The Tax Cuts and Jobs Act (TCJA) went into effect on January 1, 2018. Changes to the existing tax law were significant.
One change that will affect some real estate investors is the 20% pass through deduction. There is some debate on whether an investor needs to move their properties to an LLC or if the properties can still be held personally and still qualify for the 20% deduction. Deciding how to hold your rental properties, personally or via an LLC, is usually one of personal preference or liability, and not based on taxes.
Starting Off Your Investment Journey
Many investors starting off in their Rental Real Estate investment journey will hold their properties in their own names. They will report the income and expenses on Schedule E when they file their Form 1040. The aggregate of all the Schedule E information will flow to the investor’s 1040 Line 17. In order to protect themselves and their properties from liabilities, investors may obtain an umbrella liability insurance plan. This plan will protect the owner from any liabilities arising from tenant claims.
Creating an LLC for Your Investment Properties
Another way to for an investor to hold rental properties is through a Limited Liability Company (LLC). If the LLC involves one member, then the income and expenses would be reported on Schedule E, like the example above. If there are two or more unrelated parties sharing a real estate investment, a Form 1065 Partnership tax return will need to be filed. That return will list the income and expenses for the properties along with the balance sheet items. These types of entities are formed at the state level and can be formed with only one member. The LLC structure offers the investors protection from their personal assets arising from tenant claims.
If an investor holds the rental properties in their name, or if they are held inside of a LLC taxed as a partnership, there will more than likely be an overall loss because of the depreciation expense. Even through rental properties appreciate in value in the “real world”, in the land of the IRS they depreciate in value. This depreciation deduction is referred to as a “paper loss” because there was no cash outlay to achieve the deduction. So, an investor would always want their properties to be cash flow positive, (income minus cash expenses greater than $0.00), but will usually incur a loss because of the depreciation deduction. If there is an overall loss on your rental properties or your rental LLC partnership, then the 20% deduction is a moot point.
If however, there is income even after taking depreciation into account, then you may qualify for the 20% deduction included in the new TCJA. Each investor would need to look at all of their rental properties and multiple the total overall income by 20%. As of now, the deduction would be reflected on page two of the 1040. There are certain limitations that will be applicable. Currently they are $315,000 of taxable income from married fliers and $157,500 for any other filer.
So What's the Best Option?
To summarize, there is no structuring requirement to qualify for the 20% pass through deduction in the Tax Cuts and Job Act (TCJA). Investors should review their current rental property structuring to see if a change is needed. If your rental properties produce an overall loss, then you are not a candidate for the 20% pass through deduction. If your rental properties produce overall income, then you may qualify for the 20% pass through deduction, assuming you meet the taxable income limitations. If you find that your taxable income is approaching the amounts listed above, there are steps you can take to reduce that income. You should check with your trusted advisor on what steps are right for your situation.