank you for doing such a massive public service.

  10. Paul B.

    Currently, a small landlord with income under $100K can deduct up to $25K in rental losses, even if they are not a real estate professional, as long as they are involved in the management of the property. I wonder if that same classification will also shield this landlord from paying FICA taxes, if and when he/she runs out of depreciation and starts to show a net gain.

  11. john akolt

    Please correct me if I am wrong but a trade or business is passive unless the person materially participates. A standard which people once wanted to achieve and there are 6-7 tests (mostly hourly tests that could be avoided). However, one of the tests is claiming material participation in 5 of the last 10 years. So anyone claiming it would get hit for a few years regardless of how much work they shift to others in the future, correct?

  12. Malcolm Burney

    Hello, i just want to know if net rental property income is taxed as self employment BUT you’re able to write off 100% of a personal property item, wouldn’t that allow one to just spend their cash flow and just write it off? I’m not a tax pro of any sort, just a curious newb

    • Brandon Hall

      Of course – if you buy something like appliances, or install carpet, you can bonus depreciate 100% of the cost which you can certainly use to reduce your net income to $0.

      But what are you going to do the year after that? You don’t need to replace these things every year.

      That’s the issue.

  13. Andrew Clifton

    I really don’t think that we as investors can capitalize on the matters addressed in this bill. Without going straight to jail that is.

    Let’s just say that everything negative dose pass and everything positive don’t.

    What then? Live with it I guess.

  14. Jon Tudor

    Thanks for the article Brandon. I was waiting for this one because I wanted to see what the thoughts were on self-employment taxes for rental property.

    I believe the logical reasoning to make this change is that if you treat your rental property income as active under current tax code then you should be subject to self-employment tax and that if you treat the income as passive you should not be. This makes sense because active income should be subject to self-employment tax as it is “active” employment and you are claiming that rental property is your profession. This makes the most sense to me but the “or” nature of “Materially partipate in your rental activities” has me second guessing.

  15. John Murray

    Nice article! Moral of the story remain a RI and keep your passive income not earned income. Do not become a Real Estate professional. Live a spartan lifestyle with your home you live in. Depreciate, depreciate and knock em out by keeping your capital gains in the zero or 15% bracket. Use the 1031 like Picasso used a brush, beat the tax up that is what Pres Trump did. Him and his Dad capitalized on the last of the New Deal liberal policies and made bank.

  16. Domenick T.

    Excellent review of the proposed tax changes Brandon!

    I’m looking forward to your write up on the Senate version. Then I’ll start to worry about how it might impact me professionally and personally. It’s too soon to get worked up over a proposal this early.

    Thanks for keeping us informed!

  17. carol kohn

    Changing the real estate income to self employment income is going to royally screw any folks on SSI and SSDI. Here is why I believe this to be true: Any income, except Schedule E, over $1,000 a month will disqualify or drastically reduce SSI and SSDI income. If that is indeed the case, because I am still a small time RE investor, I will see a 90% reduction in income per year! How many other retired and disabled folks does the government plan to screw over?!?!

    Brandon, feel free to correct me if I am wrong.

  18. Christy Browning

    Great article, and incredibly helpful! Thank you for posting. At this point I have done what many others here already have: I called my 2 Senators to express my opposition to this bill in its current form and why. Hopefully many more of us investors will call our Senators to say similar: they do listen when it’s large numbers of folks calling.
    Here’s a list of our current Senators and their office phone numbers for any that need contact info:
    https://senate.gov/general/contact_information/senators_cfm.cfm

  19. Jeff Little

    Thank you for the detailed explanation. Unfortunately it was pretty much exactly what I feared. It looks like it is intended to benefit those making millions per year at the expense of those making tens or even low hundreds of thousands per year. We saw the same thing in the 1920s when no move that was good for big business was considered to even possibly be bad for the country. Of course this ended in the Great Depression. Then we did everything possible to minimize concentration of wealth under the New Deal and grew by 190% in 12 years from 1933-1945. As this got watered down, our growth rate shrank to 3%-5% from 1945-1970, then 2%-3% from 1980-2000, and 1%-2% from 2000 on.

    The more we tax the first 250k in earnings and the less we tax earnings after $250k per year, the slower our overall growth will be and the greater risk we will have of triggering Great Depression II. The pass-through rate of 25% is specifically designed to help the latter category. The AMT removal is designed to benefit the latter category. The Rehab tax credit is designed to help the poorest in society and it’s removal hurts the former category. The removal of deductions for state and local taxes is designed to hurt those in states that voted blue. Of course the rental income exclusion from self employment taxes only affects those making under 250k per year because self employment taxes are only paid on taxes up to a cap that is way below this threshold.

    Only three times in history we have had massive red waves that swept over the presidency and both houses of congress (plus a lot of the local races):
    1921 – 1933 – Culminated in the Great Depression
    2001 – 2007 – Culminated in a very close call in 2008
    2017 – ?

    The massive tax cuts on the rich in the early 1920s took most of a decade to cause problems. The far more moderate tax cuts of 2001 arguably were just one of several factors that fed into massive inequality and the instability that happened in 2008. These tax cuts are again relatively modest, but they are happening in a society that is already at 1929 levels of inequality.

    Thank you for breaking down the new tax bill. I hope that the overall economic context is helpful.

  20. Tax reform or decreasing taxes to boost the economy in a conservative manner. Basically, corporations need a tax decrease in order to hire more people and inject capital into their business so that it will boost the economy. The increased demand and sell of goods will come thereafter. The tax decrease also dis-incentives moving money overseas into tax havens. That’s the logic behind this particular tax reform.
    I’m surprised that Trump and the Republicans are changing anything with the Real Estate business as Trump is a real estate man and knows the effect of all of this.

  21. jay hinrichs

    SE tax’s have a maximum correct.. I hit my maximum by a bunch.. so this is no effect
    I like SE tax and professional landlords why should they get a pass..

    Looks like I have to keep my primary one more year than anticipated.. and here I come Nevada.. the state tax write off for me is huge.. so need to get to a state with no income tax.

    this could be a boon for southern Washington NV Texas needs no help.. FLA TN.. WY etc.

  22. I have an idea and a question. Since all my income comes from rentals, here’s my plan.

    I will hire a PM company to take care of all my rentals and just claim the income as passive. I can still do flips.

    Does this count as being a passive investor?

  23. rich dev

    If I fix up the owner-occupied rental property in Massachusetts, does this still count as “material participation” if I have another full time job? I do most of the work myself and hire contractors to do some things.

    I am not a real estate professional; I don’t have a real estate broker’s license.

    Will my rental income be considered self-employment income or passive income?

    Is the income from all rental properties that are managed by a professional property management company always considered “passive income”? What about buildings in a trust that are managed by a property management company?

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