Understanding Current Tax Implications for Real Estate Investing

By Lisa M. Borrelli, CPA | Published: September 2022

With stock market volatility continuing, many investors are looking for alternative strategies. Limited supply and Americans looking for more space or new locations during the pandemic led to red-hot housing markets, leading many investors to consider real estate.

But increasing headlines of tax reform and tax legislation change can make it hard for ordinary Americans to know what is still on the table by way of tax implications and planning opportunities.

Understanding Current Legislation’s Impacts
When considering expanding an investment portfolio with second or third personal use properties, it is important to understand the impacts of the 2017 Tax Cuts and Jobs Act (TCJA). Potential tax advantages of owning property include being able to reduce taxable income through itemized deductions. The TCJA limited itemized deductions for state and local taxes to a maximum $10,000¹. If an investor’s combined state and local wage taxes and property taxes on their primary home exceed $10,000, they will not receive any additional tax benefit by way of itemized deductions for the property taxes of the new investment.

The TCJA also limited mortgage interest expense to that of a $750,000 mortgage value (after 12/15/2017)². For investors with multiple properties, this rule does not mean $750,000 per mortgage, but in total. Depending on an investor’s financial position, the increased expense of property ownership without the income tax benefits of deducting those expenses may create unanticipated financial stress.

Other Considerations for Rental Real Estate
When property is purchased for business use, i.e. rental properties, the expenses incurred with ownership are able reduce rental income earned from the property directly. There are also instances where investors who are active in their ownership of rental real estate and adjusted gross income on their tax return is below $100,000 can take up to $25,000 annually as a loss against ordinary income.³

You may be thinking, “why would investors look to own rental real estate if they will be losing money?” Thanks to depreciation, the initial investment made may be taken as an expense over the life (27.5 years) of business use property reducing the rental income. This is what is commonly referred to as a paper loss. On the tax return, a loss is being recognized but, in the market, the property may have appreciated.

How Does Depreciation Work?
Depreciation is not “free money,” but a deferral of income to a future event. Depreciation is turning your tax basis, or the value you paid for a property with after-tax dollars from earnings and making them pre-tax. When the rental property is eventually sold, the IRS will come back to collect on the losses previously taken as expenses by recharacterizing them as income.

This occurs because income earned on the sale of stock or an investment property (when held longer than 1 year) is viewed as more tax efficient given the lower tax tables applicable to qualified investment income compared to income we earn as wages (ordinary income). Depreciation reduces rental income, which is taxed as ordinary income. When the property is sold, the IRS says owners cannot receive capital gains tax benefits today for deductions that reduced ordinary income yesterday.

Determining when to sell can be difficult if holdings have appreciated on depreciated property as investors do not want to realize the income and pay tax associated with the sale. Real estate investors can utilize 1031 Exchanges to continue to push the taxable event down the road. 1031 Like Kind Exchanges allow investors to carry both the capital gain and the recapture of depreciation to the purchase of a new investment that is deemed to be similar in nature. There are rules to meet 1031 Exchanges can be very strict and there has been discussion of further limiting their availability, with some wanting to remove them all together. At this time, no legislation has been passed altering 1031 Exchanges.

Tax law is very complicated, the rules are ever changing, and each taxpayer’s situation is unique. If you are considering an investment in real estate and are unsure how it will affect your personal facts and circumstances, seeking the advice of a professional is always recommended.

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1. H.R. 1 - 115^th Congress (2017-2018) SEC. 11042
2. H.R. 1- 115^th Congress (2017-2018) SEC. 11043
3. U.S. Department of the Treasury, Internal Revenue Service. (2021). Publication 527: Residential Rental Property (Cat. No. 15052W). Chapter 3, “Exception for Rental Real Estate With Active Participation”

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About the Author - Lisa M. Borrelli, CPA
Lisa Borrelli is a Wealth Planner at West Capital Management, a subsidiary of WSFS Financial Corporation. In her role, Lisa works with clients on a variety of planning areas such as income tax and liability exposure, business planning, and trust and estate planning. Lisa is currently pursuing her Masters in Taxation (M.T.) at Villanova University and earned her B.S. in Accounting from the Haub School of Business at Saint Joseph’s University. Lisa can be reached at lborrelli@westcapital.com.

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