When the Tax Cuts and Jobs Act (TCJA) went into effect in 2018, it brought some of the most comprehensive tax law changes in decades. When it comes to tax reform and real estate, there are a number of implications—and potential opportunities—investors should consider. Although tax reform placed limitations on some tax incentives, it expanded other incentives and left other doors open for real estate investors to help reduce their tax liability in 2019 and beyond. “We anticipate the changes in the tax code to be highly beneficial to all levels of real estate owners,” says Scott Kapin, a Real Estate Advisory Specialist with Wells Fargo Wealth Management’s Real Estate Asset Management group.
“A large number of our clients have significant exposure to real estate,” says Kenan Peterson, a Wealth Planner with Wells Fargo Private Bank. “In light of the tax law changes, that exposure can present some potential opportunities.”
Consider the following changes in the tax code when consulting with your tax and legal advisors.
Explore potential deductions of nonprimary residences
The changes: Section 199A of the Internal Revenue Code allows owners of pass-through entities (generally defined as any business other than a C corporation) a deduction of up to 20 percent of qualified business income. Also, the TCJA limits personal state and local tax (SALT) deductions to $10,000, but not for properties used in a trade or business.
The opportunity: If you own a second, third, or fourth home that’s vacant most of the year, you may be able to take advantage of 199A and potentially maximize your SALT deductions by placing your homes in a business entity and renting them out. You can still use the property for 14 days per year or 10 percent of the days you rent the house, whichever is higher.
“If you already own real estate assets as investments, consider talking to your advisors about holding them in some sort of special-purpose entity rather than personally for several reasons,” says Kapin.
Peterson agrees: “If you haven’t already placed your real estate holdings into an LLC, limited partnership, or S corporation, now might be the time to do so. Even if you already have, it’s worth talking to your advisor and accountant about structuring your real estate investments.”
Before you start: Speak to a tax advisor. Peterson says 199A is complicated, with factors including the 20 percent deduction phasing out in certain businesses and income levels. “You’ll want to talk to a tax advisor because there are many nuances involved with this new provision,” including limitations on personal use of homes treated as businesses for tax purposes and other considerations to take into account.
Investigate deductions associated with commercial real estate (CRE)
The change: The TCJA increased benefits for CRE businesses, allowing more deductions with higher limits under Section 179 of the Internal Revenue Code and elsewhere.
The opportunity: CRE owners can now deduct the cost of certain personal property used in a rental business, as well as some nonresidential improvements, including roofs and systems such as heating, ventilation, and air conditioning and security alarms.
Deduction limitations also nearly doubled to $1 million in 2018. First-year bonus depreciation rules changed, doubling to 100 percent for assets placed into service from late 2017 to the end of 2022, including used property.
“The bottom line is there are a lot more costs that you can deduct now, which you couldn’t before,” Peterson says. (For more, see “Tax Reform: 6 Considerations for Your Investments.”)
Before you start: Note that depreciation regulations and tax laws evolve over time. “There’s a lot less uncertainty now than there was in 2017,” Peterson says. “But tax law is always changing. Keep working with your advisors to make sure you understand the implications of your tax planning.”
Learn about the Qualified Opportunity Zone program
The change: TCJA established the Qualified Opportunity Zone (QOZ) program, which creates tax incentives to encourage private investment in real estate development in economically depressed areas.
The opportunity: Many investors have become interested in QOZ funds as they offer the potential to defer taxes on capital gains over a number of years. Let’s say you recently had a $1 million capital gain. Investing that money in a QOZ fund within 180 days may allow you to:
- Defer some or all of the taxes from that gain until the end of 2026.
- Defer 10 percent of the original gain if you leave the money in the fund for five years. After seven years, you can defer another 5 percent, in effect reducing the amount that can be taxed from $1 million to $850,000.
- Avoid being taxed on gains from that investment after 10 years in the QOZ fund. So if your $1 million investment turns into $1.5 million and you sell it in 2029, you don’t pay taxes on the $500,000 gain.
“If you’re not paying taxes on those gains today, you have the potential to do more with those dollars,” Peterson says.
Before you start: QOZ funds are complex and not for everyone. “Don’t try to do this on your own,” Peterson says. “Work with tax advisors and attorneys who specialize in this field because they are more knowledgeable about the details and the regulations, some of which have not been finalized yet.”
“Many details still need to be clarified with the IRS,” clarifies Kapin. “In our view, it’s evident from the tax code that this program anticipated professional developers and highly sophisticated real estate companies would be the primary players in this initiative. If smaller, private investors access this program through limited partnership interests with these larger sponsors, this may dilute the benefits and pose other risks to those investors.”