How the New Real Estate Tax Deduction Will Affect Property Investors
The Trump Administration and the United States Congress recently passed a substantial tax reform package. This overhaul of the nation's tax code significantly affects property investors.
For example, eligibility for the mortgage interest deduction was lowered from $1 million to $750,000. In addition, property tax deductions are now capped at $10,000.
However, limitations on the real estate tax deduction are likely offset by other positive features in the overhaul package. The legislation also negatively affects some regions of the country more than others.
Read on to learn more about the Tax Cut and Jobs Act. We'll also explore changes to the real estate tax deduction and how it affects property investors.
What Are the Changes to the Real Estate Tax Deduction?
On the surface, changes to the tax code are not favorable for homeowners and real estate investors. This is especially true in states with high property taxes and home values.
Under the prior tax structure, property tax deductions were not capped. In addition to property taxes, state and local income taxes (SALT) were also fully deductible.
The Tax Cuts and Jobs Act places limits on how much you can deduct. Now you can only deduct $10,000 total in property taxes and SALT combined.
It's estimated that approximately 4.1 million Americans pay $10,000 or more in property taxes alone. The number of affected Americans is much larger when considering SALT.
Mortgage Interest Deduction
The new tax bill places limits on the mortgage interest deduction, as well. In the past, homes valued at $1 million or less were eligible for the mortgage interest deduction.
Under the new tax plan, this home value is reduced to $750,000. This provision also negatively impacts homeowners with multiple properties.
If a tax filer owns a home valued at $750,000 or more, then mortgage interest on a second home is not deductible. If the main residence is less than $750,000, then the tax filer can deduct interest on a second home up to that amount.
For instance, envision your primary residence is valued at $500,000. You decide to purchase a second property for $350,000 as a real estate investment.
In the tax filing, mortgage interest is fully deductible on the primary residence. On the second home, mortgage interest is only deductible for the first $250,000 and not the full amount.
It's important to note that these tax provisions only apply to new homeowners. Those who purchased their home before December 15th are grandfathered in under the previous cap of $1 million.
What Regions Are Impacted the Most?
The changes to the real estate tax deduction affect some areas more than others. The negative impact is greater for coastal states as opposed to middle America.
States along the coast have higher property taxes and home values. This is especially true in dense urban centers like San Francisco and New York City.
In San Francisco, for example, nearly 60% of home loans exceed the new $750,000 threshold. An even greater percentage of homes, nearly 65%, exceeded the deduction threshold in New York City.
The good news is that the vast majority of the nation is unaffected by these limitations. In fact, the median home value in the United States is just over $250,000.
This bodes well for prospective buyers in Colorado. Property taxes and home values are less than the coastal states, meaning plans to purchase a second property should remain unaffected.
Should Changes to the Real Estate Tax Deduction Impact Your Future Investments?
These changes do not look good for homeowners, but the downward adjustments only tell half the story.
You will likely lose money on the changes to the real estate tax deduction. However, reductions in individual tax rates will offset the negative changes.
Thanks to lower individual tax rates, the vast majority of Americans will pay less in federal tax. The Tax Cut and Jobs Act reduces tax rates for both single and married filers.
For example, take a single filer who earns $125,000. Under the old tax code, this person would pay a 28 percent tax rate on these earnings. The new plan reduces the tax rate to 24 percent.
The tax structure is also progressive. This means for the first $38,700, the tax filer pays 12 percent. Under the old tax code, the filer paid 15 percent on the first $38,700. The benefit of reduced rates helps filers throughout all of the tax brackets.
Doubling the Standard Deduction
In addition to lower tax rates, the new tax reform package also doubles the standard deduction.
In the past, the standard deduction for single filers was just $6,350. It's now doubled to $12,000, which reduces the amount of taxable income for every single filer.
For married couples, the standard deduction was previously $12,700. Now, it's increased to $24,000. This essentially means the first $24,000 of earnings is tax-free for married couples.
What Happened to Capital Gains?
When you sell a home, a portion of the proceeds is taxable. This is still true under the new Tax Cut and Jobs Act.
Many of the proposals considered by Congress scaled back this benefit considerably. Congress ultimately left this provision of the tax code unchanged in the new legislation.
Single filers can exclude $250,000 of capital gains on a property sale. Married couples, on the other hand, can exclude $500,000.
The only requirement is that you must have lived in the home for two years over a five-year period.
What Does This Mean for Property Investors?
At first glance, the tax overhaul may influence real estate investors in a negative way. Perhaps investors are dissuaded to make new investments or sell their existing assets.
The reality is that negative changes for homeowners are likely offset by positive changes for individuals. Homeowners will benefit from a doubling of the standard deduction and lower individual tax rates.
States with lower property taxes and home values like Colorado are also less affected than coastal states like California.
The bottom line is that the tax overhaul should not dictate whether or not you invest in real estate. For more information on the real estate tax deduction, please contact us for assistance.