Last updated on October 19th, 2020

The final tax bill agreed to by the House and Senate conferees and signed into law by President Trump on Friday December 22, 2017, makes several significant changes for real estate investors.

A summary of the key provisions are below, if we assume an individual tax payer in the highest marginal rate.

Today, net income from rents is taxed at 39.6 percent, plus a 3.8 percent Affordable Care Act (ACA) tax for passive investors. All in that is 43.4 percent for passive investors (folks that have jobs other than real-estate) and 39.6 percent for active investors (folks that work full time in their-real estate businesses).

Under the new law, investors qualifying for the new 20 percent deduction, net income from rents would effectively be taxed at 29.6 percent, plus the 3.8 percent ACA tax for passive investors. All in, that is 33.4 percent for a passive investor and 29.6 percent for an active investor approximately a 10 percentage point reduction.

Many real estate investors should qualify for the 20 percent deduction. But income that does not qualify, such as rental income on land in many cases, would be taxed at the top marginal income tax rate of 37 percent, plus the 3.8 percent ACA tax for passive investors for a top, all-in tax rate of 40.8 percent.

In order to qualify for the full 20 percent deduction, the business must either pay a minimum amount of wages, generally twice the desired deduction, or have a minimum investment in tangible, depreciable property used in the trade or business (such as a building or equipment), but not including such items as land or inventory property. The rules can best be understood with several examples:

Assume that a non-depreciable, equity-financed parking lot purchased for $1,000 generates $140 of gross income before paying its employees $40 for net income of $100 (a return of 10 percent). The 20 percent deduction would be $20 and would be fully allowable because it was no more than 50 percent of the company’s wages of $40. Thus, only $80 of the $100 would be taxable at whatever rate was applicable.

If the same $40 were paid to independent contractors, no benefits would be available because payments to independent contractors do not count as “wages.” In that case the full $100 of net income would be taxable.

Even if no wages were paid and the facility was not a parking lot but was a fully-automated depreciable parking structure costing $1,000 without the land and it generated the same $140 of gross income and $100 of net income after paying $40 to independent contractors to maintain the facility, the 20 percent deduction would be the same $20. It would be fully allowable, exposing only $80 to tax. This is because $20 did not exceed 2.5 percent of the $1,000 original purchase price (unadjusted basis) of the structure, which in this case would be $25.