The passage of the Tax Cut and Jobs Act (TCJA) has excited real estate investors, who see opportunities to achieve more growth and profit, while also causing some consternation among homeowners who will lose large tax deductions.
The effect on home prices remains controversial, with some experts more optimistic than others. Without question, there are opportunities for real estate investors to enjoy tax benefits, though the impact on house values in states with high home values bears cautionary analysis before embarking on real estate investment in those regions.
The Good Stuff
If you are a landlord, there are some things to celebrate in the TCJA. These include reductions in taxes for pass-through entities, increased opportunities for capital improvement deductions, and reductions in both personal and corporate income tax rates. Real estate investors who take advantage of these perks could see a nice reduction in the profits they must share with Uncle Sam.
Pass-Through Entity Benefits
Real estate investors who file as an LLC or an S-Corp are in good stead. These pass-through entities are designed to provide the liability protection of a corporation, while avoiding the double taxation that occurs when business owners must pay corporate income tax and personal income tax. With an LLC, owners enjoy liability protection while paying all taxes at their personal income tax rate.
Under the TCJA, paying taxes under an LLC has gotten even better. If you have not converted your real estate business to an LLC, now is the time, both for liability reasons and to take maximum advantage of the TCJA.
Because many small businesses pay taxes through their owner's personal income tax returns, Congress needed a way to provide a tax break to small business owners. After all, what's the point of cutting the corporate tax rate, from a small business owner's perspective, if your taxes are paid on your personal return?
To cut the small business owner in on the tax cuts, Congress provided a juicy 20-percent tax deduction for small businesses. This deduction comes off the top of business profits. Also, real estate investors filing as pass-through entities will by and large also enjoy the TCJA reductions in personal income tax rates.
Capital Investments Deductions
Property owners usually become familiar with Section 179 of the tax code as soon as they start making capital improvements. In real estate investment, capital improvements are often the key to a project's success. Spend too much, however, and it can doom the project to failure. Sometimes, when the line between profit and loss becomes thin, taxation makes all the difference.
The TCJA increases the capital improvement deductions available to real estate investors and landlords. More improvements qualify as deductions than ever before, and the TCJA also expands the allowable amounts. For example, HVAC systems, roofs, and security systems are now deductible as capital improvements. If a new roof is under consideration at an investment property, now might be the time to get some bids.
Net operating loss (NOL) carryovers remain in place; however, the TCJA did away with the 2-year carryback provision. NOL deductions are also limited to 80 percent of the pre-NOL taxable income. Though NOL deductions can certainly still help real estate investors, their utility may be reduced for some.
What About Home Values?
The TCJA reduced income tax rates for many, but it also reduced the mortgage interest deduction. In Los Angeles and other high value markets, in many neighborhoods, some or all homes are priced above the point where most mortgagees run into the limit. The $10,000 per year limit sounds reasonable in Cincinnati, but in Santa Monica, it's going to cost homeowners at tax time.
Will this make homes less valuable, causing a retrenchment in prices? Will the decline in deductibility really keep the buyers away? That depends on who you ask.
For example, Core Logic released an optimistic forecast for 2018 housing prices. Its formula predicts a 4.2-percent increase in the U.S. as a whole. California, according to Core Logic, will enjoy a whopping 8.4-percent increase.
If those numbers hold, California's market can clearly absorb the tax changes, which, in view of housing shortages and unceasing demand in certain areas, seems quite possible.
The National Association for Relators (NAR) disagrees. Due to the TCJA impacts and other factors, the NAR sees weakness in the real estate market nationwide. High value Eastern states like New York and New Jersey will see declines in prices, along with Illinois. California, despite all the demand, will eek out a gain of just over 1 percent.
Impacts here in the LA area are starting to take shape. The market has clearly become very heated. Those who want to see renters and homeowners get a break in their budgets may welcome some cooling, but real estate investors would be very disappointed if the NAR's 1-percent prediction holds.
Nicki Zvik, expert Real Estate investor Co-Founder of Green Solar Technologies and Spectrum Holdings says, "In order to minimize risk in real estate investing, it's important to look at a property from every angle.
This means a thorough physical inspection from roof to foundation to neighborhood and demographic trends, school district, risk of earthquake, etc. The buyer with the most information will always be the one who carries the least risk because he/she will never be surprised and will not overpay from the beginning."
SALT on those wounds
The State and Local Tax deductions have long benefited California homeowners. Considering the property taxes in some counties, as well as California's state income tax rates, the increase in the standard deduction under the TCJA provides no comparison. Without question, California homeowners are getting a tax bite with the elimination of SALT deductions.
For real estate investors, this could spell pressure on prices; however, there may also be some sellers willing to let go of a property for less, now that the SALT deductions no longer help them keep their household budgets on target. The effect of the changes in SALT deductions, by most estimates, varies greatly by region. Some areas, like Arizona, have strong appreciation prospects, according to both Core Logic and the NAR. Arizona, with lower wage bases and housing prices, isn't expected to be largely affected. California, on the other hand, has a very high wage base and housing prices. It stands to reason the effect will be much greater.
Despite any jitters the TCJA causes in regards to housing prices, the benefits to California landlords and investors are substantial. California's economy is amongst the strongest in the nation, and demand shows little sign of slowing. Landlords are in especially good shape in an economy where rental demand won't quit.