Shawn Henderson, a Certified Public Accountant and Senior Manager at Withum Smith and Brown in Princeton, NJ provides detailed responses to our team’s and clients’ most commonly asked tax questions.
Apple Peeled Question: There was so much uncertainty after the Tax Cuts and Jobs Act of 2017. Do you believe any of that uncertainty still exists?
Shawn Henderson: Yes, there is still a level of uncertainty. In many instances, tax professionals had to rely on proposed regulations and interpretations this past year. The Act had many layers and implications for every type of taxpayer, so the IRS has been working as quickly as they can to provide guidance to all of them. Additionally, the Act had the state and local jurisdictions in a bit of a “wait and react” position, as they had to decide how they were going to handle certain changes and if they were going to conform to the new regulations.
Apple Peeled Question: What were the biggest misconceptions?
Shawn Henderson: This really depends on what side of the argument you were on. Depending on a taxpayer’s income level, filing status, number of dependents, income characterizations, etc., some individuals found relief under the Tax Cuts and Jobs Act, while others didn’t. Honestly, taxpayers’ results were aligned with their impression of the Act – good, bad, or indifferent.
Apple Peeled Question: Do you think the changes or the uncertainty (if any) had an impact on the housing market?
Shawn Henderson: Certainly, based on two reasons – the state and local tax deduction cap at $10,000 and the mortgage interest limitation changes for individual taxpayers. Of course, these are only relevant to personal-use real property, not business use, such as rental properties.
The $10k Tax Cap
Shawn Henderson: The $10,000 tax cap, refers to the maximum deduction for the combination of real estate taxes and state/local income taxes paid during the year. If you itemize your deductions, the combination of these taxes paid are capped at $10,000, regardless of how much you paid. In the high real estate tax jurisdictions, such as the northeast, this was a significant pitfall of the Act.
Apple Peeled Question: Is the $10k limit inclusive of primary and 2nd homes?
Shawn Henderson: It’s for real property used for personal use – which includes primary and secondary homes. There is not a cap on rental property deductions.
The Mortgage Interest Limitation
Shawn Henderson: Additionally, changes to mortgage interest deductibility also had an impact. For mortgage contracts entered into after December 15, 2017, the allowable interest taken as an itemized deduction is limited to $750,000 of principal. This means interest attributable to a loan amount more than this balance is not deductible. Taxpayers are only permitted to deduct interest on a primary and secondary home. Interest related to more than two homes is not permitted as a deduction as an itemized deduction.
Taxpayers still receive a pro-rata deduction for the interest paid if the principal exceeds the new threshold limitation. Grandfathered loans (meaning, loans entered into prior to December 15, 2017) were also affected as interest deductions are only permitted for loans used for the acquisition, building of, or to substantially improve a residence, limited to $1,000,000. This is a change from the previous $1,100,000 limitation, which included Home Equity Lines of Credit (HELOC) not used for the residence.
Additionally, if a HELOC was used for non-residence related purchases like a vehicle, the interest paid on that was permitted as a tax deduction on your personal return as an itemized deduction. The new limit for grandfathered mortgages is $1,000,000, and these HELOC non-residence type acquisitions are no longer permitted. The interest for all loans now must be associated with the acquisition, build or substantial improvement of the residence.
Apple Peeled Question: The $10,000 limit on the property tax deduction probably got the most negative attention; Can you explain why that change might not be as impactful as some might think?
Shawn Henderson: This really depends on an individual’s tax situation, but often we have seen that while the state and local tax deduction was capped at this amount, taxpayers have benefited in other ways. For example, taxpayers may have lost the ability to deduct hundreds of thousands of dollars in taxes, but they also are no longer subject to the Alternative Minimum Tax (“AMT”). AMT is, just as it sounds, an alternative method of calculating a minimum amount of tax. It is a calculation that starts with Federal taxable income, and then altered by preferences or exclusion items. This includes state and local taxes paid. So, previously taxpayers were deducting taxes to arrive at Federal taxable income, however, those taxes were added back to arrive at AMT taxable income, really providing minimal or no benefit. AMT also increased some of its thresholds, which provided benefit to a lot of the taxpayers previously subject.
Apple Peeled Question: From a tax standpoint, are investment properties looked at the same as they were before the changes in 2017?
Shawn Henderson: In general, if business use, yes. There are other interest limitations for business use, specifically Internal Revenue Code 163(j). This Section limits interest deductible for taxpayers that either have average gross receipts of more than $25 million over the last three years, or if they are considered a tax shelter. This Section is very complicated and would require its owns feature to fully grasp its implications and applicability. There are so many nuances to how this is interpreted.
Apple Peeled Question: Can you provide a brief overview of AMT?
Shawn Henderson: “AMT” stands for the Alternative Minimum Tax, which I briefly described above.
What is it? (SH): It is an alternative calculation of tax based on adjustments to exclusion and preference items. Exclusion and preference items include items such as state and property taxes paid, private activity bonds that were exempt from federal tax, depreciation differences on business activities, etc. It starts with federal taxable income, adjusted for these preference and exclusion items to arrive at alternative minimum taxable income prior to a permitted exemption. There is a statutorily defined exemption that is permitted, and phased-out.
Who it impacts/Impacted? (SH): As part of the Act, corporations are no longer subject to AMT. It still impacts individuals. As mentioned above, certain adjustments to Federal taxable income will get you to the AMT taxable income prior to the allowed exemption. The exemption under pre-TCJA law for a married couple was $84,500 (2017) and is $109,400 under current law. Additionally, this exemption begins to phase out at certain income levels – old law this income number was $160,900 (2017) and is now $1,000,000 under new law. Based on these changes, fewer people were impacted by AMT.
What changes were made? (SH): See the preceding answer. Based on the cap of $10,000 for taxes and the elimination of miscellaneous itemized deductions (2% floor deductions – investment management fees, job hunting expenses, tax prep, etc.), the adjustments for AMT for a majority of taxpayers are significantly less than prior years.
Apple Peeled Question: Many of our clients obtain gift from a family member(s) when purchasing a property. From a tax standpoint, how does that impact the donor? The recipient?
Shawn Henderson: The recipient is generally not impacted from a tax perspective, as the tax obligations lie solely with the donor. The annual gift tax exclusion is $15,000 (2018, 2019) per donor to an individual recipient. Note, married donors can give $30,000 to a recipient as $15,000 would be considered from each spouse. Further, married donors can give $60,000 to married recipients as $15,000 would be from each donor spouse to each recipient spouse. Anything above these annual threshold amounts would go against the donor’s lifetime gift exclusion ($11.18 million in 2018). As long as the donor hasn’t exceeded their lifetime exclusion, there will be no tax on the gift. However, an annual gift tax return is needed when gifts exceed $15,000. With proper planning individuals can gift significant amounts throughout their lifetime if using the combination of the annual exclusions and the lifetime exclusion.
Apple Peeled Question: Were there any major changes to the Estate tax?
Shawn Henderson: Yes, the estate exemption more than doubled from the 2017 amounts. The exemption is now $11.18M for an individual and $22M for married couples. The estate tax exemption is “unified” with the gift tax exemption. This means that amounts gifted during an individual’s lifetime in excess of their annual exclusion reduce their estate tax exemption, as well.
Apple Peeled Question: What should homeowners or potential homebuyers know about the estate tax?
Shawn Henderson: The current gift and estate tax exclusion is only enacted through 2025, so without Congressional action to permanently set this exclusion amount, the exclusion will be reduced to the pre-2018 thresholds—closer to $5 million per individual. Therefore, careful tax planning is essential, especially centered around real estate. Often, especially in New York City, real estate appreciates significantly over time. Proper planning to ensure that you or your descendants don’t get stuck with a huge tax bill is something that should be prioritized. The thresholds above relate to all an individual’s assets, so ensuring there is proper gift and estate tax planning in place is a must.
Apple Peeled Question: For the first time in our lifetime, we’re hearing that homeownership might not be a no-brainer investment. There are some advisors who would suggest that you’re better off renting vs. owning. What are your thoughts?
Shawn Henderson: This really depends on your philosophy related to homeownership. The long-term investment mindset was, “Why waste money on rent when you could build equity after ‘x’ years of ownership.” I think that still holds true in most minds. The only change to it is the benefit you receive along the way. This is an appropriate time to talk about itemized deductions versus standard deductions, even though we have touched on it above.
When arriving at Federal taxable income, one of the last steps is determining whether you will be relying on the standard deduction or itemized deductions. A taxpayer will take the greater of these two numbers as a deduction. Included in itemized deductions are medical expenses in excess of a certain limit, real estate and state/local taxes, mortgage interest, investment interest, charitable contributions, previously miscellaneous (2%) itemized deductions, etc. The standard deduction for 2017 was $6,350 for a single taxpayer and $12,700 for a married couple, and in 2018 those amounts are $12,000 and $24,000, respectively.
So, looking at the above amounts, understanding the cap on property/state/local taxes of $10,000, and changes to the mortgage interest limitation, taxpayers are re-evaluating their view on homeownership. There is a possibility that there is no tax benefit received from homeownership based on the changes to the standard and itemized deduction limitations, so homeowners really need to understand the market. Regardless of the length or intended length of ownership, I would think the focus is, now more than ever, on appreciation of the home.
Apple Peeled Question: With the market softening and prices dropping (in New York City) during the last 2+ years, should real estate investors consider selling their property and purchasing a higher end property where the overall discount on purchase price might be higher?
Shawn Henderson: This depends on subsequent appreciation. Most of these tax law changes are only through 2025, so uncertainty after that date is present. However, a long-term investor may see the benefit of purchasing higher end properties at the discount now. I am not one to make choices centered solely around tax, because they must make sense otherwise. It does seem that the market is trending with the change in the tax law, so presumably we should see a little or that on the backend (if these changes are eliminated).
Apple Peeled: Have you seen this happening?
Shawn Henderson: I have seen a significant drop in the prices of homes over the past two years. Buying homes for investment (business use) may be a smart play, as there are fewer restrictions on the deductions. Long-term investment presumably should provide future benefit.
Apple Peeled Question: Is there an uptick on 1031 exchanges? (can you give a brief overview on the 1031 exchange?)
Shawn Henderson: In its simplest form, a 1031 exchange is the exchange of property for like-kind property that allows the deferral of the gain on the property given up. Essentially, this means a taxpayer doesn’t recognize the gain from a tax perspective on the property given up at the time exchanged; rather that gain is deferred by reducing the basis of the newly acquired property. The overall gain will be recognized from a tax perspective when the newly acquired property is disposed of in a non-1031 exchange (i.e. sold). In my fifteen-year career, I have seen more 1031 exchanges this year than any other year. It’s a way to exchange and defer gain to acquire a property with more appreciation potentially at a discount. Note: 1031 exchanges are more complicated than stated here and could potentially have current year tax consequences based on the boot received.
Apple Peeled Question: Since 2017, we’ve read a lot about Opportunity Zones, which were also a part of the Tax Cuts and Jobs Act. Can you give our readers a brief overview?
Shawn Henderson: Opportunities Zones are new concept found within the tax law. In the simplest explanation, this is a strategy for taxpayers with a long-term investment tolerance. Taxpayer will take gains—not proceeds, but gains— to invest in Opportunity Zones. The Zones themselves have certain investment thresholds that they must maintain, but for investors, here is the relevant information. If you invest your gain in an Opportunity Zone, after five years, the IRS will discount your gain 10%. If held for another two years, the IRS will discount your gain another 5%. However, to get the extra 5%, an investment needs to be made by December 31, 2019. Then at the end of 2027, the gain deferred, whether that’s 85%, 90% of 100% of the gain (depending on when you invested in the Opportunity Zone) will then be recognized. Now, any appreciation of the Opportunity Zone will be tax free but must be sold by 2047. So, this is a two-part incentive – savings on the gain invested and then savings on the Opportunity Zone investment itself.
Apple Peeled Question: What strategic advice are you giving to your clients, especially how it relates to real estate?
Shawn Henderson: Any tax advisor will explain, it all depends. So many variables go into a decision to advise a client. It is hard to give advice without having a complete picture of one’s tax situation, and on top of that you have to consider the non-tax related reasons. Being a partner with a taxpayer is a deep dive into not only their goals for now but for the future.
Apple Peeled: Is there anything that people are not taking advantage of?
Shawn Henderson: There are so many things mentioned above that a taxpayer could take advantage of. The exclusion of a personal residence under Section 121 (up to $500k if married) is still relevant. Again, it really comes down to their personal tax situation and their otherwise financial tolerance.