Joseph Darby

The Trump Tax Act – referred to by almost no one as the “Tax Cuts and Jobs Act” – contains a veritable Noah’s Ark of changes, many affecting the real estate industry, and nearly all as difficult to digest as grandma’s holiday fruitcake.

Nonetheless, we have undertaken to clarify the unclear, simplify the complex and deliver the low-down on the act and its impact on real estate.

Lower Individual Rates

Individual tax rates are lower, and so-called “pass-through” tax rates are potentially much lower (and definitely much more complicated), while corporate taxes are now astonishingly low – though not low

Gene Schlack

enough to justify owning real estate in a C corporation (an imprudent proposal, advocated elsewhere, that we’ll put the kibosh on below).

The standard deduction increased dramatically (almost double), to $24,000 for joint filers and $12,000 for single filers, and this increase, coupled with new limits on state and local tax (SALT) deductions, interest deductions and miscellaneous itemized deductions, means far fewer taxpayers filing Schedule A.

Is the act a good thing? Consider that an estimated 80 percent to 90 percent of U.S. taxpayers will enjoy a tax cut. However, some taxpayers residing in high-tax states – California, New York, New Jersey, maybe Massachusetts – will see an increase. The devil, as always, is in the details.

Your Home is Your Tax Shelter

Income tax planning begins at home: the personal residence is famously the first and best “tax shelter” under U.S. tax law.

This is still true, but less so than before. Personal mortgage interest (both the personal residence and one second home) is still deductible, albeit with a lower cap ($750,000 versus $1 million). However, HELOC interest is no longer deductible. The $500,000 gain exclusion on selling a principal residence – after numerous Congressional gyrations – remains unchanged. The SALT deduction, capped at $10,000, realistically impacts state income taxes far more than property taxes ($10,000 being a rough proxy for the average property tax on homes around the country, except in the more exclusive enclaves).

SALT Deduction Impacts High-Income Taxpayers

The SALT deduction cap adversely impacts high-income taxpayers in high-tax states – particularly blue coastal states. Big surprise: The Republicans were fully aware of this. Ironically, Republicans wanted to eliminate SALT deductions entirely, in their push to eliminate Schedule A, but lobbying was so intense that the final compromise left $10,000 on the table (and on the tax return). Mathematically, this actually puts the screws even more harshly to the blue states – every state, red or blue, needs to raise SOME tax, and the increment above $10,000 actually skews the tax hit even more heavily toward the high-tax states.

Qualified Business Income Deduction Ambiguous

The new “qualified business income,” or “QBI” deduction, is mathematically abstruse, but basically provides a consequential deduction equal to 20 percent of QBI (with a complicated taxable income cap) for taxpayers below specified income thresholds. The so-called “20 Percent Rule” phases out for taxable income (pre-QBI deduction) between $157,500 and $207,500 for single filers and $315,000 and $415,000 for joint filers. Above those thresholds, the deduction is limited to the greater of 50 percent of W-2 wages paid with respect to the qualified trade or business (QTB); or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all depreciable property used in the QTB.

This convoluted formula basically does two things: it makes pass-through taxation (S corporations, partnership and sole proprietorships) approximately equal to reduced C corporation taxation (see below), and it rewards companies with higher W-2 wages and higher investment, both priorities for the Trump administration.

This intriguing deduction applies to pass-through business income, qualified REIT dividends and qualified publicly traded partnership income. Real estate businesses will benefit, but it is disturbingly ambiguous whether the QBI deduction applies to real estate leasing activities that don’t qualify as a “trade or business” (an amazingly amorphous concept under the tax law). Regulations were helpful under the net investment income tax (NIIT) on this point, so watch closely for developments.

S corporations enjoy the beneficial “corridor” that avoids FICA and NIIT taxes on distributed income, which income now also qualifies for the QBI deduction. Operating through an S corporation just got more tempting – although there are well-known drawbacks to owning real estate in a corporation. The QBI deduction also applies to partnerships and sole proprietorships, so the choice-of-entity analysis remains complicated.

C corporations have a 21 percent tax rate, but deferral lasts only until owners extract the wealth through compensation or dividends. A 21 percent corporate tax, plus a 20 percent dividend tax (on the remaining 79 percent) almost exactly equals the top individual rate of 37 percent. Given other corporate headaches, it remains imprudent to hold real estate in a C corporation.

There are more provisions affecting real estate, but this first serving – like grandma’s fruitcake – gives everyone plenty to chew on.

Joseph B. Darby III is a partner in Sullivan & Worcester’s Boston office and Gene Schlack is an associate in the firm’s tax department.