02 Mar New Tax Law and Effect on Rental Real Estate
The recent tax reform, known as the Tax Cuts and Jobs Act (TCJA), added some good benefits to your real estate rentals, both commercial and residential.
Notably, your qualified business income from your real estate rentals creates a possible 20 percent tax deduction with no effort on your part.
And if you want less taxable income, the TCJA gives you enhanced bonus depreciation and new avenues for Section 179 expensing.
New Deduction for Pass-Through Business Income
Under prior law, if you had net taxable income from a pass-through business entity (meaning for this purpose a sole proprietorship, an 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 net income was simply passed through to you and taxed at your personal rates.
For 2018 and beyond, the TCJA establishes a new tax deduction based on a non-corporate owner’s qualified business income (QBI) from a pass-through business entity. The deduction generally equals 20 percent of QBI, subject to restrictions that can apply at higher income levels.
While it is not entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable real estate rental that you own via one of the aforementioned pass-through entities. For example, the rentals you report on Schedule E of your Form 1040 appear to qualify, as they are named in the conference report present law discussion.
Liberalized Section 179 Deduction Rules for Nonresidential Buildings and Property Used to Furnish Lodging
For qualifying property placed in service in tax years beginning in 2018, the TCJA increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017).
As you probably know, the Section 179 deduction privilege allows you to deduct the entire cost of eligible property in Year 1.
For real estate owners, eligible Section 179 property includes any improvement to an interior portion of a nonresidential building if the improvement is placed in service after the date the building was placed in service.
The TCJA also expands the definition of eligible property to include expenditures for nonresidential building roofs, HVAC equipment, fire protection and alarm systems, and security systems.
Finally, the TCJA expands the definition of Section 179 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.
Warning: Section 179 deductions cannot create or increase an overall tax loss from business activities. So you may need plenty of positive business taxable income to take full advantage of the Section 179 deduction privilege.
100 Percent First-Year Bonus Depreciation for Qualified Real Property Expenditures
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 percent (up from 50 percent).
Unlike the old 50 percent deduction, which was for new property only, the new 100 percent deduction is allowed for both new and used qualified property.
The TCJA eliminates the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and it provides one category for qualified improvement property that is eligible for
- Section 179 expensing,
- bonus depreciation, and
- 15-year MACRS depreciation.
New Loss Disallowance Rule
If your rental property throws off a tax loss—and most do, at least during the early years—things get complicated. The passive activity loss (PAL) rules will usually apply.
Now, whether you are subject to the PAL rules or not, the TCJA adds a new hurdle to deducting business losses regardless of where they come from. For tax years 2018-2025, you cannot 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 (1) your aggregate business income and gains for the tax year plus (2) $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 new rules for net operating loss (NOL) carryforwards.
Like-Kind Exchanges Are Still Allowed for Real Estate (but Not for Personal Property)
The TCJA continues prior law and allows real estate owners to upgrade their real property portfolios without taking a federal income tax hit by using a like-kind exchange, also known as a Section 1031 exchange. With the like-kind exchange, you essentially use the tax rules to sell your old property and then buy the replacement property.
Your profitable real estate investments just became more profitable with the TCJA tax reform because of the new Section 199A 20 percent deduction—which you will likely realize.
Also, unlike many other businesses, your rental property business suffered almost no harm from the new law. Sure, the excess business loss curtailment is a bummer, but the odds of it doing any real harm to you are slim.
Both residential and commercial properties obtained a number of new tax breaks with respect to Section 179 deductions and bonus depreciation. The new breaks make it easier for you to plan your business income for the year.
We know that some of the rules are murky and you are hoping the IRS will add some clarity. We are in that boat with you and hope for the same. But the bottom line for your real estate rental activity at the moment is that the TCJA is good.
Mark S. Fineberg, CPA