Most Americans this year will feel the effect of the new tax law, in one way or another, on their personal financial positions.
Some will benefit thanks to lower tax rates, higher alternative minimum tax (AMT) exemptions, and increased deductions.
Others will be penalized due to the new restrictions on state and local taxes, mortgage interest, miscellaneous deductions, and dependency exemptions. Similarly, these new tax rules will also have a significant impact on individual investors of all sizes as well as on public and private enterprises.
An Overview of the TCJA Changes
The good news is that tax rates on long-term capital gains and qualified dividends have remained unchanged. The “bad” news, depending on how it is viewed, is that the marginal rates on other forms of income have decreased, causing the favored long-term capital gains and qualified dividends to lose a bit of their appeal. The previous 19.6% differential between the highest individual rate and the long-term capital gains rate has been reduced. Does this mean fewer people will be investing? Probably not.
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A positive aspect of the TCJA for investors is that the flat tax rate for C corporations is now only 21%, a significant improvement over the burdensome 35% rate imposed under preexisting regulations. C corporations comprise a significant percentage of publicly traded securities. So, if all other factors remain constant (which they hardly ever do) the reported net income of public companies should increase, subsequently improving the likelihood of dividend distributions in addition to creating more value enhancement from reinvestment of the tax savings. Large multi-national companies should expect to see their cash flow enhanced through the tax incentive for repatriation of foreign-based earnings.
TCJA Taxation of REITs
The impact of the new tax law on real estate investment trusts (REITs) has become an interesting topic of interest for investors. The tax law created a new deduction for qualified business income (QBI) of pass-through entities. Most REITs are large publicly-traded companies, and accordingly would not typically be implicated in any discussion of pass-through entities. However, REITs enjoy a favorable tax status if many technical rules are adhered to, including a requirement that they distribute 90% or more of their taxable income to shareholders. By doing so, REITs pay corporate tax only on their undistributed taxable income for the year. The new pass-through entity deduction is available to REITs, thereby decreasing its taxable income, but not its cash flow. Distributions to shareholders will come from a smaller pool of taxable earnings. Subsequently, if the distributions remain constant, a larger portion will be treated as a distribution in excess of corporate earnings and profits—resulting in a return of capital. Investors love distributions without taxation. Keep in mind, however, that these excess distributions reduce the basis of the REIT shares, thus increasing any capital gain upon sale.
How Does the TCJA Affect Investors Who Own Real Estate?
If an investment in real estate falls along the more classic lines, either by purchasing investment quality real estate directly or through the various partnership entities that are popular with financial planners today, such an investment may become somewhat more tax-advantaged in both the current year and into the future. From the possible availability of the 20% QBI deduction to more liberalized depreciation allowances, the taxable income reported by these entities will likely decrease, while the underlying economics of the investments may be enhanced. If cash flow from these investments remains the same while the taxable income reported by them simultaneously drops, investors will experience a net positive increase in value. The recently published regulations on the QBI deduction will further this cause by allowing real estate investors and operators to qualify as a trade or business under a safe harbor provision. This will take some of the uncertainty out of the applicability of the new tax law benefits to real estate investors.
The TCJA also created a brand new way to temporarily defer, partially reduce, or completely eliminate certain capital gains taxes. With the advent of the Opportunity Zone come tax breaks garnered via investing in U.S. government-promoted economically disadvantaged areas. Investors can take the capital gains proceeds, including gains from stock sales and sales of businesses, and transfer them into opportunity zone funds in order to defer or partially eliminate the tax burden . Under certain circumstances, the appreciation of the fund assets may also completely avoid taxation.
Categorizing Interest Revenue: Business or Portfolio Income?
There are investors who like to invest in partnerships that lend money to other businesses and individuals which are not attractive to standard lending sources. The rates of return will generally be higher than what a bank would earn on its loan portfolio because of the increased risk factor. The interest income here may or may not be eligible for the QBI deduction, depending on whether the level of activity of the partnership constitutes a trade or business. The recently published regulations under QBI specifically exclude “any interest income other than interest income which is properly allocable to a trade or business.”
The trade or business requirement has always plagued taxpayers who are looking to characterize interest income as business income instead of portfolio income. For example, a finance company that provides floor plan financing to cover the auto dealer’s inventory appears to be clearly classified as a trade or business, as compared to an investor who buys existing mortgage loans and holds them to maturity. Unfortunately, the safe harbor provisions now available to real estate investors have not been extended to interest income recipients.
How Are Carried Interests Taxed Under the New Tax Law?
General partners and managing members of hedge, private equity, and real estate investment funds are also affected by changes enacted by the new tax law. This area of the law transitioned from the favorable treatment granted to these savvy investment professionals, who formerly received shares of the investee partnerships, to instead providing only for an income interest in the partnership, not a capital interest. The use of the income interest transfer was intended to preclude immediate taxation as ordinary income upon receipt, as compensation for services rendered. These income partners received their share of dividend income or long-term capital gains as determined by the partnership using the classic rules. Also, the partner managers were free to sell these interests after one year and receive long-term capital gain treatment for the selling price, with no offsetting basis. The new law extends the minimum holding period for long-term capital gain treatment from one to three years. This is true for both the underlying investments held by the partnership as well as the income interests themselves. Congress allowed this as a significant concession to Wall Street financiers, since there was much discussion over the past several years that called for these interests to be taxed as ordinary income upon receipt.
Tax Treatment of Investment Expenses
One final observation on behalf of the smaller investors: The new rules suspend for the next seven years miscellaneous itemized deductions subject to the 2% of AGI (adjusted gross income) exclusion. Included in this category are expenses for the determination and collection of any taxes, as well as investment-related expenses. The pass-through of investment expenses from partnership investments, investment management fees from the brokerage firms, tax preparation fees, and asset management expenses will not be deductible for the foreseeable future. Unfortunately, this means investing just got a little more costly for smaller market participants.
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Wise Investment Decisions and Tax Law Changes
When it comes to successful investing, economics tops the priority list, with tax minimization coming in at a close second. Time will tell if the changes brought about by the TCJA will keep investors satisfied. As the industry adjusts to the new regulatory framework, expect further IRS tax law clarifications affecting investments in the form of explanatory regulations and other pronouncements.
This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com
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