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Prior to the federal government shutdown earlier this year, IRS interpretations of the Tax Cut and Jobs Act of 2017 (TCJA) were issued for expenses and depreciation for real estate, confirming that the time is right for building something, even if not a wall. From the start it was evident the TCJA benefited real estate investors, and recent interpretations underscore these benefits.
This is a good time to get out and start investing in real estate. Roll up your sleeves, and get to work as an active investor, or more passively through private lenders (our firm is one of the many). To help you make an informed decision, below are some of the key changes in federal rules that make investing in real estate even more attractive.
1. A cap in the mortgage interest deduction allows homeowners to deduct interest for the first $750,000 of mortgage debt, or the first $1 million if purchased before December 25, 2017.
This deduction remains one of the best tax benefits available for the real estate asset owned by most Americans. Contrary to many pundits, I expect the new ceiling will contribute to a modest rebound for luxury property. Last year, we saw a slowdown in the luxury market as homebuyers took a wait-and-see approach to interest rates, TCJA’s limit on property tax deductions and the stock market. Many baby boomers refinanced and remodeled their homes instead of upgrading, but now the lower cap reduces the tax benefit of using a home equity loan this way.
Here’s why: Say your first mortgage is $800,000. While you can keep deducting its interest, now, because of the new cap, you can’t deduct interest on a new home equity line. Wealthy homeowners now have more impetus to sell their home and plow the proceeds into a down payment for a new mortgage up to $750,000, especially since there’s more clarity around interest rates, the new tax code and the stock market.
Developers and builders should look at desirable neighborhoods where prices have leveled off but not declined. I think you’ll find many with pent-up demand due to historically low inventory. The normalization of prices should spur demand from luxury buyers who’ve been on the sidelines. If you’re an investor, look for bargains among REITs that invest in residential real estate, or put your money to work at lending firms.
2. If you invest in real estate as an individual, sole proprietor, partnership, LLC or S-corp, you should be able to deduct up to 20% of your qualified business income through the Section 199A deduction.
Effective through 2025, owners of entities that pass through income to individual taxpayers may deduct 20% of “qualified business income” from their “qualified trade” in real estate. It’s a bit of a gift for developers, contractors, brokers, active investors and leasing operators, since it’s a straight 20% reduction of their taxable income.
This gets even more interesting considering the many professional firms that don’t qualify. For instance, lawyers can’t take the deduction even if they create a pass-through entity, buy a building and lease it back to the firm. When the TCJA first passed, it wasn’t clear which pass-throughs were disqualified. This was recently clarified by the IRS. Now an entity such as a law firm can move income into a qualified pass-through entity and take the deduction, but only if they own 49% or less of it. In addition, they’ll need to partner with a true real estate professional in order to do so.
I’m seeing a wide variety of people now looking to collaborate with real estate pros, including accountants, lawyers, athletes, consultants and other high-income individuals. So it’s time to get out there and expand your network. Get involved with civic groups and networking events, and see who wants to put their money to work and benefit from this deduction.
3. Real estate depreciation rules are more favorable than ever because qualifying property acquired after September 27, 2017 is eligible for 100% bonus depreciation over its first year in service.
If you’re new to real estate investing, this topic may seem arcane, but it can mean big bucks. Depreciation is an expense deducted from rental income annually to reduce your tax bill. It’s calculated by dividing the property’s value by its number of years of useful life.
Bonus depreciation creates an advantage because it puts cash back in your pocket with your next tax return, which can be used to pay down principal. In addition, it creates an incentive to upgrade. Say you buy a qualifying commercial building, refurbish the interior and rent it out. Now, 100% of the renovation cost can be deducted from the first tax year’s rental income. My advice is to leverage this and upgrade. Not only will you get the bonus depreciation; you can also raise your rents accordingly, putting even more money in your pocket.
To be eligible, the real estate assets must be placed in service after October 2017 and have a depreciable life of 20 years or less. There was an old rule that limited bonus depreciation to new construction: The taxpayer had to be the first to actually use the property. Now, however, that rule has been eliminated, so bonus depreciation can be applied to a building that someone else built, used and sold to you — a big boost to the market for used commercial properties.
Another benefit, found in Section 179, expands how assets for commercial properties can be expensed. The annual limit doubled to $1 million per year, up to a maximum of $3.5 million over several years. Another change now allows you to deduct costs of repairing roofs, sprinklers, HVAC and security systems. This is a win for older B- or C-class properties, where bonus depreciation can offset a remodel to attract tenants willing to pay those higher lease rates.
Summary
As the Internal Revenue Service continues to issue regulations bringing more clarity to the TCJA, take a closer look at investing in real estate. I have always advocated for and helped facilitate people making money in real estate, and with all these new tax incentives working in your favor, 2019 is a great year to invest.