Real Estate Owners to Get Pounded With Taxes

As the Senate closes in on a vote for tax reform, both Republicans and Democrats focus on talking points to persuade public opinion. Republicans like to focus on the lowering of nominal tax brackets. Democrats choose to concentrate on the larger tax break for the wealthy. As the bill stands now, tax brackets will decrease, the wealthy will get a greater break, teachers will get a nominal tax deduction taken away, corporate taxes will decrease, the Federal deficit will rise, and small business owners with pass-through status will get a tax break. Of course, this is debatable depending on which side of the aisle you ask. With sweeping tax changes, there are always going to be Americans who benefit and those who do not. And with a bill this size, projections of who may benefit in the future may be difficult. As Benjamin Franklin famously said, “In this world nothing can be said to be certain, except death and taxes.” As the tax reform bill stands now, add one more certainty to the list: Real estate owners and investors will get pounded with additional taxes and nobody is talking about it.

CAPITAL GAINS TAX

The current tax law is generous for homeowners to exclude profits when selling a primary residence.  This encourages home ownership and portability for Americans. Under the current tax laws, a homeowner can exclude up to $250,000 ($500,000 if you’re married) in profit from the sale of their personal residence. The main provision for a homeowner to exclude profits is often called the 2-out-of-5-year rule. A homeowner must live in a house for a minimum of two out of five years to receive a capital gains tax exclusion. 

As the new tax reform bill stands, Americans would have to live in a house five-out-of-eight years to exclude capital gains taxes. This is a dramatic change that will impact Americans across the country and hit residents in dramatically rising markets like Colorado particularly hard.

Here is an example:

A married couple bought a house three years ago for $250,000. Today, they would like to move due to a job change in Denver, upgrade, or move into a different school district – there are many reasons people move. The house is now worth $450,000 and will sell quickly in Colorado’s red-hot housing market. Under current tax law, this couple can take the profit of $200,000 tax free. 

With the new tax bill, this couple has not met the requirement of living in the house five out of the last eight years. They would have to pay capital gains tax of 15 percent on the profit of $200,000 making the total tax liability $30,000. Worse yet, the tax change could blind side homeowners and investors with a plan to sell a previous house under the current tax law. 

SELF-EMPLOYMENT TAX

With the current tax law, real estate investors do not have to pay self-employment tax on rental income.  This is huge for real estate investors large and small. Self-employment tax is a Social Security and Medicare tax which currently amounts to 15.3 percent. As it stands in the new reform bill, a paragraph was taken out of the new tax reform bill requiring real estate investors to pay self-employment tax on rental income. Whether you own a vacation home rental, are renting a past residence or own multiple units, plan on a massive increase in taxes if this bill passes.

INTEREST DEDUCTION

Colorado is a state where the average home price is not far from half a million dollars. Likewise, many people in the Denver metro area own or dream of owning a place in the mountains. Under current tax law, homeowners are able to deduct interest on up to $1 million in mortgage debt. This includes not only a primary residence, but also a vacation home. This is a huge write-off Americans have enjoyed for decades which promotes home ownership.

If the Donald Trump tax reform act he likes to call “Cut, Cut, Cut” bill passes as it is written now, the mortgage interest deduction will be reduced to debt up to $500,000 only on a primary residence purchased after it becomes law. Current homeowners will be grandfathered into the old tax law. In Colorado’s rapidly rising housing market with vacation homes in the mountains, the impact will be felt. With changes like this, most will not look back to see the opportunity cost lost with past deduction. They will just accept the law in the new tax bill.

STATE + LOCAL TAX DEDUCTIONS

Under current tax law, state and local taxes (SALT) can be deducted in full from Federal income taxes.  For high property tax states like New York, California and New Jersey, this deduction was a huge tax relief for residents of these states. The current bill limits the amount of the SALT deduction to the first $10,000. Although rising, property taxes in Colorado remain relatively low. This change to the tax bill will impact a small percentage of Coloradans, but may greatly impact other states.

WAIT + SEE

With any change, there will be winners and losers. As the tax bill is debated, morphed and pushed through, it is extremely important to understand how tax law changes may impact your specific situation.  Like everything in life, you can’t worry about what you can’t control; you must worry about what you can control. While the new tax bill may leave some Americans happy, others frustrated and many scrambling to find loopholes, it is important to understand the new bill and develop a plan. As Will Rogers said, and many Americans agree, “The only difference between death and taxes is that death doesn’t get worse every time Congress meets.” While many Americans will benefit if the tax bill passes, the real estate industry is the big loser.