Take-Away: Many changes were made by the 2017 Tax Act (the Act) to real estate, both for individuals and for those who are engaged in real estate development. Some of the changes are well known, e.g. the ‘capped’ $10,000 SALT itemized income tax deduction, while other changes are less well known, such as restricting IRC 1031 like-kind exchanges only to real estate, and provisions that encourage investments in REITs and Opportunity Zone Investment Funds. A summary of some of those changes that impact owners of real estate follows.

Mortgage Interest Deduction: The Act limits the mortgage interest tax deduction for new mortgages, i.e. those that originate after 2017, to interest paid on a mortgage balance up to $750,000 (down from the interest paid on $1.0 million of mortgage balances in place prior to 2018.) Note: Refinancing an existing home mortgage, however, will be grandfathered which means mortgage interest paid can continue to be tax deductible using a $1.0 million mortgage balance if it is a refinance of that mortgage balance. This change primarily affects a taxpayer who acquires a new residence after 2017, the purchase of which is financed by a mortgage in excess of $750,000.

Home Equity Line-of-Credit Interest: The interest paid on a home equity line-of-credit is no longer deductible (formerly the interest paid on a $100,000 line-of-credit amount was deductible) unless the proceeds of such a home equity loan are invested to improve a home. The aggregate loan balance for deductible interest paid on both a home mortgage and a home equity line-of-credit is now $750,000. Note: This change primarily affects a taxpayer who has an outstanding home equity loan or who was planning to borrow against the equity in his/her home for a purpose other than to make home improvements.

Casualty Loss Deduction: The Act limits a casualty loss deduction to those losses that are attributable to a designated disaster area that is formally recognized and declared by the President, e.g. hurricane damage regions; massive forest fire regions. Previously losses that arose from any fire or storm [no matter the magnitude] were tax deductible by the real estate property owner. This prohibition of an income tax deduction for casualty losses does not apply to a casualty loss sustained by real property that is used in a trade or business. Note: Due to this severe curtailment in casualty loss deductions, it is a good idea for real estate owners to review their coverage in existing property and casualty insurance policies.

Real Property Taxes: Under the Act the total amount that may be claimed as an itemized tax deduction for state and local taxes (SALT), including real property taxes paid, is $10,000. No income tax deduction can be claimed for foreign property taxes paid. This limitation on income tax deductions does not apply to: (i) real property taxes that are attributable to real property that is used in a trade or business; or (ii) taxes that are attributable to real property that is held for investment purposes. Note: This $10,000 limitation per taxpayer, including a married couple filing jointly, prompted the planning suggestion that title to a valuable parcel of real estate like a waterfront home be ‘fractionalized’ and the fractional units transferred to multiple non-grantor trusts, so that each trust can claim the maximum $10,000 real property tax itemized income tax deduction.

IRC 1031 Exchanges: IRC 1031 provides that no gain or loss is recognized if property that is held for productive use in a trade or business, or which is held as an investment property, is exchanged for like-kind property. Thus, gain recognition can be deferred by the owner if appreciated property is exchanged for like-kind property. Unlike the prior law where almost any type of property that was used in a trade or business, or held for investment, could be exchanged for like-kind property, thus deferring capital gain recognition, the Act eliminates like-kind exchanges for all property other than real property.

Interest Expense Limitations and Election: The Act limits a business’ ability to deduct business interest expense in excess of the sum of the business’ interest income and 30% of the amount of the business’ adjusted taxable income. However, a real property oriented trade or business may make an election out of the interest expense deduction limitation. Real property oriented trades or businesses that can elect out of the limitation include those businesses in: development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerage services. Note: If such an election out is made by the business, that business must then use an alternative depreciation schedule for certain specified types of depreciable property.

REITs: The 20% qualified business income tax deduction under IRC 199A applies to real estate investment trust (REIT) dividends. Unlike other qualified businesses which face a wage limit on the amount of the IRC 199A income tax deduction that can be claimed under IRC 199A, there is no wage limitation ‘test’ for a REIT that passes through the IRC 199A income tax deduction to its individual owner-members.

Qualified Opportunity Zone Funds: This new addition to the Tax Code permits a flexible deferral mechanism for short and long-term capital gains, including gains that are attributable to the sale of appreciated real estate. Like many provisions of the Act, this opportunity sunset after December 21, 2026 [but not 2025 as the sunset date for several other ACT provisions.] Summarizing these benefits: (i) gains reinvested in a qualified opportunity zone fund may deferred temporarily, and eventually reduced if the investment in the fund is held long enough: (ii) there is a step-up in income tax basis in the deferred gain by 10% if the investment in the fund is held for at least 5 years, with another 5% added to the basis if the investment is held for at least 7 years; and (iii) all capital gains on appreciation that accrues after the initial investment in the fund after 10 years is eliminated. To obtain the benefits of this gain deferral, the investment in the fund must be within 180 days of the sale of the of the appreciated asset and the gain is realized. Note: Unlike an IRC 1031 exchange where the entire amount to be received on the sale of the appreciated asset must be exchanged to obtain the tax deferral, only the gain portion of the realized sales proceeds needs to be ‘reinvested’ in the opportunity zone fund in order to defer that gain’s recognition.

Example: Barney sells an office building for $200,000. Barney’s income tax basis in the building is $100,000. If Barney invests $100,000 in a designated opportunity zone fund within 180 days of the sale of his office building, all gain recognition ($100,000) will be deferred. If Barney invested $80,000 in the opportunity zone fund, he would recognize and pay tax on the $20,000 of gain, but not on the balance of the gain ($80,000) that was ‘reinvested’ by Barney in that fund. Continuing with the example, Barney’s income tax basis in the opportunity fund investment starts out at $0.00 [it’s all gain on which no tax was paid by Barney after the sale] but that basis will increase to $10,000 (10%) if Barney holds the $100,000 investment in the opportunity zone fund for at least 5 years. After 7 years holding the $100,000 investment in the opportunity zone fund, Barney’s basis in his $100,000 ‘investment’ increases to $15,000. When December 31, 2026 rolls around, if Barney has not yet then sold his investment in the zone fund, he must then recognize his deferred gain, taking into account the increase in his basis throughout the years. The amount of Barney’s gain to be recognized after 10 years will be the lesser of: (i) the remaining deferred gain, but taking into account any basis increases along the way; or the fair market value of Barney’s investment in the qualified opportunity zone fund. If Barney holds the qualified opportunity fund investment for at least 10 years, all post-acquisition capital gains can be excluded from Barney’s reportable income when the investment is sold. Note: If Barney dies during this deferral period owning his opportunity zone investment, his deferred gains will not receive a ‘step-up’ in cost basis- rather, that gain will be treated as income in respect of a decedent (IRD) in Barney’s taxable estate, meaning Barney’s heirs will probably pay the deferred income tax.

IRC 199A: The federal income tax rate on C corporations was reduced to 21% (down from 35%.) However, few businesses that invest heavily in real estate are organized as C corporations because of the double taxation of corporate profits, which makes it difficult to pass the benefits of real estate ownership on to the corporation’s shareholders. The Act does not change the manner in which a pass-through entity, like an S corporation or LLC, is taxed. Instead, Congress attempted to ‘level the playing field’ with C corporations by creating the IRC 199A 20% qualified business income tax deduction for smaller businesses like S corporations and LLCs which often own real estate. The qualifying rules, and limitations to claim the IRC 199A income tax deduction, are extraordinarily complex and as a result they won’t be addressed here, but a couple of examples of how the IRC 199A 20% qualifying business income tax deduction applies to a real estate investor follows:

  • Example #1: Fred and Wilma have taxable income of $650,000. Wilma is a radiologist. Fred is a 50% partner in an LLC that is taxed as a partnership, which owns and operates a parking garage in a large city. Fred’s share of the qualified business income from the parking garage business is $300,000. Fred’s share of the business’ W-2 wages is $100,000. Fred’s share of the LLC’s unadjusted basis in depreciable property in the parking garage business is $500,000. To determine Fred’s qualified business income deduction under IRC 199A, the following steps (#) are taken: #1: take 20% of Fred’s qualified business income, or $60,000 [20% of $300,000]. #2: take 50% of the W-2 wages Fred’s parking garage business paid, or $50,000 [50% of $100,000]; #3 take 25% of the W-2 wages paid by Fred’s parking garage business [$25,000], added to which is 2.5% of the unadjusted basis of Fred’s share of the parking garage business’ depreciable property, or $37,500 [$25,000 + $12,500= $37,500.] Fred’s maximum qualified business income tax deduction using IRC 199A is 20% of the qualified business income [$60,000] reduced to the greater of steps #2 [$50,000] and #3 [$37,500.]. Because step #2 is greater, Fred’s qualified business income tax deduction that he can claim on his Form 1040 income tax return filed with Wilma is $50,000.
  • Example #2: Same facts as above, except Fred’s parking garage business is now owned by two separate entities. One entity, an LLC, owns the parking garage real estate. The second entity, another LLC, provides all the management functions with respect to the parking garage; this second LLC employs all of the parking garage attendants to whom that second LLC pays W-2 wages. Fred and his business partner each own 50% of these two business entities. The wage limitation of the IRC 199A qualified business income deduction applies on a business-by-business basis. Under the first example, if the two businesses are treated as a single business, then Fred and Wilma can deduct $50,000 on his Form 1040 as qualified business income tax deduction. If the two business entities owned by Fred are treated as separate businesses, and the parking garage business produces all of the qualified business income, but it pays no wages, Fred’s qualified business income deduction will be limited to 2.5% of the unadjusted basis of Fred’s share of the garage business’s depreciable assets, or $12,500 [2.5% of $500,000= $12,500.] Fortunately, the proposed Regulations under IRC 199A provide that if multiple business entities are under a common control and the businesses that are operated through each such entity are interrelated, a taxpayer-owner like Fred can elect to aggregate the separate business entities for purposes of the determining Fred’s (i) qualified business income, and (ii) the wage or W-2 limitation on the amount of the income tax deduction that is claimed. Thus, by virtue of being able to aggregate the two LLCs, Fred can claim an IRC 199A deduction of $50,000 and not just $12,500, which is a big deal when you consider that Fred and Wilma’s combined incomes put them at the 37% marginal federal income tax bracket.

Conclusion: The Act changes the income tax rules for homeowners and business owners that own real estate interests. Some of the new rules are beneficial, like REIT ownership, while some rules will hurt individuals, such as prohibiting any interest deduction for interest paid on home equity lines-of-credit not used for home improvements. For those new rules that harm taxpayers, whether individuals (like the limits on mortgage interest paid or the SALT limit) or businesses, it is important to plan ahead to mitigate the impact of these income tax deduction changes on their ultimate income tax liability.