Do you own residential or commercial rental real estate? The Tax Cuts and Jobs Act (TCJA) brings several important changes that owners of rental properties should understand.
In general, rental property owners will enjoy lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025. In addition, the new tax law retains the existing tax rates for long-term capital gains. (See “Close-Up on Tax Rates” below.)
Close-Up on Tax Rates
If you own property as an individual or via a pass-through entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation — net income from rental properties is taxed at your personal federal income tax rates.
For 2018 through 2025, the TCJA retains seven tax rate brackets, but six of the rates are lower than before. The 2018 ordinary income rates and tax brackets are as follows:
In 2026, the rates and brackets that were in place for 2017 are scheduled to return.
In addition, the new law retains the current tax rates on long-term capital gains and qualified dividends. For 2018, the rate brackets are:
These brackets are almost the same as what they would have been under prior law. The only change is the way the 2018 inflation adjustments are calculated.
Additionally, as under prior law, you still face a 25% maximum federal income tax rate (instead of the standard 20% maximum rate) on long-term real estate gains attributable to depreciation deductions.
Consistent with prior law, you can still deduct mortgage interest and state and local real estate taxes on rental properties. While the TCJA imposes new limitations on deducting personal residence mortgage interest and state and local taxes (including property taxes on personal residences), those limitations do not apply to rental properties, unless you also use the property for personal purposes. In that case, the new limitations could apply to mortgage interest and real estate taxes that are allocable to your personal use.
In addition, you can still write off all the other standard operating expenses for rental properties. Examples include depreciation, utilities, insurance, repairs and maintenance, yard care and association fees.
Possible Deduction for Pass-Through Entities
For 2018 and beyond, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
While it isn’t entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable rental real estate activity that you own through a pass-through entity. The unanswered question is: Does rental real estate activity count as a business for purposes of the QBI deduction? According to one definition, a real property business includes any real property rental, development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing or brokerage business.
Liberalized Section 179 Deduction Rules
For qualifying property placed in service in tax years beginning after December 31, 2017, the TCJA increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017). Sec. 179 allows you to deduct the entire cost of eligible property in the first year it is placed into service.
For real estate owners, eligible property includes improvements to an interior portion of a nonresidential building if the improvements are placed in service after the date the building was placed in service. The TCJA also expands the definition of eligible property to include the expenditures for nonresidential buildings:
- HVAC equipment,
- Fire protection and alarm systems, and
- Security systems.
Finally, the new law expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples of such property include:
- Beds and other furniture,
- Appliances, and
- Other equipment used in the living quarters of a lodging facility, such as an apartment house, dormitory, or other facility where sleeping accommodations are provided and rented out.
Important: Sec. 179 deductions can’t create or increase an overall tax loss from business activities. So, you need plenty of positive business taxable income to take full advantage of this break.
Expanded Bonus Depreciation Deductions
For qualified property placed in service between September 28, 2017, and December 31, 2022, the TCJA increases the first-year bonus depreciation percentage to 100% (up from 50%). The 100% deduction is allowed for both new and used qualified property.
For this purpose, qualified property includes qualified improvement property, meaning:
- Qualified leasehold improvement property,
- Qualified restaurant property, and
- Qualified retail improvement property.
These types of property are eligible for 15-year straight-line depreciation and are, therefore, also eligible for the alternative of 100% first-year bonus depreciation.
New Loss Disallowance Rule
If your rental property generates a tax loss — and most properties do, at least during the early years — things get complicated. The passive activity loss (PAL) rules will usually apply.
In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you 1) have sufficient passive income or gains, or 2) sell the property or properties that produced the losses.
To complicate matters further, the TCJA establishes another hurdle for you to pass beyond the PAL rules: For tax years beginning in 2018 through 2025, you can’t deduct an excess business loss in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:
- Your aggregate business income and gains for the tax year, plus
- $250,000 or $500,000 if you are a married joint-filer.
The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.
Important: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental real estate loss, you don’t get to the new loss limitation rule.
The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental real estate) to offset income from other sources (such as salary, self-employment income, interest, dividends and capital gains). The practical result is that the taxpayer’s allowable current-year business losses (after considering the PAL rules) can’t offset more than $250,000 of income from such other sources or more than $500,000 for a married joint-filing couple.
The TCJA still allows real estate owners to sell appreciated properties while deferring the federal income hit indefinitely by making like-kind exchanges under Section 1031. With a like-kind exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to put off paying taxes until you sell the replacement property — or you can arrange yet another like-kind exchange and continue deferring taxes.
Important: For 2018 and beyond, the TCJA eliminates tax-deferred like-kind exchange treatment for exchanges of personal property. However, prior-law rules that allow like-kind exchanges of personal property still apply if one leg of a personal property exchange was completed as of December 31, 2017, but one leg remained open on that date.
The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule). At this point, how to apply the TCJA changes to real-world situations isn’t always clear, based solely on the language of the new law.
In the coming months, the IRS is expected to publish additional guidance on the details and uncertainties. Your tax advisor can keep you up to date on developments.
Loss Limitation Rules in the Real World
Dave is an unmarried individual who owns two strip malls. In 2018, he has $500,000 of allowable deductions and losses from the rental properties (after considering the PAL rules) and only $200,000 of gross income. So he has a $300,000 loss. He has no other business or rental activities.
Dave’s excess business loss for the year is $50,000 ($300,000 – the $250,000 excess business loss threshold for an unmarried taxpayer). The $50,000 excess business loss must be carried forward to Dave’s 2019 tax year and treated as part of an NOL carryfoward to that year. Under the TCJA’s revised NOL rules for 2018 and beyond, Dave can use the NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.
Important: If Dave’s real estate loss is $250,000 or less, he won’t have an excess business loss, and he would be unaffected by the new loss limitation rule.