Most people would agree that the US tax code is too complex and should be simplified. Once you move from the general concept of simplification to the execution is where the difficulties occur. Personal self-interest favors keeping tax deductions one qualifies for while eliminating deductions of one’s neighbor.
Mortgage Interest Deduction
Tax deductibility of mortgage interest has been favored by the real estate industry for, what seems like, forever. Actually, it dates back to 1913 and most consider it sacred and not to be touched by any reforms. The current proposal leaves it in place, but ineffective or irrelevant, to all but the wealthiest Americans.
President Trump’s tax overhaul plan removes every deduction except for the home mortgage interest deduction and charitable contributions. Many experts argue, nonetheless, the plan effectively makes both these deductions irrelevant by doubling the standard deduction to $12k for single tax payers and $24k for married couples. No longer would state and local taxes be deductible. Effectively, over 80% of homeowner’s who itemize under the current tax system would see a greater benefit by taking the standard deduction under the new plan.
For example, a couple with a $500k mortgage (which is much higher than average) at 4% interest would pay about $20k in interest. That couple would then have to donate $4k to charities to match the standard deduction under the new plan. Fewer homeowners would choose to itemize deductions as the standard deduction would be more beneficial. This would effectively eliminate the incentive to buy homes and donate to charities. Many experts believe this could further decrease the US homeownership rate, which is currently 63% down from 69% in 2004.
Is the US destined to become a nation of renters?
The National Association of Realtors suggest most middle income homeowners who currently itemize would likely pay higher taxes due to the elimination of state and local tax deduction and dependency deductions that would be folded into the higher standard deduction.
A recent Fortune article states it a little differently, “The elimination of mortgage-related tax savings for most homeowners, and reduction for others, compounded with the loss of tax savings from deducting property taxes means the after-tax cost of home ownership will increase. A taxpayer in the 25% tax bracket with $11,000 in mortgage interest and $5,000 in real estate taxes would receive tax savings from these itemized deductions of $4,000, or $333 per month, under the current law. The elimination of the home-ownership tax subsidies means that the after-tax cost of home ownership will increase”.
Rental property owners will likely continue to enjoy favorable tax benefits.
While the proposal does not have all the details specified, it does not appear to reduce the tax subsidies benefiting owners of residential rental real estate.
Residential rental property owners and vacation rental property owners may continue to deduct mortgage interest paid to purchase the rental property and can also deduct state and local property taxes. These items are not considered itemized deductions but are deductions in computing net rental income.
Eliminating the state and local tax deduction under the proposal only applies to an individual taxpayer’s itemized deductions. Rental property owners will still receive the federal tax savings from both mortgage interest and real estate taxes. Clearly, the proposal creates a stark difference in the tax treatment and incentives between owner-occupied homes and rental properties.
Furthermore, rental property owners can also deduct the cost of maintenance and depreciation. When it comes time to sell, the rental property owner can use a 1031 exchange and avoid taxes on the sale and acquiring a like property. The proposals reduced tax rate of 25% for pass through will further benefit real estate rental industry.
Individual Tax Rates
Tax brackets under the new plan would also be reduced from 7 currently to 4. The top tax bracket would be reduced from 39.6% to 35%. Next, there would be a 25% and 12% bracket. The fourth bracket in the plan was not described in detail but would be for the highest income households and exceed the 35% bracket.
The alternative minimum tax and estate tax would be eliminated from the tax code.
The plan did not define tax treatment for dividends or long term capital gains, or the profit on the sale of one’s primary residence.
The gift tax was also not mentioned in the proposed tax plan. Gift taxes are payable on gifts of more than $14k annually. “Gifts” are commonly used by first time homebuyers.
Changes in taxes for small or family owned businesses was included in the plan but not well defined. Some of these are organized as flow through businesses or pass through (sole proprietorship’s, partnerships or S Corporations) but it is unclear if all business structured as such would have a 25% maximum tax rate or if it would only be limited to an organization that meets criteria for “small” or “family owned”. It could also be defined with a revenue limit. Many legislators have previously indicated that “professional service” companies like healthcare, legal, accounting would not be eligible for the 25% maximum rate.
The Corporate tax rate is to be reduced to 20% in the proposal. This is believed to work as an incentive to keep companies in the US instead of moving profits offshore. However, labor and raw material costs would have to be competitive to wipe out the incentive to operate globally in the most efficient manner.
The tax proposal would like to create incentives for companies to invest in new assets by allowing full depreciation or immediately expensing to lower taxable income. While all eligible assets were not specified, structures were specified, which is believed to mean buildings. If borrowed funds are used to purchase new assets and then the assets are depreciated immediately then the interest expense would not be deductible.
The tax proposal does keep the low-income housing credit to continue to provide an incentive to developers to build affordable housing.
Tax planning and preparation can be complicated, hopefully tax reform will simplify the process for most Americans. In the meantime, it is always best to consult with an expert in this area for specific advice that considers your exact circumstances. The Eillu team has decades of experience selling real estate on the Outer Banks and have insight to structure 1031 exchanges and more complicated deals. Schedule an appointment today to learn how to maximize the profit on the sale of your home with our low real estate listing commission.