Many people own residential or commercial rental real estate properties, the income from which helps to supplement their regular income. If you are one of them, this article is a must-read because the rules related to rental property income are changing under tax reform (also known as the Tax Cuts and Jobs Act or TCJA). The following summarizes the key changes that may impact your tax situation.
Key tax reform provisions which may apply to freelancers with rental properties:
- You can still deduct mortgage interest and state and local real estate taxes on rental propertiesunless they are used for personal purposes (then the new limits for personal residence mortgage interest and state and local tax deductions would apply).
- You can deduct eligible expenses related to your commercial rental properties such as depreciation, utilities, insurance, repairs and maintenance.
- There may be additional tax savings for rental real estate owners via the qualified business income (QBI) deduction that tax reform makes available to pass-through business entities. See below for additional details.
- For qualifying property placed in service in tax years beginning after December 31, 2017, the TCJA ups the maximum Section 179 deduction to $1 million (increasing it from $510,000 for tax years beginning in 2017). This deduction allows you to write off the entire cost of eligible property in the first year it is placed into service.
- The TCJA also expands the definition of eligible property to include the following expenditures for nonresidential buildings: roofs, HVAC equipment, fire protection and alarm systems, and security systems. It also includes depreciable tangible property such as the furnishings and appliances used in apartments, houses, dormitories, or other structures where sleeping accommodations are provided in exchange for rent.
- Tax reform allows for expanded bonus depreciation deductions. This means that for qualified property purchased and placed in service between September 28, 2017, and December 31, 2022, the TCJA bumps the first-year bonus depreciation percentage for new and used qualified property from 50 percent to 100 percent.
- The bonus depreciation deduction also applies to qualified improvement property and fixed asset additions that fall into these categories:
- Qualified leasehold improvement property,
- Qualified restaurant property, and
- Qualified retail improvement property.
How the new QBI deduction and loss disallowance rules apply to rental income: As mentioned above, a highlight of tax reform for many small business owners is the new 20 percent tax deduction based on qualified business income (QBI) from a pass-through business entity. This deduction generally applies to sole proprietorships, limited liability companies (LLCs) treated as a sole proprietorship, partnerships, LLCs treated as a partnership, and S corporations.
The QBI deduction may offset net income from any rental real estate activity that you generate a profit from through a pass-through entity. However, if you experience a tax loss from your rental property activities, you need to be familiar with passive activity loss (PAL) rules which only allow you to deduct passive losses in proportion to passive income from other sources, including that from other rental properties or gains from selling such property. Passive losses beyond that of your passive income are not allowed unless you have enough income or gains, or until you sell the property on which you took a loss.
The TCJA adds the following provision to the existing PAL rules: For tax years 2018 through 2025, any excess business loss cannot be deducted in the current year. Essentially, any current-year business losses can’t offset more than $250,000 of income from such other sources for single filers or more than $500,000 for a married joint-filing couple.
If you have an excess business loss, it will be carried over to the next tax year and can be deducted as a net operating loss (NOL) carryforward as long as your loss meets the PAL rules as a valid deduction.
How like-kind property exchanges fit into the picture: The TCJA still allows the sale of appreciated properties with an indefinite deferral of federal income tax through like-kind exchanges of commercial (not personal property). Under tax reform, you can trade the property you have for a replacement property and delay paying taxes until you sell the replacement property. In theory, you can perpetually trade properties and continue deferring taxes. In the case of personal property, the TCJA eliminates tax-deferred like-kind exchanges for 2018 and beyond. If you transacted a personal property exchange on or before December 31, 2017 and one end of it remained open after that date, the prior rules on like-kind tax deference still apply.
Be sure to check how these new tax reform rules impact your real estate rental income.
The TCJA has some new benefits tied to real estate rental property income as well as some changes which may not be as beneficial, depending on your unique situation. If you have questions, contact our NYC CPA office.