How the Tax Law Affects Rental Real Estate Owners

by Billy Litz, CPA

Do you own residential or commercial rental real estate? The Tax Cuts and Jobs Act (TCJA) brings several important changes that owners of rental properties should understand.

In general, 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.

Unchanged Write-Offs

Consistent with prior law, you can still deduct mortgage interest and state and local real estate taxes on rental properties. While the TCJA imposes new limitations on deducting personal residence mortgage interest and state and local taxes (including property taxes on personal residences), those limitations do not apply to rental properties, unless you also use the property for personal purposes. In that case, the new limitations could apply to mortgage interest and real estate taxes that are allocable to your personal use.

In addition, you can still write off all the other standard operating expenses for rental properties. Examples include depreciation, utilities, insurance, repairs and maintenance, yard care and association fees.

Possible Deduction for Pass-Through Entities

For 2018 and beyond, the TCJA establishes a new deduction based on a non-corporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a partnership, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.

While it isn’t entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable rental real estate activity that you own through a pass-through entity. The unanswered question is: Does rental real estate activity count as a business for purposes of the QBI deduction? According to one definition, a real property business includes any real property rental, development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing or brokerage business. Stay tuned as we await more clarity from the IRS.

New Loss Disallowance Rule

If your rental property generates a tax loss — and most properties do, at least during the early years — things get complicated. The passive activity loss (PAL) rules will usually apply, unless you are a materially participating real estate professional.

In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you 1) have sufficient passive income or gains, or 2) sell the property or properties that produced the losses.

To complicate matters further, the TCJA establishes another hurdle for you to pass beyond the PAL rules: For tax years beginning in 2018 through 2025, you can’t deduct an excess business loss in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:

1. Your aggregate business income and gains for the tax year, plus

2. $250,000 or $500,000 if you are a married joint-filer.

The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.

Important: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental real estate loss, you don’t get to the new loss limitation rule.

The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental real estate) to offset income from other sources (such as salary, self-employment income, interest, dividends and capital gains). The practical result is that the taxpayer’s allowable current-year business losses (after considering the PAL rules) can’t offset more than $250,000 of income from such other sources or more than $500,000 for a married joint-filing couple.

    Loss Limitation Rules in the Real World
    Dave is an unmarried individual who owns two strip malls. In 2018, he has $500,000 of allowable deductions and losses from the rental properties (after considering the PAL rules) and only $200,000 of gross income. So he has a $300,000 loss. He has no other business or rental activities.

    Dave’s excess business loss for the year is $50,000 ($300,000 – the $250,000 excess business loss threshold for an unmarried taxpayer). The $50,000 excess business loss must be carried forward to Dave’s 2019 tax year and treated as part of an NOL carryforward to that year. Under the TCJA’s revised NOL rules for 2018 and beyond, Dave can use the NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.

    Important: If Dave’s real estate loss is $250,000 or less, he won’t have an excess business loss, and he would be unaffected by the new loss limitation rule.

Need Help?

The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule). At this point, how to apply the TCJA changes to real-world situations isn’t always clear, based solely on the language of the new law.

In the coming months, the IRS is expected to publish additional guidance on the details and uncertainties. Snyder Cohn will keep you up to date on developments as they become available.

Changes to Employer Provided Transportation Benefits

by Greg Yoder

One of the many provisions in the new tax law is a disallowance of any deduction for certain employer-provided transportation benefits, including employee parking.

Under the old law, provided certain requirements were met, if an employer paid for an employee’s parking, the employee would not have to report any income for the benefit, and the employer would get a deduction for the amount paid.

Under the new law, employees can still exclude the income for these “qualified transportation fringes,” but employers can no longer take a deduction. This provision means that employers face the choice of either (a) not providing the benefit, or (b) paying more for it. The disallowance affects even non-profit employers: the new law makes any amounts paid for employer-provided parking (and other excludable transportation benefits) subject to Unrelated Business Income Tax (UBIT).

Some commentators who are knowledgeable in the area of benefits taxation have suggested that there may be a workaround to this problem. They believe that putting parking benefits inside a salary reduction arrangement (SRA) may maintain both the employee exclusion and the employer deduction.

An SRA works by offering the employee the choice between the actual receipt of compensation and the provision of a benefit. In this case, for example, assume that an employer has an employee who, in 2017, received monthly compensation of $5,000. In addition, the employer paid $150 each month for the employee’s parking. In 2018, to put the employee in the same position and implement a salary reduction agreement, the employer would increase the monthly compensation to $5,150. The employee could either receive the entire $5,150 (less the other normal withholding amounts, such as employment and income taxes) or could reduce her salary to $5,000 and take the employer-provided parking benefit on a pre-tax basis, much like a 401k deferral.

The theory here is that by moving the parking benefit to an SRA, the $150 paid by the employer for parking effectively becomes deductible compensation, rather than a nondeductible benefit.

It’s not clear to us that this approach works. The new law added provisions to make employer-provided parking nondeductible, but it also left in place the old provision that allowed parking to be provided under an SRA. We hope that there will be additional guidance from IRS resolving the issue.

Regardless, many employers will find it difficult to stop paying for their employees’ parking, and if the SRA approach does work, then implementing an SRA will reduce the employer’s tax burden. Additionally, a parking SRA is neither expensive nor difficult to implement. An employer who feels compelled to provide parking for its employees has little to lose by implementing an SRA.

Technical Requirements

In order to provide parking under an SRA, IRS regulations have a number of requirements. We’ve attached a sample election, but any format is acceptable provided it meets IRS requirements:

  1. The election needs to be in writing. “Writing” in this case also includes electronic formats, subject to additional requirements. The election has to include:
      2. a. The date of the election
      b. The amount of the compensation to be reduced
      c. The period for which the benefit will be provided
  2. The election can be automatic. In other words, an employer can provide that the benefit will be deemed to have been elected unless the employee affirmatively elects to receive the cash compensation instead. In order to make the election automatic, you must provide employees with adequate notice that there will be a compensation reduction, as well as adequate opportunity to choose the cash compensation instead.
  3. The monthly benefit can’t exceed the statutory amount. This amount changes each year and is $260 per month in 2018. Any excess over this amount will be taxable to the employee and nondeductible to the employer.
  4. The election must be made before either the benefit or additional compensation can be provided. In other words, if you already paid for January 2018 parking in January, the election won’t be effective until February.
  5. The election can’t be revoked once it’s made for a given period if that period has started. As an example, if an employee elects in January 2018 to receive the parking benefit beginning in February 2018, the employee can still revoke the election until the end of January. But once February starts, and the employee is eligible to use the parking benefit, a February revocation wouldn’t be effective until March. Similarly, if the same employee continues to receive the benefit until, say, September, a revocation in September would be effective in October.

If you have any questions regarding this matter, we’d love to discuss them with you.