Under the Tax Cuts and Jobs Act of 2017 (TCJA) several benefits long associated with residential real estate were effectively lost. Could the same thing happen this year?
In the 2017 round of tax changes residential real estate took a hit. The once unlimited deduction for state and local taxes – SALT – was capped at $10,000. Mortgage interest remained deductible but for new financing the debt limit was $750,000, down from $1 million. Deductible interest for home equity lines of credit (HELOCs) went from $100,000 to $0 in many cases.
Why were the changes made? The government needed more money and estimated that residential tax increases could raise an addition $668.4 billion for the US Treasury.
But – also in 2017 – the standard deduction almost doubled, going to $24,400 for married couples and $12,000 for single taxpayers.
For many residential property owners the option was clear: forget about itemized deductions and just take the standard write-off.
On the other hand, investment real estate cruised along with lots of yummy deductions.
“In general,” says Mitchell Wiggins , an accounting firm based in Richmond and Petersburg, VA, “rental property owners will enjoy lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025. In addition, the new tax law retains the existing tax rates for long-term capital gains.”
There were, however, some changes. For instance, Mitchell Wiggins explained that “for 2018 and beyond, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.”
Another change for the better was that the maximum Section 179 Deduction increased from $510,000 to $1 million.
A Biden Change?
We now have a new President, a Senate that is 50-50 Democrat/Republican plus a Democrat Vice President, and a House where the current split is 221 Democrats, 210 Republicans, and four vacancies. While the Democrats have control of the House and the Senate in neither case is their majority especially strong, particularly in the Senate.
What changes can or will be made to the tax system are unclear given the close political split on Capitol Hill. In addition, Washington must deal with the pandemic and the serious economic downturn experienced by millions of households as a result.
There is, however, an exception to the general drift in DC. One real estate provision seems to be getting an inordinate amount of attention, the step-up in basis rule.
Imagine that an investor bought a single-family rental for $100,000 in the 1980s and today the property is worth $500,000. Sell it now and there’s a long-term capital gain on the $400,000 profit before getting into the details and deductions.
But what if the investor dies? Now the rules change. Forget about those pesky capital gains taxes. The investor’s heirs will inherit the property at its “stepped-up” value, $500,000.
In practice the heirs are unlikely to pay any federal tax. “For an estate of any decedent dying in calendar year 2021,” explains the IRS, “the basic exclusion amount is $11,700,000.”
According to the Tax Policy Institute (TPI), of the 2.8 million people who died in 2020 only about 1,900 actually owed federal estate taxes.
Are new rates coming?
Most people would not be bothered at all if the estate exclusion amount fell to something lower. Before the 2017 tax changes the exclusion amount was $3.5 million. In fact, according to TPI, the exemption was just $1 million as recently as 2002.
“One problem with a change to the stepped-up basis rule is that it’s likely to impact a lot of people in high-cost states and cities,” said Rick Sharga, Executive Vice President with RealtyTrac. “The estate of a modest investor with two or three properties in New York, San Francisco, Los Angeles, Washington, or Boston could potentially face a federal estate tax if the stepped-up basis is sufficiently reduced. Ditto for small business owners and farm families.”
Sharga added that “a second problem is that long-term prices are invariably distorted by inflation. A property bought in 1965 for $25,000 would be priced at about $209,000 today if we correct for inflation. The $184,000 difference is not ‘profit’ in the sense of increased wealth, it’s simply a number that reflects the reduced buying power of the dollar.”
Estate and gift tax exclusions in the tax code may well move from $11.7 million to something lower. That could happen because the government needs the money and taxing only 1,900 estates a year suggests that the current exclusion level is too high. But care needs to be taken. An exclusion number set too low could force even middle-class “estates” to face a significant new tax burden, something unlikely to pass through the political process.