New Rules for Reits
With a few exceptions, the new tax law is favorable for REIT investors. The effective federal tax rate, on ordinary REIT dividends, has shrunk from 29.6 percent to 37 percent for individual taxpayers because REIT shareholders are now eligible for the new 20% pass-through deduction. Unit-holders may need additional information such as asset acquisition and wage information to determine if there are any deduction limitations. Investors and their tax advisors should carefully scrutinize REIT K-1s to make sure that they correctly account for limitation information on the investors’ individual income tax returns.
The new tax law retains the depreciable lives of 39 and 27.5 years for nonresidential and residential rental property, respectively. Many REITs can now expense qualified new and used improvements, which is a significant tax benefit for REITs and may favorably impact returns to investors. The Section 179 deduction is $1 million in the new tax law with a phase-out threshold amount to $2.5 million. The new law also defines qualified real property eligible for section 179 expensing to include: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems.
Several provisions in the new corporate tax law will also help REIT investors. The reduced corporate tax rate of 21% will benefit REITs that don’t distribute all of their income and those which have taxable REIT subsidiaries. While REIT NOLs carryovers will be reduced, the new rules allow NOLs to be carried forward indefinitely. Previously, REIT NOLs could only be carried forward 20 years.
Capital gains are still taxed at a maximum rate of 23.8%, including the Net Investment Income Tax. Taxpayers in the lower tax brackets continue to pay no tax on long-term gains on most assets. Capital losses may continue to be used to offset $3,000 of other income. The unused portion of a capital loss may be carried forward.
$250,000 of gain on the sale of principal residences remain tax free for single taxpayers and up to $500,000 for married taxpayers filing jointly. Taxpayers may also exclude up to 50 percent of small domestic C corporation capital gain as long as the stock held for more than five years.
Tax-lot Selling rules Survive
Investors won big when the proposed first-in-first-out rule on stock sales was eliminated from the final tax bill. The first-in-first-out, or FIFO, method, would have taxed individual investors based on the sales price less the purchase price of the first shares they bought and would have eliminated the flexibility to choose which lot to sell. The net result would have been that investors would take a tax hit on those stock sales because the oldest shares tend to have the gains.
“Qualified dividend” tax rates remain lower than rates on ordinary income. A qualified dividend must be issued by a U.S. corporation, or by a foreign corporation that readily trades on a major U.S. exchange, or by a corporation incorporated in a U.S. possession. It is usually most tax-efficient to hold funds or stocks which produce qualified dividends within non-retirement accounts, outside of your IRA, Roth IRA, or 401(k).
When a mutual fund receives a qualified dividend, the dividend will maintain its qualified status when passed through to shareholders. Active traders should track their holding periods carefully to benefit from the qualified dividend tax treatment.
Investment Expenses Not Deductible
The tax deduction for investment fees and expenses has been repealed, and, unfortunately, investment newsletters fees are no longer deductible. These changes may make commission-based trading accounts more appealing. Remember that fees paid to manage a tax-exempt bond portfolio and fees paid using IRA assets were never deductible. Also, only amounts more than 2% of adjusted gross income, and not limited by AMT, were deductible.
Domestic Mutual Funds
Mutual funds deduct their management fees before distributing any investment income to individual investors. Therefore mutual fund income may be higher versus a managed portfolio because investment fees are no longer deductible in a managed portfolio. Lower corporate tax rates may also help mutual fund net returns. Many mutual funds bundle most of their payouts into single, net distributions at the end of each year.
Annuities are contracts for lump-sum payments in exchange for income for a lifetime income stream. The new tax law reduces annuity issuer’s ability to deduct reserves from taxable income, but it includes a reduction in corporate rates, which will likely reduce annuity issuer’s overall tax bills. Also, some annuities have “deferred tax assets,” stored-up tax deductions, because of losses they suffered in 2009 and 2010. Annuity issuers may pass at least some of these tax savings on to customers this year.
The new $10,000 deduction limit on state income taxes make muni bonds more attractive. However, the new tax law eliminates the ability to exchange muni bonds before they are due to mature, which will limit bond issuance. But lower corporate tax rates may make muni bonds less attractive to banks and insurance companies. Also, keep in mind that some activities do not fall under muni bonds tax exemption.
Rental Real Estate
The new pass-through deduction will benefit landlords, LLCs, and S-Corps generating qualified business income. Rental properties with net income after amortization and depreciation will receive a 20 percent deduction on net income or a 2.5 percent deduction on your property’s unadjusted basis.
A 1031 Exchange, which has been part of the tax law for almost 100 years, allows real estate investors to exchange property for a “like-kind” property without paying taxes immediately on the gain. Exchanges of personal property, collectibles, aircraft, franchise rights, rental cars, trucks, heavy equipment, and machinery remain taxable transactions.
Under the previous tax rules, the bonus depreciation deduction was limited to 50% of the eligible new property. The new tax law allows bonus depreciation and immediate deduction of 100% of eligible property placed-in-service after September 27, 2017, and before January 1, 2023.
Section 179 property includes specific depreciable tangible personal property improvements made to nonresidential real estate, such as roofs, air-conditioning property, fire protection and alarm systems and security systems. The deductible amount has doubled, from $500 thousand to $1 million, which is great news for commercial and short-term rental owners. When 100% first-year bonus depreciation isn’t available, the Sec. 179 tax deduction provides similar benefits.
Alternative Minimum Tax
The new tax law reduces the burden of the alternative minimum tax (AMT) on investors. The AMT rate, 28 percent, applies to the excess of $191,500 for all married taxpayers or $95,750 for singles. The new tax law phases out AMT exemptions at 25 cents per dollar earned once taxpayer income hits $500,000 in AMTI for single filers and $1 million for married taxpayers filing jointly.
Converting a traditional IRA to a Roth between retirement and age 701/2 could help reduce your tax bill significantly later. Roth gives retirees tax-free withdrawals and no required distributions. Accelerating income between retirement and age 70 ½ can help smooth out tax brackets, avoid alternative minimum taxes, and reduce Medicare premium rates and capital gains taxes on investment income.
This is just the barest scratching of the surface of the new tax law. For your individual tax benefits you should have your entire tax situation analyzed by an experienced tax professional.