The tax reform bill that House Republicans released last week contains a number of provisions that could impact the real estate industry. We highlight a few of the most significant proposals below:
Business Income of Individuals. As described in more detail here, the bill proposes a new regime that effectively introduces a maximum 25% tax rate on 100% of passive business income and generally, unless an election is made or the business is a service business, on 30% of active business income.
- The real estate industry will benefit from the fact that, under the new rules, most rental activity will produce passive business income.
- However, real estate professionals who previously sought active status for their rental activities in order to deduct their real estate losses against their active income by, among other things, spending at least 750 hours per year on real estate activity, may no longer wish to do so.
- Under the new rules, qualifying for that exception from the passive loss rules would prevent a taxpayer’s real estate activity from producing the passive business income favored by the new regime.
Repeal of Rental Activity and Limited Partner Self-Employment Tax Exemption. The bill repeals the rental activity and limited partner exceptions to the self-employment tax, which would subject domestic real estate investors to a tax of 12.4% on a portion of their rental income up to a cap equal to the social security contribution and benefit base (currently about $128,000) and up to 3.8% on an uncapped portion of their rental income.
Limitation on Business Interest. The bill generally limits the amount allowed as a deduction for business interest to 30% of the taxpayer’s adjusted taxable income (plus the taxpayer’s business interest income) for the taxable year. However, interest on indebtedness incurred in a real property trade or business is not subject to this limitation. Because this new interest deduction limitation would replace the old interest deduction limitation on interest paid to related parties contained in Section 163(j) of the Code, REITs, which are currently subject to the old limitation, would be relieved of interest deduction limitations under Section 163(j) of the Code.
REIT Dividend Rate Reduction. The bill taxes REIT dividends (other than designated QDI dividends, which generally cannot exceed the amount of qualified dividend income received by the REIT, and designated capital gains dividends, which generally cannot exceed the amount of net capital gain realized by the REIT) at a maximum rate of 25%. This proposed rate reduction is likely designed to preserve the tax benefit of REITs as a response to the proposed reduction in the corporate income tax rate.
Section 1031 Preserved for Real Estate. Under the bill, the revised version of Section 1031 preserves the benefit of non-recognition of gain or loss on the exchange of real property held for productive use in a trade or business or for investment for other real property of a like kind held for productive use in a trade or business or for investment but eliminates Section 1031 non-recognition for all other types of property. Real property held primarily for sale is not eligible for Section 1031 non-recognition.
Repeal of Partnership Technical Terminations. Real estate businesses are often impacted by “partnership technical terminations” that occur when, within a twelve month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. As a result of a partnership technical termination, the partnership must “restart” depreciation on the depreciable property owned by the partnership at the time of the termination. The adjusted basis of the property is unaffected but this basis is now spread across a “restarted” depreciable life, resulting in a reduced annual deduction for depreciation. The proposed legislation eliminates partnership technical terminations from the Code, a change that would benefit real estate partnerships.
No Expensing for Real Estate Business Property. For most qualified property purchased after September 27, 2017 and placed in service before January 1, 2023, the proposed legislation allows taxpayers to immediately deduct the entire cost of such property. Real property does not constitute qualified property under the current Code, and the proposed legislation does not change this. However, tangible personal property used in a real estate trade or business can be treated as qualified property under the current Code. The proposed legislation explicitly removes any property used in a real estate trade or business from the definition of qualified property, which, if the bill becomes law, would prevent the real estate industry from enjoying the 100% expensing of tangible personal property enjoyed by other industries under the new Code as well as the “bonus depreciation” that real estate companies currently enjoy with respect to their tangible personal property under the current Code.
Changes to SALT Deductions. As has been widely discussed, the new bill repeals the deduction for state and local income taxes for non-corporate taxpayers, introduces a $10,000 cap on the deduction for state and local property taxes for non-corporate taxpayers, and repeals the deduction for foreign real property taxes for non-corporate taxpayers. Although non-corporate real estate businesses will no longer be able to deduct state and local income taxes, the $10,000 cap on the deduction for state and local property taxes and the repeal of the deduction for foreign real property taxes will not apply to state and local property taxes paid or accrued in carrying on a trade or business or other activity for the production or collection of income. As a result, though state and local income taxes will no longer be deductible at all, non-corporate real estate businesses will still be able to deduct all of their state and local property taxes and all of their foreign real property taxes. However, the cap on the property tax deduction could affect the residential real estate market in markets with high property taxes such as the New York metropolitan area in particular.
Changes to Mortgage Interest Deductibility and Principal Residence Gain Exclusion. The residential real estate market could also be affected by a few other tax changes contained in the bill:
- (1) the amount of residential mortgage indebtedness on which a taxpayer can deduct interest payments is reduced from $1,000,000 to $500,000;
- (2) the number of homes on which indebtedness eligible for the mortgage interest deduction is allowed is reduced from two to one (i.e., it now applies only to indebtedness on the taxpayer’s principal residence);
- (3) the amount of home equity indebtedness on which a taxpayer can deduct interest is reduced from $100,000 to $0; and
- (4) the current law exclusion of the first $250,000 of gain from the sale of a principal residence ($500,000 if married filing jointly) is retained but the proposal limits the exclusion to apply only once per taxpayer during any five-year period, extends the length of time a taxpayer must own and use a residence to qualify for this exclusion from two of the five years ending on the date of the sale to five of the eight years ending on the date of sale, and phases out the exclusion for those earning more than $250,000 ($500,000 if married filing jointly) so that it is completely phased out for those earning more than $500,000 ($1,000,000 if married filing jointly). Property already purchased as well as certain property already under contract will continue to be subject to the old mortgage interest deduction rules.
Update. The House bill was amended on November 9, 2017. As a result, the version of the bill reported to the Floor does not contain the changes to the self-employment tax described above. Instead, it preserves current law with respect to those self-employment tax exceptions.