The 2018 year has started and with it we have new tax laws! Now, I’m not a licensed CPA or enrolled agent with the IRS, but I can inform you on how these new laws affect mortgage and real estate. You should be very strategic on how you handle your largest debt (mortgage) based on your individual and financial goals. I’m here to give you information on how 5 new tax laws could potentially impact your home buying and refinance strategies.
#1. New Tax Brackets –The first change to look at are the new tax brackets. In our country, we pay different tax rates on different levels of income that we earn. These tax rates are called “marginal tax brackets”. For example, assume that I’m married filing a joint tax return. If our income is $200,000 our tax bracket would be 24%. Not all my money is taxed at 24%. I’ll pay 10% on the first $19,050, 12% on the income earned from $19,051-$77,400 and so on. The highest tax rate I pay on the last dollars of income I earn from $165,001-$200,000 is at 24%.
2018 Marginal Tax Brackets
Knowing your highest marginal tax bracket is important because you use it when you calculate the tax benefit of homeownership. This is because the mortgage interest deduction comes off the last dollar of income you earn. In my example with the $200,000 of income, if you assume $20,000 of mortgage interest, the 24% tax would change because the taxable income is reduced to $180,000 instead of $200,000 due to that $20,000 in mortgage interest deduction. Then I’d only be paying 24% on $165,001 – $180,000.
#2. Standard Deduction- The second change that happened with the new tax law is that the standard deduction was doubled. In fact, individual taxpayers now have a standard deduction of $12,000 and married couples filing a joint tax return have a standard deduction of $24,000. This rather large increase in the standard deduction means that less people will choose to itemize their tax deductions moving forward. If your itemized deductions (including mortgage interest and property taxes) are less than your standard deduction, you may as well just take the standard deduction… no need to itemize in that case. However, if your itemized deductions are greater than your standard deduction, you would likely want to itemize instead. If you itemize, you would be able to take a tax deduction for your mortgage interest and property taxes.
#3. SALT- The third change that occurred with the tax law is that the allowable deduction for state and local taxes was capped. If you itemize, you can take a federal income tax deduction against the property taxes that you pay at the city, county or state level. However, the new tax law caps the total allowable state and local tax (SALT) deduction at $10,000. This means that if your property taxes are $15,000 per year, you can only deduct $10,000 of those property taxes against your income when you file your federal tax return. This again reduces the incentive for people to itemize.
State & Local Taxes (SALT)
#4. Real Estate Rental Income– Another change of the new tax law is that many real estate investors will now receive a tax deduction for up to 20% of the income they generate from real estate! In the past, real estate rental income was taxed at the ordinary income tax rates. That’s still the case. However, the new tax law treats real estate rental income as “pass-thru” income, and allows investors to deduct up to 20% of their “pass-thru” income.
Here’s an example for an investor who earns $200,000 per year (married filing jointly). Under the old rules, if the investor earns $10,000 in taxable income from real estate, their taxable income would be $10,000. Taxed at 28% (the tax rate for an investor in this situation in 2017), the tax bill would be $2,800. Under the new rules, if the investor earns $10,000 in taxable income from real estate, they would receive up to a 20% ($2,000) tax deduction. Their taxable income would be $8,000. Taxed at 24% (the tax rate for an investor in this situation in 2018), the tax bill would be $1,920.
Real Estate Rental Income Example for Investor Earning $200,000/year
The 20% tax deduction is generally what many investors will experience. However, the actual tax deduction could be less depending on the individual investor’s tax situation. In some case, this deduction is limited, capped or phased out. It’s outside the scope of this blog to get into all the specifics. Each investor will need to check with his/her CPA for specific details. The reason why we mention it is because this is potentially great news for real estate investors!
#5. Mortgage Interest Rate Deduction– There were some additional changes made to the mortgage interest deduction. Prior to 2018, taxpayers who were not subject to paying Alternative Minimum Tax (AMT) were able to deduct the interest on up to $100,000 of “home equity indebtedness” – this is basically cash-out mortgage proceeds that were NOT used to buy, build or improve the house. In 2018, this is no longer tax deductible. The ONLY type of mortgage interest that is deductible is interest on “acquisition indebtedness”, which is basically mortgage proceeds that ARE used to buy, build or improve a house. The limit on acquisition indebtedness was reduced from $1,000,000 to $750,000
Mortgage Interest Deduction
A taxpayer can deduct the interest on up to $750,00 of mortgage balances used to buy, build or improve a qualified home (one primary home + one vacation home). The $750,000 is aggregate total on both qualified homes. This is important to think about for any refinance.
Here is an example of this new rule with a refinance. Assume you purchase a property for $500,000 using a $100,000 mortgage. You later reduce the mortgage balance to $50,000 through amortization and by making extra principal payments. Then, you decide to refinance into a $400,000 mortgage using a cash-out refinance and you’re not using any of the funds for home improvements. In this case, the interest on the first $50,000 would be deductible as Acquisition Indebtedness Interest. That’s because you’re using those funds to pay off your original acquisition mortgage. The interest on the next $350,000 would not be tax deductible at all because you’re not using the funds for home improvements.
When doing a cash-out refinance to fund home improvements, there are also three tax rules you should know about to stay within the deductible acquisition indebtedness clause. The IRS requires the project to be a “Substantial Improvement” that 1. Adds to the value of the home, 2. Prolongs the home’s useful life, or 3. Adapts the home to new uses. For example, painting a room may not qualify, but an addition or new kitchen may qualify.
There is a look-back and look-forward period for your home improvements to qualify for acquisition indebtedness deduction too. There is a 24-month look-back period if you pulled cash out to reimburse yourself for improvements already made. You also have a 12-month look-forward period if you are pulling cash out in order to make improvements to the home. Those home improvements would have to be completed within the following 12 months of pulling the cash out of the home. In all these cases, you’ll need to show receipts in case of an audit.
#6. Lifetime Exclusion from Gift Tax- The final change I’m going to discuss is the change that was made to the lifetime exclusion from gift tax. In 2017, the annual gift tax exclusion limit was $14,000, and it went up to $15,000 in 2018 (not because of new tax law, but because it was already scheduled to go up). However, the lifetime gift tax exclusion was pretty much doubled.
The federal government gives each of us an allowance to gift anybody $15,000 per year without incurring any gift tax. This $15k/year replenishes every year, and it’s $15k per person. So, theoretically, I could gift every person reading this blog $15,000 today, and then another $15,000 next year and the year after, and there would be NO gift tax.
What most people don’t realize, is that there’s a second allowance of $11.2mm! This is called the “lifetime exclusion”. In other words, let’s say that I want to give you $115,000. That’s $100,000 more than what I can give you with the annual exclusion. That’s not a problem at all, because I also have this Lifetime Exclusion. If I use any of my Lifetime Exclusion during my lifetime, I simply reduce my estate tax exclusion by that amount. If I gift you $100,000 using my “lifetime exclusion”, I won’t have to pay any gift taxes on that money. My estate tax exclusion would simply be reduced by that same dollar amount. My remaining estate tax exclusion in this case would then be $11.1M.
In other words, the Lifetime exclusion bucket is used for both gift and estate tax purposes. So every time I use it to not pay gift taxes, I’m also reducing my estate tax exclusion… that’s how and why the gift tax and the estate tax are related to one another.
Also, keep in mind that I can “port” over my $11.2M to my spouse if I’m married.
So technically, a married couple have a total joint exclusion of $22,400,000. Therefore, if you are a married couple who have a net worth of less than $22,400,000, there is absolutely no reason whatsoever for you to concern yourselves with the gift tax. Even if you gift your entire net worth during your lifetime, they would pay $0 in gift taxes and their heirs would pay $0 in estate taxes. I see gift funds being used in real estate transactions all the time and the gift tax question always comes up. This will hopefully explain why the gift tax is really a non-issue for most people. Especially after the more than doubling of the lifetime exclusion.
I know this has been quite a bit of information, but I want to make sure you are all informed of the changes that will affect your 2018 tax return and strategic financial planning for this year. Hopefully you learned a thing, or 6, that you can apply to your life, or can use to sound super smart at your next dinner party.