The new federal tax law took away some benefits of homeownership but
gave real estate investors a gift they might not be aware of yet.
Owners of investment property — from mom and pop landlords to big-time real estate moguls — could get a federal tax deduction of up to 20 percent of their net rental income for tax years 2018 through 2025. Most people who own shares in real estate investment trusts can also
deduct up to 20 percent of their ordinary REIT dividends.
This income limit would apply to real estate agents but would not apply to real estate investors because their principal asset is their property, not their skill, said Kenneth Weissenberg, chair of real estate services at EisnerAmper.
If you are not a service professional and your taxable income exceeds $157,500/$315,000, then your pass-through deduction may be limited by a convoluted computation. It says: Yo
ur pass-through deduction can’t exceed the greater of either 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of the “unadjusted basis” of depreciable assets, which generally means what the owner paid for the assets, excluding land. Real estate investors would be subject to this nutty math if their income exceeds the limit.
To get the deduction, real estate investors must have net income from a property. Many real estate investors have net losses thanks to depreciation, interest, repairs and other expenses.
Suppose Donna is single, earns $100,000 a year working for a tech company, and owns a duplex that generates $20,000 a year in net income. Her taxable income, we’ll assume, is $10
Under the new law, her pass-through deduction would be 20 percent of $20,000 or $4,000. It is not reduced because $4,000 is less than than 20 percent of her taxable income..
Now suppose she makes $200,000 at her tech job and her taxable income including the rental is $208,000. In this case she would have to do the complex computation.
We’ll assume she bought the duplex for $600,000 but $100,000 of that was land value. Her unadjusted basis is $500,000, and 2.5 percent of that is $12,500. She doesn’t pay anyone a salary, so her W-2 wages are zero. Her deduction still is not reduced because $4,000 is less than $12,500.
“The wages and depreciable property limits won’t impact most real investors,” said Stephen L. Nelson, a CPA in Redmond, Wash., who wrote a monograph on the new deduction.
One gray area is whether people who own real estate in their own names and file their rental income on Schedule E would qualify for the pass-through deduction.
“It’s not 100 percent clear,” said Jeff Levine, director of financial planning with Blueprint Wealth Alliance. To get the percent deduction, “it has to be a qualified trade or business.” The new law does not clearly define trade or business, and the term is defined differently in different parts of the tax code. “Depending on IRS interpretation, a taxpayer’s involvement in the rental property could be a factor” in whether he or she qualifies.
Luscombe said he believes Congress intended real estate investors who use Schedule E to qualify for the deduction, and a congressional committee report supports that idea.
Weissenberg said they clearly would qualify for the deduction.
Nelson also said they should qualify, “but we’ll have to see what the IRS says” when it issues regulations.
Real estate investors do not need to form a limited liability company to take this deduction, Nelson added. They can put property into an LLC (many do for liability reasons) as long as it’s not taxed as a corporation.
The law does state that people who own shares in a real estate investment trust can deduct 20 percent of their ordinary dividends (but not capital gains dividends) starting in 2018. This deduction cannot exceed 20 percent of their taxable income, but other limits do not apply.
“Real estate is a big-time winner” in the tax law, Weissenberg said, thanks to this and other provisions.