A lot of Realtors are complaining about the recently released Tax Cuts & Jobs Act. In particular, agents are getting hung up on the proposed reduction in mortgage interest deduction. What they fail to see, however, is that this a small disadvantage in wake of other incredibly advantageous benefits for property owners. I will try to explain, in the simplest terms possible, the three reasons why this bill could be huge for real estate owners and investors.
1. The Reduction in the Allowed Mortgage Interest Deduction is Negligible
When you actually do the math, the net out-of-pocket difference for taxpayers is negligible. The reason why Realtors are complaining is that most of them don't understand how a deduction actually works. In simple terms, a deduction reduces "the number" (aka your taxable income) that is applied to your given tax schedule. What you actually pay is the product of "the number" and your tax bracket. A deduction IS NOT a dollar-for-dollar offset of the tax bill you pay to the IRS.
Let's do a quick scenario. You have $1m of mortgage debt at 3% interest, and you make $250k a year before your mortgage interest deduction. Based on the proposed new tax brackets (and assuming no other factors), this is how it would work out:
So in the end, your increase in taxes PAID would be $5,250. While $5,250 is nothing to joke about, keep in mind 3 things. 1) This is a worst case scenario for someone who has a full $1m in debt. For somebody who makes $250k a year and can afford a $1m mortgage, they will be fine. 2) Outside of the Bay Area, most Americans don't even have mortgages over $500k. So for nearly everybody else, this limitation would have no effect on them. 3) This scenario fails to include the two big tax incentives that will help real estate owners make MUCH more money than they would lose here.
2. 25% Maximum Tax Rate for Passthrough Entities
This is insane, because if this bill passes, it would make real estate far more profitable for investors. Investment properties are typically held in passthrough entities such as LLCs (if you aren't holding your investment property in a passthrough entity, you're making a huge mistake and we need to talk). Under current law, any income from passthrough entities are taxed at your ordinary individual rate. Given somebody in the 35% tax bracket with a rental property, their property would only need to make $52,500 or more to break even with the above scenario. For self employed individuals who make ALL their income through LLCs, they will benefit even more from this tax rate cap.
3. Immediate Expensing of Business Investments (Sec 179)
Typically, owners who make capital expenditures (aka upgrades) to their business and/or their rental properties can only deduct the first $500k. In the simplest terms, any expenses over $500k would need to be slowly deducted over the following years meaning that you have to wait before you can benefit from those expenses (we call this depreciation). Under the new rules, the yearly amount has been expanded to $20m. So for investors making soft story changes to their buildings, making ADU (accessory dwelling unit) additions, or starting development projects, this is a huge benefit for investors. Add this benefit in conjunction with the 25% tax rate cap for passthrough income... it's clear to see that this new bill provides exciting opportunities for real estate investors and entrepreneurs in America.
So in closing, the new tax laws only serve as a very slight disadvantage to a small population in the US. That same population also stands to benefit far more from the other tax cuts in the bill. If these changes pass into law, we could be entering a golden era for real estate investors in the country.
Questions? Comments? Concerns? See below for a direct link to the tax bill and a great synopsis of the bill from Business Insider.
Disclaimer: Although I still maintain an active CPA license in the state of California, you SHOULD NOT rely upon the tax advice in this article until consulting with your own tax CPA. Everyone's situation is unique, so you must consult with a qualified tax practitioner to receive the right advice for you.