Everyone knows the new tax law went into effect this year. Officially called the Tax Cut and Jobs Act (TCJA) of 2017, the law made sweeping changes to individual and corporate taxation, which have impacted real estate.
The law likely has negative consequences for residential real estate buyers, and this is particularly true in New York. It limits state and local tax deductions to $10,000, and you can only deduct mortgage interest on loans up to $750,000, down from $1 million.
However, those that pursue real estate investing as a business likely benefitted from the new tax legislation. This includes the ability to deduct more depreciation, and hence improve your cash flow. It is an arcane but an important consideration.
What is depreciation?
You can expense certain items, such as mortgage payments, insurance, taxes, and repairs, immediately.
Depreciation falls into a different category. This is the amount the Internal Revenue Service allows you to expense annually for a period of time for normal wear and tear. This includes the purchase price (but not the portion for land) and any long-term improvements you have made. This differs from regular maintenance and repairs, such as a paint job.
In New York, you may choose to invest in condo units given their preponderance. It is more challenging to purchase co-ops as an investment since the board places restrictions on subletting.
What is Section 179?
This has received a lot of attention. Under the IRS Code, Section 179 you can deduct the entire upfront cost for improvements, subject to a limit. However, according to the IRS, this applies to “qualified real property,” which it defines as a “qualified improvement property” (non-residential building) and some improvements.
The law made it easier for real estate buyers to take advantage of this provision. However, the provision is only available to those that operate real estate as a business. Among other things, you have to pursue a profit and work regularly and continuously (although you can hire someone to manage it for you). If it is an investment, it will not qualify.
If real estate investing is your business, you can now use Section 179 to deduct personal property used in the residential rental. Previously, you could not do so. Therefore, if you buy a new refrigerator or furniture and put it into the rental unit, you can deduct the full amount in the first year. You may also deduct property and equipment that are offsite but used in running the business. These include computers, cell phones, and office equipment.
The upshot is that the new law’s more generous depreciation rules made it more favorable for New York City’s real estate investors that recently purchased property or plan to going forward.
First, the TCJA doubled the maximum allowable deduction to $1 million, if you purchased the property in 2018. This amount increases annually since it gets for inflation. Second, there is a phase-out, which the new law increased. The deduction limit currently starts at $2.5 million, which is also inflation-adjusted each year, from $2 million.
You can only take the deduction to the extent your business earns a profit. Therefore, it cannot create a loss or widen your loss.
The major advantage of taking Section 179 deduction is the upfront expense in the first year. However, when you sell the property, the IRS treats this amount as depreciation recapture. This gets taxed at a higher rate (up to 37% plus 3.8% net investment tax) than the capital gains tax rate. If you deduct depreciation over the average 27.5 year recovery period, the tax on that portion of the gain is 25% plus the 3.8%.