The Tax Cuts and Jobs Act closed out 2017 introducing many unknowns to the American taxpayer. While a full version of the bill is not available as of this writing on January 15, 2018, many news organizations have released general summaries of its contents. Unfortunately, there is still an element of incomplete and incorrect information in these summaries that will exist until the bill is fully released. What follows is an understanding of the publicized information, but it comes with the caveat that this information is subject to change when the full bill becomes available.
As information slowly emerges on the bill’s contents, the obvious question arises:
How does this affect me?
Owners of rental properties are likely to see significant benefits under the new tax bill. Whether your rental property is a portion of your home, a property you rent for a portion of the year or a year round property, there are benefits under the new plan. More importantly, it appears that many of these benefits may not require a significant restructuring of your rental business or a change to how you file your tax return(s).
Real Estate Tax & Mortgage Interest
At the end of 2017, many individuals rushed to pre-pay their 2018 Real Estate taxes knowing that a new limit on individual deductions would reduce the benefit of payment in 2018.
For owners of rental properties, the deductibility of that property’s Real Estate Taxes and Mortgage Interest remains the same.
- Real Estate Taxes and Mortgage Interest are both fully deductible as an expense of the rental provided the property is used exclusively as a rental property.
- Real Estate Taxes and Mortgage Interest are both partially deductible as an expense of the rental if a portion of the property is used as a rental or if it is rented for a portion of the year.
Pass-through income arises when business profits (in this case, from vacation rental income) pass through the business to be taxed on one’s personal tax return. The pass-through income benefit is one of the most significant components of the Tax Cuts and Jobs Act. It also happens to be one of the most under reported components. The benefit gives eligible taxpayers a 20% deduction on qualified pass-through income. Eligibility for this deduction varies by business field, but our understanding, at the time of this posting, points to Rental Income (defined as actual income minus allowable expenses) as qualifying as pass-through income.
The pass-through income benefit does carry with it a threshold or “phase out” that limits many industries from taking advantage of the 20% deduction. Our understanding is that rental income does not “phase out” but rather is subject to a different calculation upon hitting the threshold.
The threshold is tied to your taxable income, not your adjusted gross income. In 2017, taxable income is on page 2 of the 1040 return, line 43. The thresholds are as follows:
- $157,500 for Single filers
- $315,000 for Married Filing Joint filers
So, what does all this mean?
In short, the new plan potentially saves vacation rental homeowners money regardless of whether they have property set up under an S-Corporation, a Partnership, or on Schedule E of their individual tax return.
The extent of the savings will vary depending on an individual’s or a couple’s other income.
- Scenario 1: If an individual’s or a couple’s rental income is less than their taxable income and they are below the phase out range, they will receive the 20% pass-through deduction on their rental income.
- Scenario 2: If an individual or couple’s rental income is greater than their taxable income and they are below the phase out range, they will receive the 20% pass-through deduction on their taxable income.
The examples below further explain the corresponding scenarios above:
- Scenario 1: Joe and Jane rent half of their house and report the income from that rental on Schedule E. In 2018, they anticipate a net profit of $24,000 of rental income. The couple has other income that brings their taxable income to $224,000.
Joe and Jane’s rental income ($24,000) is less than their taxable income ($224,000). They will be eligible for a pass-through deduction of $4,800 ($24,000 x 20%) on their rental income. At their tax rate of 24%, this deduction will reduce their total tax liability by $1,152.
- Scenario 2: Susan rents two buildings and reports the income from the two rentals on Schedule E. In 2018, Susan anticipates a net profit of $150,000 of rental income. Susan has no other income, and she will use the new $12,000 standard deduction as a single filer. Since the Tax Cuts and Jobs Act also removes personal exemptions, Susan’s taxable income will be $138,000 ($150,000 less the $12,000 standard deduction).
Susan’s rental income ($150,000) is greater than her taxable income ($138,000). She will be eligible for a pass-through deduction of $27,600 ($138,000 x 20%) on her taxable income. At her tax rate of 24%, this deduction will reduce her total tax liability by $6,624.
The calculations for individuals and couples with taxable income above the threshold are more complex. If you exceed the thresholds, your deduction is the LESSER of:
- 20% of your Qualified Business Income (rental income)
- The GREATER of:
- 50% of W-2 wages paid to employees
- 25% of W-2 wages paid to employees PLUS 2.5% of the unadjusted asset basis
Consider the following example to explain the calculation:
- Bill purchased a rental property 5 years ago for $500,000 (unadjusted asset basis).
- Bill has a single W-2 employee that makes $25,000 a year.
- Bill earns $100,000 in income a year from the rental property.
- Bill has another job where he makes $350,000 income.
As a single filer, Bill is above the $157,500 threshold for total income, so his deduction will be determined as the LESSER of:
- 20% of his rental income ($100,000 x 20% = $20,000)
- The GREATER of:
- 50% of W-2 wages paid to employees ($25,000 x 50% = $12,500)
- 25% of W-2 wages paid to employees PLUS 2.5% of the unadjusted asset basis ($25,000 x 25% = $6,250 PLUS $500,000 x 2.5% = $12,500, $6,250 PLUS $12,500 = $18,750)
Bill’s deduction would be $18,750 in this scenario.
The pass-through deduction will first appear on your 2018 tax return (which would be due April 15, 2019). Like many other changes to the tax code, this deduction is set to expire at the end of 2025.
As stated at the beginning of this article, a full version of the Tax Cuts and Job Acts is not currently available to the public, and the preceding information comes with the caveat that this information is subject to change when the full bill becomes available.
Should you have additional questions about how the bill may affect you, I am available via e-mail at firstname.lastname@example.org.