We now know exactly what is in the new tax bill since the House, Senate, and President have singed it into law. I first wrote this article before the House and Senate agreed on a bill, but I have updated it to show the final changes. Some of the changes will be huge and will have great impacts on the country, especially real estate. There will be changes for real estate investors and homeowners. Some of these changes will save people money, and others will cost people a lot of money. It is important to know what these changes are because some of the changes will take effect in 2018, which means you have less than one month to take advantage of the current rules. There will be changes to the tax-free gain most homeowners see when they sell an owner-occupied house; to mortgage interest deductions; to depreciation schedules; to taxable income rates; to home equity loan interest deductions; to property tax deductions, and more.
What are the tax code changes that will affect real estate?
The tax code in the United States, and the way the government comes up with the tax code, is very complicated. The House of Representatives came up with their own tax bill that they and the Senate passed, but the bills are different. For the tax bill to become law, both the House and the Senate have to pass the same bill, and the President has to sign it. We know the bills that were passed, but we don’t know the exact bill that will become law. However, many of the provisions that affect real estate are the same or very similar in both bills, which means there is a good chance those provisions will stay the same. I was wrong to assume this as some of the final changes were not in the House or Senate bill! Here are the major changes proposed and the actual changes that were made:
- The deduction for mortgage interest on an owner-occupied home will mostly stay the same unless you have a mortgage of more than $500,000. Currently, there is a loan cap of $1 million to take the mortgage interest deduction, and the House version would lower that to $500,000. The Senate version would not change the cap, which means good news, right? Well, because of other changes in the tax code, most people would no longer take the interest deduction from their home mortgage, which would greatly decrease the incentive to buy a house. 74% of people take the standard deduction for taxes right now, but that deduction would double under both bills. That means more than 90% of people would take the standard deduction, and the ability to deduct mortgage interest would mean absolutely nothing to them. *The law was changed so that you can take the mortgage deduction up to $750,000 on new purchases. If you already own a home this will not affect your current mortgage.
- You can also deduct state and local property taxes. Under both the House and Senate bills, the property tax deduction would remain in place but would be capped at $10,000. Many people would not be affected by this, but for those in high-property-tax states, it is a huge deal. *Your combined state income tax and state property tax deduction is capped at $10,000 in the new final version.
- Under the Senate and House bill, you would no longer be able to deduct interest from home equity loans, which you can currently do up to $100,000. You also could not deduct interest for second houses, which you can also do now. *You can still deduct interest for second houses in the final bill, but you can no longer deduct home equity loans, unless they are used for business purposes.
- The biggest change is to the tax-free gain from selling a personal residence. Right now, if you live in a house for two out of the last five years, you can sell it and take up to $250,000 (individually) or $500,000 (jointly) in tax-free profit. The new law in both the House and the Senate would change that to 5 out of 8 years. The House bill would even phase out the tax-free gain for high-income earners. *Even though this clause was in both the House and Senate version of the bills, it was removed from the final bill. The capital gain exclusion remains the same as it is now (2 out of 5 years).
How will these new tax rules affect the real estate market, and when will they take place?
It is not clear when many of these tax laws will go into effect. The House bill states the interest deduction clause would take effect November 2nd, 2017. The change in the tax-free gain rule could affect all houses sold in 2018, or as long as a house goes under contract in 2017, it may not be affected. Either way, the rules could change things very quickly.
No one knows exactly how these new laws will affect the housing market, but many think it will cause a drop in prices. The changes could cost homeowners tens of thousands of dollars in new taxes. The National Association of Realtors (NAR) thinks the changes will cause prices to drop over 10% in the next year! *Now that the capital gains exclusion change is gone from the final bill, I think the housing market will not take a huge hit from this bill.
NAR also states it would be much more advantageous to rent a house than to buy one based on the new rules. They state a renter who makes $120,000 per year would save $3,408 with the new tax bill, while a homeowner would actually pay $226 more in taxes each year. The savings with the new tax bill varies based on how much money you make, but they think just about everyone will save more money in taxes by renting.
I personally do not think the new tax bill will decrease home prices by 10% within one year. I think many people want to buy a house no matter what the tax savings are. We could see some people who are very analytical regarding the cost to buy or rent decide to rent. Most people will not be crunching numbers to see exactly how much in taxes they will have to pay under both scenarios. I think that the housing market will be affected because people will have less money to buy houses with. Many people will also have to pay taxes on the gain from the sale of their house. This means they will have 10 to 30% less to spend on a new house or on other things.
Why are so many changes being made to real estate taxe codes?
It is estimated that changing the tax rules for real estate will increase the revenues the government receives by $1 trillion. The government has rules that any tax reform they come up with cannot create more than $1.5 trillion in additional deficits over the next decade. The plan they came up with increases the deficit by just under $1.5 trillion. Actually, the only reason they were able to stay under $1.5 trillion is because almost all of the tax-law changes expire in 2025. If the tax laws would have continued, they would have gone over that $1.5 trillion figure. The increase in real estate tax revenue helps make up for the decreases in revenue from other sources. One of those sources is pass through and corporate income tax rates that are being greatly reduced.
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How will the new tax code reform laws affect real estate investors?
The new tax laws aren’t doing any favors for homeowners, but the same cannot be said for real estate investors. The tax bills in the House and Senate are very business friendly. Right now, real estate investors pay much of their taxes as ordinary income. The highest tax bracket is 39.6% (which will also likely change), so on rental and flip income, most investors pay high tax rates based on how much income they make.
Most real estate investors use LLCs or S corporations to do business if they do not simply pay taxes as an individual. When you operate these types of businesses, the income passes through the corporation to the individual. In both the House and the Senate bills, pass-through tax rates would drastically change. If you were in the highest tax bracket, instead of paying 39.6%—or whatever the new highest rate will be (possibly 38)—you would pay 25% on pass-through income. The senate bill has some restrictions for those that make over $700,000, while the House bill does not. For those who have rentals or flip houses in a corporation, you will likely see big drops in your tax bill. I have 18 flips going at the moment, so this could literally save me hundreds of thousands of dollars in taxes in the next couple of years. However, some of these rules may not take effect until 2019.
*The final tax bill included a 20% deduction for pass through entities. That means that if you have a pass through entity you may pay 20% less taxes than you do now. However there are some conditions:
- Service industry is excluded from this rule and would not get the deduction. That may apply to real estate agents, but not flippers or landlords.
- You get the lower of the 20% deduction, 50% of your employees w2’s, or 25% of your employees w2’s and 2.5% of your investments (based on original purchase price). Basically if you have a lot of investments or employees you will save a lot of money.
The new rules change the corporate tax rate from 35% to 21%.
Here are some other changes that will benefit real estate investors if the changes make it into the final bill:
- The depreciation schedule will decrease for rental property owners from 27.5 years to 25 years on residential properties and from 39 years to 25 years for nonresidential property. *This did not make it into the final bill and the depreciation schedule will stay the same.
- Landlords will still be able to deduct their interest from mortgages in full on rentals they own.
- Landlords will be able to deduct some expenses instead of depreciate them now.
- You can deduct more car expenses now (especially nice for agents).
The new tax brackets are much lower:
What do I think of the new proposed tax code reform laws?
I try to not write about politics, religion, or other touchy subjects. My main goal is to educate others about real estate. I hesitate to give my opinion on this bill because there are so many strong beliefs on both sides. However, this bill will greatly affect all of us, and I feel I need to warn people about what I think will happen.
This reform will hurt homeowners and therefore could hurt the economy as well. Much of the economy is driven by the housing market and disposable income from the middle class. The new tax laws punish homeowners by reducing their deductions, changing the tax-free gain on sales, and eliminating deductions on home equity loans. Some of the elimination of deductions will not hurt people because the standard deduction is being doubled, but the change the to the capital-gain rule is huge. People will have to stay in their house more than twice as long, and if they don’t, pay hefty penalties. The other concern is how many people are going to have the discipline to save the money they need for that hefty tax bill? Or, will the government require closing companies to hold back money for taxes at closing? If you make $100,000 on the sale of a house, you could end up paying $20,000 to $40,000 in taxes on that profit. The middle and lower classes typically spend everything they have, which means that is money that would go directly into the economy but will now go to the government. *Taking out the change to the capital gains exclusion is a huge win for homeowners. I do not think the final bill is as scary as the proposed bills.
It has been argued that cutting corporate taxes will boost the economy as well, but that is not guaranteed. Here are some things to consider:
- The economy is already doing extremely well, with 4.1% unemployment rate, so how much better can it get?
- With the economy doing well, many corporations have a ton of cash right now that they could be investing into higher wages or more hiring, but they don’t need to. How will having more cash cause them to raise wages?
- The last huge tax break for corporations did not help the economy. In 2004, there was a tax holiday where corporations could bring overseas profits into the US at a five-percent rate instead of 35%. “Most of the money went to repairing balance sheets and rewarding shareholders, according to the CRS. According to one study cited, as much as 91 cents on the dollar went to share repurchases, even though that, along with compensation increases, was an expressly prohibited use by Congress.” From https://www.cnbc.com/2017/04/26/what-happened-the-last-time-companies-got-a-break-on-overseas-profits.html
- Many economists believe that the money corporations receive from the tax breaks will not be used to hire people or increase wages but simply to buy back shares, pay off debt, or give directly to shareholders as dividends.
My thoughts are that tax breaks do not cause corporations or businesses to reinvest more money into the business. Why? Because you are already rewarded with today’s tax code to reinvest money into your business. When you spend money on hiring new people, increasing wages, etc, that is an expense that comes off your profit and reduces your tax liability.
The government needed a way to pay for the huge tax decreases they are giving to corporations (including me), and they chose homeowners as the people to pay for it. They are also giving huge breaks to real estate investors in the form of the decreased depreciation schedules and pass-through income tax rules. The two studies that have been on the tax reform suggest the economy will improve some but not nearly enough to pay for these cuts, causing our deficit to increase from $1 to $1.3 trillion dollars. The tax cuts will benefit the wealthiest Americans. In the Senate bill, those earning more than $700,000 will enjoy an increase in after-tax income in 2018 of 2.2% and an average savings of $34,000. The middle class will see an increase of 1% to 1.5% in after-tax income in 2018. However, it is estimated that 15 to 20% of the middle class will actually see a tax increase (mainly because of the homeownership tax rules). Thank you to this article again for many of these stats. I am not sure if these studies take into account that many more people will be starting up corporations to take advantage of these new laws so they can save money.
The tax reform proposal encourages people not to buy houses, which is sad because most people gain almost all of their net worth from their house. Below is a graph on the percentage of net worth from home equity based on age.
The averages say that anyone over 35 has most of their net worth from their house. As you get older, that number increases to over 80%! The biggest reason for this is that a house is a forced-savings plan. Most people do not save any money, but owning a house forces them to save. Some studies have suggested people could be better of renting instead of buying, but those studies assume people would invest all the money they save, which they do not. In fact, renters have a net worth 44 times lower than that of homeowners.
This tax bill will save me a ton of money on my taxes which I could use to invest back into my business or buy more cars. I do not think this bill will help the economy since housing will be hurt greatly. We will also see more people become renters simply for the fact that everyone is saying renting is better than buying. The gaps between the rich and the poor will widen even more. I am a strong believer that real estate is a fantastic way to build wealth, whether you are an investor or homeowner. Unfortunately, these bills only helps investors.