The jury is still out for the Tax Cuts and Jobs Act (H.R.1), more popularly known as tax reform or the GOP tax plan. For the purposes of this discussion, we’ll refer to it as the TCJA, a bill that has been a source of confusion and opposing viewpoints.
Regardless of your stance on tax policy, the law will have undeniable implications for Bay Area property homeowners. After fielding questions from owner-occupants and investment property owners alike, we wanted to chime in on how this may affect their bottom lines.
Deductions for homeowners
As part of the tax code restructuring, the TCJA includes a mortgage interest deduction for homes that cost $750,00 or less. If you throw a dart at a map of North America, it’s a huge amount of money, unless that dart lands in California’s largest metro areas. Alameda, Marin, Orange, San Francisco, San Mateo, Santa Clara and Santa Cruz counties all have average home prices north of $750,000, so the end result of the TCJA is a tax break for homeowners that prices out most Bay Area properties, even the teardowns.
Some would argue that for those buying $750,00 homes, the tax write off is not calamitous – people who are bent on buying are bent on buying - and that limiting the mortgage interest deduction would not dampen the search efforts and enthusiasm of aspiring homeowners. More backdrop here »
The California Association of Realtors takes issue with that sentiment. It was at the forefront in opposing the bill, arguing it dramatically weakens the tax incentives for new homeowners and that the lower mortgage interest deduction cap punishes homeownership in high-tax, Democrat-leaning states like California.
In a heartfelt message to members we published on our website, C.A.R. President Steve White lamented that the TCJA puts home values at risk and undercuts the incentive to own a home.
Redfin offered their take, claiming that, “pass-through tax cuts, combined with changes in the ability to deduct state and local taxes will continue to drive American migration, where people from coastal cities strike out for affordable places to live.", in the words of chief economist Nela Richardson. They predict that the tax cut could limit the supply of homes on the market by reducing the landlord’s incentive to sell. The National Association of Home Builders went a step further by warning it could casue a national housing recession.
Rental property owners, on the other hand, are not seeing the sky fall.
A boon for the rental housing industry?
The National Apartment Association, in partnership with the National Multifamily Housing Council, has applauded the tax overhaul, touting it as a smart tax policy.
One of the most adorning centerpieces of the TCJA is the protection of flow-through entities. Not surprising, because three quarters of apartment properties operate as flow-through entities, including residential landlords who own their rental property as sole proprietors, real estate investment trusts, LLCs, S corporations or partnerships.
Under these tax provisions, businesses avoid the double taxation of paying corporate and individual taxes. Instead, taxes are applied solely at the individual level. Unlike owner-occupants, rental property owners can write off expenses like mortgages, repair and management costs. Since these costs of doing business are deducted from the income the property produces, investors are only taxed on that income, so by reducing it, the investment acts as a tax shelter.
The TCJA, however, creates a new tax deduction for individuals who realize income through pass-through entities under Section 199A, also known as the Qualified Business Income Deduction, which arose from the Tax Cuts & Jobs Act of 2017. If rental activity qualifies as a business for tax purposes, as most do, owners may be eligible to deduct an amount equal to 20% of their net rental income. This is in addition to all other rental-related deductions. If landlords qualify, they are effectively taxed on only 80% of rental income.
There are many rules and limitations, of course, and as with any major revisions to the tax code, there will be modifications and interpretations which will change how this creature can be used.
The rich get richer?
Although wealthy real estate investors will be beneficiaries of the new tax rules, anyone who invests in rental real estate is likely to benefit. While critics note that Washington political figures emerge richer, perhaps they overlook the many small, mom-and-pop landlords. As we noted in this earlier post, these responsible landlords are stewards of the community, treat their tenants well, and are the driving force of affordable housing. They did not cause the housing crisis and indeed, have been adversely impacted by it with rising costs.
Pass-throughs are shrouded in mystery for many observers, with an accompanying undercurrent that they are an unseemly and arcane vehicle for corporations to avoid taxes or otherwise create some sort of mischief. In fact, roughly 95% of all businesses are categorized as pass-throughs, and they are very common for small business owners. In a pass through, profits are merely passed through to the owners of the business, who then report that income on their individual tax returns and pay tax on it, with the rest of their normal income and thus, there is nothing evasive.
Like most other matters we encounter at Bornstein Law, the law is cleaner on the page than it is in the real world, and many ambiguities need to be wrinkled out. Our job is not to legislate, but counsel property owners and protect their real estate investments given their unique circumstances. While there is no shortage of viewpoints on tax reform circulating around the web, it is strongly recommended that you muffle the noise and sit down with an attorney to discuss your unique circumstances and real estate goals.
Daniel is the founding attorney of Bornstein Law, the San Francisco Bay Area's foremost authority on managing landlord-tenant relationships, property management issues, and complex real estate litigation. Having protected the rights of property owners for over 23 years, he is also renowned for his educational workshops, his speaking engagements with numerous organizations, and as an expert witness. Contact his office today.