The year 2017 was a dramatic time for investors. The stock market rose by about 40%, swelling most investor portfolios and retirement savings. The Tax Cuts and Jobs Act of 2017 (TCJA) made sweeping changes in many tax rules, but it will take time to determine precisely how they will impact investors. It is, however, clear that now is a good time for investors to reassess their holdings, factor in the new tax rules, and determine what to do going forward.
Capital Gains and Qualified Dividends
The TCJA did not change the basic rules for taxing net capital gains and qualified dividends. The same long-term capital gains rates—0%, 15%, and 20%—continue to apply. Because of the reduced tax brackets for individuals, however, the tax on this investment income will be lower.
The breakpoints for the zero and 15% rates are based on the same breakpoints under current law, but are indexed for inflation for tax years beginning after 2017 (chained consumer price index for urban consumers, C-CPI-U). Applying this new rule for the breakpoints, the 0% rate on net capital gains and qualified dividends essentially applies to those in the 10% and 12% regular income tax brackets (compared with 10% and 15% under prior law); the 15% tax rate applies to those in the 22%, 24%, 32%, and 35% tax brackets (compared with 25%, 28%, 33%, and 35%); and the 20% rate applies to those in the top tax bracket of 37% (compared with 39.6%).
Investors who acquire shares of stock at different times and sell off part of their holdings can identify the shares being sold (“the specific identification method” for determining basis). This can favorably affect capital gains or losses, according to the investors’ choosing. For example, an investor may have an overall gain but realize a loss by selling specific shares that can then offset other capital gains. There had been a proposal to impose a first-in-first-out (FIFO) rule for such sales, but it was not included in the final package. Investors can continue to use the specific identification method for sales; however, the FIFO rule remains the default rule for determining the basis of shares sold.
Deductions for Investment Expenses
Deductions that could previously be claimed for certain investment expenses no longer apply. The miscellaneous itemized deduction for investment expenses and tax preparation costs on Schedule A of Form 1040 has been repealed.
Those with real estate investments may benefit considerably from the TCJA.
The TCJA does not change the itemized deduction for net investment interest [Internal Revenue Code (IRC) section 163(d)]. Those who itemize can continue to deduct interest expense in excess of interest income. Excess investment interest can be carried forward and used in future years; however, because the standard deduction has been nearly doubled in 2018 ($24,000 for married filing jointly, $18,000 for head of household, $12,000 for other individuals), it may be more favorable to not itemize. Thus, the write-off for investment interest may essentially disappear for many investors.
Real Estate Holdings
Those with real estate investments may benefit considerably from the TCJA. Individuals who hold real estate in a pass-through entity, such as a limited liability company, may pay tax on only 80% of their income because of a new 20% deduction for owners of pass-through entities. This deduction effectively reduces the top tax rate of 37% to just 29.6%. Set to expire after 2025, it cannot be claimed when income exceeds a threshold amount ($315,000 for joint filers; $157,500 for others), and other limitations apply. Individuals with pass-through income from service trades or businesses cannot use the deduction, but real estate investors are not barred.
The 20% deduction also applies to individuals who own interests in real estate investment trusts (REIT), as REITs are pass-through entities. In contrast, profits from real estate owned by a C corporation are taxed at a flat 21% under the TCJA. Depending on the extent of an individual’s holding, a review of the entity owning real estate may be advisable.
Gain on the sale of realty can continue to be deferred through a like-kind exchange (IRC section 1031). The TCJA bars like-kind exchange treatment for tangible personal property but does not alter the rules for exchanges of real property.
Other investment expenses continue to be deductible by individuals on Schedules C, E, or F. For example, while the deduction for mortgage interest on an individual’s home is limited to mortgages under $750,000 for mortgages obtained after December 15, 2017, there is no dollar limit on the amount of a mortgage for investment purposes.
For those in the real estate business, there is a limitation on the deduction for interest expense, but interest for this purpose does not include investment interest under IRC section 163(d). The limit on business interest is 30% of adjusted taxable income, but this limitation does not apply to those with average annual gross receipts of $25 million or less.
Real estate taxes on realty held for investment are also fully deductible. While individuals can only deduct up to $10,000 of real estate taxes (along with state and local income or sales taxes), there is no dollar limit for real estate taxes on property held for investment.
The new law also introduces favorable rules for writing off the cost of certain realty items. The IRC section 179 deduction (first-year expensing), which has been increased to $1 million, has been expanded. It applies to:
- Qualified real property; that is, any qualified improvement to nonresidential real property. Such improvements include roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems. This change applies to property placed in service after December 31, 2017.
- Tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. Again, this change applies to property placed in service after December 31, 2017.
The 28% tax rate on unrecaptured IRC section 1250 gain continues to apply. This is essentially depreciation recapture realized on the sale of depreciable real estate; however, an individual with an ordinary income tax rate below this special rate would only pay the ordinary rate. For example, an investor in the new 24% tax bracket (after taking the unrecaptured gain into income) would pay only 24% on the unrecaptured section 1250 gain.
Net Investment Income Tax
The 3.8% net investment income tax (NIIT) has not been changed; it continues to apply to high-income taxpayers (those with modified adjusted gross income over $250,000 for married filing jointly, $200,000 for single/head of household, and $125,000 for married filing separately). These threshold amounts are not adjusted annually for inflation. Thus, while income taxes may be lower, the NIIT continues to be an added tax burden on investors.
The basic rules for qualified retirement plans and IRAs are unchanged. These vehicles will continue to provide a tax-advantaged way to save for retirement.
Individuals may wish to convert some or all of their traditional IRA to a Roth IRA. Income resulting from the conversion is currently includible in gross income, but future earnings can be tax free. Conversions in 2018 will be less costly for most taxpayers because of reduced tax rates; if Congress raises the rates in the future, the value of the tax-free income becomes even more meaningful. Conversions made in 2017 can be undone by re-characterizing the converted amount as a traditional IRA by October 15, 2018. This may be a good idea if the value of assets has declined from the date of the conversion. For conversions in 2018 and later, however, no recharacterization is permitted.
Individuals who are age 70½ and must take required minimum distributions (RMD) may want to utilize the charity transfer opportunity. This rule allows RMDs from IRAs (but not qualified retirement plans or IRA-like plans such as SEPs and Simple IRAs) to be transferred directly to a public charity, up to $100,000 annually. The transfer reduces the amount of the RMD reported as income; it also reduces modified adjusted gross income used to figure the additional Medicare premiums. No charitable contribution deduction can be claimed, but given the increased standard deduction, this transfer option is particularly attractive. Those who wish to make a transfer should be sure to do it correctly: have funds transferred directly from the IRA trustee to the charity or have the IRA make a check payable to the charity.
Conversions in 2018 will be less costly for most taxpayers because of reduced tax rates; if Congress raises the rates in the future, the value of the tax-free income becomes even more meaningful.
Estate and Gift Taxes
The TCJA did not repeal the estate and gift taxes but it did greatly increase the exemption amount, effectively allowing a married couple to exclude up to $22 million from their estates starting in 2018. Heirs continue to receive a stepped-up basis for inherited property.
Until now, some individuals have used family limited partnerships and other vehicles as a way to reduce the value of their estates and save estate taxes. These strategies may no longer be necessary from a tax perspective, but they may still be helpful for non-tax purposes, such as asset management.
A New Beginning
The start of the new year is always a good time to review investment holdings so that action can be taken to improve these holdings. In 2018, it is not only a good idea, it is essential to review investment holdings and assess the impact of the TCJA.