Will U.S. Tax Reform Affect Your Real Estate Investments?By Abe Schlisselfeld | November 20, 2017
Both Congressional Republicans and the Trump administration have announced their intentions to have a new tax reform bill on the President’s desk by the holidays this year. A big part of the proposed tax reform bills that were recently released by the House and Senate deal with the treatment of real estate investments.
A pressing question is how will tax reform affect real estate investors? It’s anyone’s guess what specifics of tax reform will eventually pass, but we do have a sense of how the proposed plans would impact the real estate community.
Our real estate tax team is closely watching the provisions in the current tax reform proposal plans, including 1031 exchanges and carried interest.
Impact on Real Estate Investors
At this point it looks like the IRC Section 1031 that covers the use of tax-deferred exchanges (property swaps) will survive, but will be limited to real property. In a tax-deferred exchange, owners can postpone recognition of gains on investment real estate when they swap one property for another of “like kind.” The capital gains that would otherwise be due get deferred until the owner sells the replacement property and receives cash. It is estimated that like-kind exchanges are used in 10-20% of commercial real estate transactions.1
The other potentially big moving part for real estate tax reform is the carried interest provision. Carried interest is the portion of a private investment fund’s profit – usually a 20% share – that is paid to investment managers. The carried interest provision enables private equity managers, hedge fund managers and real estate investors to pay the lower capital gains tax (20%) on their income rather than having the gains taxed as ordinary income (currently a maximum taxable rate of 39.6%). Both versions of the bill propose that, after 2017, transfers of applicable partnership interests held for less than three years will be treated as short-term capital gain.
There may also be a reduction of taxes for pass-through entities. In the House legislation, the maximum pass-through rate for passive business income is lowered from 39.6% to 25% with special rules limiting individuals from transforming wage income into passive business income. The bill clarifies that owners or shareholders receiving distributions from passive business activities would be able to treat 100% of this income as business income. The House version also would impose a phased-in 9% rate on certain taxable income thresholds of active owners or shareholders of pass-through businesses. For active business income, taxpayers could elect to treat 30% of income as taxable at a 25% rate and the remaining 70% at their ordinary rates, or elect a determination based on capital investments.
The Senate version provides for a deduction instead of a lowered business income rate. Individuals may deduct 17.4% of domestic qualified business income from a partnership, S corporation or sole proprietorship, limited to 50% of the W-2 wages of a taxpayer with qualified business income.
Both bills preserve the mortgage interest deduction for real estate, but limit it for other industries.
Elimination of State and Local Tax Deductions
The White House is maintaining a hard line on eliminating deductions for state and local taxes, including property taxes. Nearly all Democrat and Republican lawmakers who represent high-tax areas (like New York City) are pushing back against the plans to do away with these deductions.
Opponents of the deduction argue that it primarily benefits upper-income taxpayers and encourages some states to maintain high tax rates. Ending it would also raise more than $1 trillion to offset proposed individual rate cuts and other benefits the Republicans are adding to the tax code, so it’s not hard to see the political and economic motivation here.
As of now, the House bill still allows for up to $10,000 in property tax deduction.
A Word of Caution
High-net-worth investors should not rush to make their investment decisions based on the rough tax reform plans currently on the table in Washington, D.C. There is significant sentiment that no tax reforms will be passed this year, and will more likely come in 2018. If the tax cuts do stimulate the economy, it may indeed be good news as real estate does well in periods of positive economic growth in terms of higher rents, increased rental income opportunities and higher real estate values.
With so much speculation and unknowns, it is a wise idea to seek intelligent professional real estate tax advice as the whole process unfolds in the coming months.
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This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please consult your Marks Paneth tax advisor for specific advice.
1 Wall Street Journal, “1031 Exchange, a Cherished Real Estate Tax Break, Faces Extinction”
About Abe Schlisselfeld
Abe Schlisselfeld, CPA, EA, is the Managing Partner of Marks Paneth LLP. In this capacity, he oversees the firm's operations, manages business development efforts and consults on key clients. He is chairman of the firm’s Executive Committee and plays a major role in developing strategy, setting policy and overseeing acquisitions. Prior to becoming Managing Partner in 2021, Mr. Schlisselfeld was the Partner-in-Charge of the firm’s Real Estate Group. In that role, he advised commercial and... READ MORE +