A month ago, in early October, I wrote about the initial outline of Trump tax reform. Looks like at least some of my predictions were on target:
- The proposals keep changing. Hard to trace a moving target.
- Congress is under heavy pressure from all sides, as nobody wants to lose their tax breaks.
- There is no major tax relief for the working families. For many it may get worse.
- Businesses will get some help, but most of it goes to large domestic corporations.
- Personal taxes may indeed become somewhat simpler, mostly because a lot of tax breaks are out.
- However, business taxes are going to be much more complicated and confusing.
- Business owners, real estate investors in particular, will need to adjust and restructure.
As of today, November 12th, we have two unfinished bills, one from the House and another from the Senate. Both are work in progress and eventually will have to be reconciled before becoming a law.
As we’re all waiting to see what the eventual compromise will look like, here’re some interim observations.
Personal itemized deductions are an endangered species
Both current proposals essentially replace the combination of itemized deduction and per-person exemptions with a doubled-up standard deduction. While itemized deductions are not eliminated entirely, doubling of the standard deduction will make itemizing pointless for a lot of people, especially since a lot of familiar itemized deductions will be either limited or completely removed. Which itemized deduction will survive the negotiations is unknown, since the two proposals differ substantially in details.
So, the obvious question here is: will I pay less taxes or more taxes, as a result of this change? Good question. And there is no answer, even if we already had the final proposal. It all depends. If you’re a single guy on a $50k W2 and renting an apartment – you will likely pay less taxes. If you’re a family of four with a combined $100k income and a $200k mortgaged house – you may end up with a larger tax bill than you are used to. Especially if you live in a state with high state income tax.
Elsewhere, individual taxation is a big unknown
The differences between the House and Senate tax plans are very significant. They disagree on everything from tax brackets and rates to eliminating certain deductions and credits to retirement plans and benefits. What will they end up agreeing on? Your guess is as good as mine at this point. A few random observations:
- Everybody wants to kill the stupid AMT. Good. Long overdue.
- A lot of familiar deductions will disappear
- A lot of credits will disappear, too, but their list is not finalized
- The EIC – earned income credit, the federal subsidy for low-income folks – stays
- Education-related credits and tax-deferred accounts are likely to change
- Some rules for retirement accounts may change, too
- Tax-free sales of personal homes may get much more restricted
Business taxes are a YUGE mess
During his campaign, Trump got the attention of business owners by promising a massive tax cut not only for corporations, but “for any business of any size” – to 15%, if anybody remembers. All that sexy talk is history, as expected. What we’re talking about today is 20% for corporations and 25% for part of the income of some of the other businesses. Sounds weird? It is.
For starters, let’s be clear about the fact that the current law uses 3 different systems to tax businesses.
- No business entity and “disregarded” single-member LLCs. Their income is reported on personal tax returns, using Schedules C/E/F. It is taxed at the individual income tax rates, plus self-employment tax (Social Security and Medicare).
- Pass-through entities: partnerships and S-corporations, including most multi-member LLCs. Their income is reported on separate business returns and transferred to the owners via Form K-1. It is then taxed at the owners’ individual income tax rates, either with or without the self-employment tax.
- C-corporations. These are the truly independent entities that report and pay their own taxes. C-corporations are highly complicated, and their owners do not have access to the company’s money, other than by drawing a salary and some benefits.
The 1st group is getting no help from the new tax law, none whatsoever. The 3rd one is getting a major reduction from 35% down to 20%, with some strings attached. This leaves the Pass-Through entities, which is how the majority of small businesses are organized.
What they propose for Pass-Through businesses is a nightmare. Both the Senate and the House versions offer some middle-ground compromises, however with completely ridiculous stipulations. Here is a preview.
- Pass-through income will have a ceiling of 25% tax rate, stopping it from going into the higher individual tax brackets, whatever they will be.
- However, it does not apply to “service” businesses, such as law firms, accounting firms and Realtors. Those will get no relief, as in the current law.
- The rest of the pass-through entities will need to divide their income into two buckets, and only one of the buckets will be eligible for the 25% ceiling.
- The proposed rules for such break-out are opening the door for endless interpretation, manipulation, and eventually IRS audits and litigation. Have fun!
In other words, every partnership and S-corporation business will have to self-identify as being or not being a so-called service business, and then allocate its income based on some poorly defined rules. Oh boy. If you thought that the reasonable salary rules for S-corporations were bad (which they sure were) – they will seem like a walk in the park, in comparison to the new “simplified” tax code.
What’s in store for real estate investors?
I recommend that you read this blog post by my colleague, Brandon Hall, a CPA who also specializes in real estate. Brandon examined the preliminary House version and found a few alarming provisions. One of them was a proposal to remove a current rule that exempts rental income from the self-employment tax. His post triggered some strong reactions in the REI community.
It’s not good news for investors, no argument. However, unlike Brandon, I’m not too alarmed. First, this change (IF implemented) will only affect companies that are designated as “a trade or business.” This term has been often used in the current tax law – but never defined! It led to numerous lawsuits against the IRS, with inconsistent results. Basically, it’s grey area and will likely remain such. Casual passive investors holding rental portfolios should not be affected.
For the investors who have a more active involvement and are concerned that they will now be labeled “a trade or business” – remember that the self-employment tax would only apply if you have positive net income. You take rents, subtract mortgage interest, subtract holding costs like taxes and insurance, subtract operating expenses like repairs and utilities, subtract business overhead such as marketing and driving, and finally subtract depreciation. At that point, most investors have a negative number, so they are not affected.
If you do have positive net income even after depreciation – then the self-employment tax could be a concern. This is why you need a tax accountant like myself who specializes in real estate and can help you structure your business around the new rules.
So, what can we do to prepare?
Not much, because there’s nothing solid yet about the tax reform. The following suggestions are gambling on what might happen. They may turn out to be smart moves – or they may completely fail and even backfire. Proceed at your own risk.
- If you’re planning to sell your house, see whether you can sell it before the end of the year. It may not be enough time, but if you can pull it off – maybe you could benefit from the current liberal rules before the new rules kick in. If you lived in your house for more than 5 years, then you’re probably safe either way.
- If you’re about to receive significant chunk of money, like a year-end bonus, last-minute commissions, year-end option exercise, etc. – see if you can safely defer it until January. The key word is safely. No tax savings will compensate you for a lost deal or bonus. Never let tax considerations override business decisions.
- If you’re planning to buy expensive business assets, such as vehicles or intellectual property – you may want to wait until January, too. Like all the other suggestions, this one is speculative and may even end up being a bad idea. Remember, at this point we’re feeling out the way while blindfolded.
- If you do not operate through an LLC or treat your LLC as a disregarded entity, this may need to change for 2018. Form an LLC if you have not yet, and then consult a good tax accountant (hint, hint) about which tax classification is best for your LLC. Wait until the dust settles though, so we have a better idea of what to expect.
Changes are coming, possibly major ones. Make sure to get quality help from us tax professionals!