Congress and the President gave the country a huge Christmas present with the signing of the “Tax Cuts and Jobs Act” on December 22, 2017. We have all heard varying accounts about this new tax law; but what is the impact for rental property, apartment property, and commercial-investment real estate owners and managers?
Our models show a 25 to 35 basis point increase the internal rate of return over a 10-year holding period for the sample apartment property as a result of this new tax law.
- Pass-Thru Entities
To provide small, closely-held business owners with tax relief somewhat consistent with lowering the top corporate tax rate from 35% to 21%, the new tax law lowers the top rate for individuals from 39% to 37%. In addition, income from “Pass-Thru Entities” such as an S-Corporation, Limited Liability Company (LLC), and Partnerships, is reduced by 20%.
Effectively, a tax-payer in the top marginal rate would pay tax on this pass-through income at an effective rate of 29 1/2% (37% less the 20% reduction for pass-thru entities) instead of 39.6% under the old law.
Simply, an S-Corporation or LLC having $100,000 in taxable income would pay tax on $80,000 at the individual rate.
Rental property owners are advised to review title to their properties. Consider the advantage of changing title to any properties held in the name of an individual into a “pass-through entity” in order to take advantage of the 20% discount.
Consult your tax advisor because the 20% reduction is limited to no more than 2.5% of the depreciable basis at the time of purchase (Basis=purchase price minus land value).
2. 1031 Tax-Deferred Exchanges Remain in-tact for real property
Feared to be on the chopping block, the final bill retains the ability to exchange one rental property for another without incurring capital gains taxes on the transaction. The gain in the relinquished property is rolled into the replacement property(s). When a relinquished property is sold for cash, the gain is realized and capital gains taxes are due at that time.
Tax-Deferred Exchanges on non-real property have been eliminated.
Remember, if you chose to engage in a 1031 Like-Kind Tax-Deferred Exchange, you must engage the services of a Qualified Intermediary before closing. The Qualified Intermediary prepares paperwork necessary to effect the exchange and holds the funds in escrow for closing on the replacement property. If the tax payer receives money at closing, the tax payer is obliged to pay capital gains taxes.
Other key rules are that one or more “Replacement Properties” must be “identified” within 45 days of the date of closing on the “Relinquished Property”. Closing on the “Replacement Property(s)” must occur within 180 days of the closing on the Relinquished Property.
3. Mortgage Interest
Mortgage Interest is fully deductible for income-producing rental properties. However, tax payers must “elect” to deduct interest. When they do, the property is depreciated over 30-years. The old law depreciated residential rental property over 27.5 years. Stretching the depreciation schedule to 30-years has the effect, in our models, of reducing the after-tax internal rate of return by 10 basis points.
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Ben Frederick III, CCIM has specialized in helping property owners buy, sell, exchange, manage, and develop apartment properties and mixed-use commercial-investment real estate in Baltimore for more than 30 years. Mr. Frederick is past president of the Property Owners Association of Greater Baltimore and the Maryland/DC CCIM Chapter. Mr. Frederick is a director of the Maryland Multi-Housing Association, past director the Greater Baltimore Board of Realtors and the Multiple Listing System in Baltimore. Mr. Frederick is a third-generation real estate professional, following in the footsteps of his father and grandfather.