The largest tax code change in over 30 years has left many investors wondering what it means for them. The final tax bill is over 500 pages (560 pages to be exact) of rather dense material giving tax experts a run for their money. However, some clear changes have been widely talked about and weighed in on since the new tax bill was passed.
Notably, corporate taxes have been slashed in an effort to drive job growth while pass-through entities were also addressed in the massive tax bill. In a last-minute effort, a tax break for pass-through entities was added into the tax overhaul before acquiring enough votes from both the House and the Senate. This pass-through measure has drawn a lot of attention and is set to have a substantial impact on some entities set up in this way.
Since many real estate investors have their businesses set up as pass-through entities the new tax plan could have a large impact on the industry. Another change that could have an impact are the exclusions that have been added back in to 1031 exchange rules, no longer allowing the deferment of gains on the value of personal property.
What is considered a pass-through entity?
A pass-through entity is a business that is set-up in a manner that the profits pass through the business and onto its owner/owners. A pass-through entity does not pay corporate taxes but rather the profits are passed on to the owner and then reported on the individual’s tax return as income. Prior to the new tax plan, the business income was taxed at the individual tax rates, with the top individual rate taxed at about 40%.
For federal tax purposes, pass-through entities include sole proprietorships, partnerships, LLCs and S corporations. This structure takes the owners’ share of the profits and losses and reported income all into account on the individual tax return and is designed to avoid double taxation.
How does the New Tax Plan affect
The new tax plan significantly changes business taxes and are permanent, unlike the individual tax scheme. The new tax rate for corporations is a flat 21%, which would have given no incentive to pass-through entities, so an additional tax break for these entities was also thrown into the tax overhaul. They created a new tax rate for pass-through entities at a 20% tax rate for those that meet the criteria. For those investors being taxed at the top individual rate around 40%, this is nearly a 20% decrease, but it comes with limits and restrictions.
Your taxable income must be below the threshold amount in order for the qualified business income (QBI) of each entity to be taxed at a straight 20%. If your taxable income is over the threshold amount you are subject to the limitations and exceptions which are then determined by occupation and a capital limit. The threshold amount is $157,500 for individual taxpayers and $315,000 for married filing jointly.
Section 1031 allows the swap of one investment asset for another. The law is set up so that you can grow your investment while allowing it to change form while deferring the taxes paid because you haven’t recognized the capital gains. However, you must reinvest in qualifying property which is defined as “like-kind’ property.
The new rules amend Section 1031 to strike anywhere it says “property” and exchange it with “real property.” This then means that an exchange can only defer the capital gains on the value of real property only, which does not include personal property. This exclusion is not likely to affect fix and flips as these types of investments are not typically associated with a high value of personal property like furniture and equipment that you might find in corporate real estate like restaurants, for example. However, it is something to be aware of moving into 2018. Robert W. Wood explains the 1031 exchange much more in-depth.
Moving into 2018
Keep in mind these are just some highlighted points and this is not an exhaustive list. The potential impacts will vary with each individual and/or entity. For the full definitions and explanations of The Cuts and Jobs Act, you can read it for yourself here.
It will be interesting to see how investors will structure their businesses moving forward to take full advantage of the tax cuts. It may make sense for some to structure themselves as a corporation and simply pay the corporate tax of 21%, while others may look to form a pass-through entity. Your answer depends on many factors. It is a good idea to consult a tax expert, if you have not already, to decipher how to best position your business to save on taxes, boost your profits, or at least look to mitigate any potential negative impacts.