Deductibility of State Taxes and Interest Under the New Tax Law
By Michael Repka, Esq. (LL.M. (Taxation) NYU School of Law ’01)
On December 22, 2017, President Trump signed into legislation public law 115-97, more commonly known as the Tax Cuts and Jobs Act of 2017 (“TCJA”). The majority of commentators feel, and I agree, that the TCJA will have an overall negative impact on the California real estate market.
Two of the provisions that will have the most direct impact on California real estate are: (1) the reduction of residential mortgage interest deductibility, and (2) the dramatic reduction in the deductibility of state and local taxes.
However, it should be noted that neither of these provisions should have an impact on the deductibility of interest and state or local taxes related to investment properties. Thus, we may see an increase in demand from real estate investors.
MORTGAGE INTEREST DEDUCTION
Generally, Internal Revenue Code (“I.R.C.”) § 163(h)(1) & (2) provides that no income tax deduction is permitted for interest incurred on personal debt. However, under I.R.C., § 163(h)(3), there is an important and long-standing exception for Qualified Residence Interest (“ORI”). Until the enacting of the TCJA, ORI included both: (1) Acquisition Indebtedness, and (2) Home Equity Indebtedness.
Acquisition Indebtedness – Interest is deductible on Acquisition Indebtedness if the debt was incurred to acquire, construct, or substantially improve a qualified residence, and the debt is secured by the residence. Through 2017, the amount of Acquisition Indebtedness was capped at an aggregate of $1 million (1.R.C. § 163(h)(3)(B)(ii)). However, the TCJA has since reduced this limit to $750,000.
A qualified residence is defined to include the taxpayer’s principal residence and one other residence selected by the taxpayer which is used as a residence, such as a vacation home (I.R.C. § 163(h)(4)(A)). If Acquisition Indebtedness is refinanced, it retains its character up to the amount of the refinanced debt.
Home Equity Indebtedness – Home Equity Indebtedness included any other debt secured by a Qualified Residence to the extent that the total amount did not exceed the fair market value of the property less the aggregate amount of Acquisition Indebtedness. The amount of Acquisition Indebtedness was capped at an aggregate of $100,000 (1.R.C. § 163(h)(3)(C)). Unfortunately, the TCJA eliminated this deduction.
Combined Limits – After years of speculation, the Internal Revenue Service issued guidance confirming that Acquisition Indebtedness that exceeds the $1 million limit could be treated as Home Equity Indebtedness (1.R.S. CCA 200940030 (Aug. 7, 2009)). Thus, prior to 2018, a homebuyer was able to deduct interest on up to $1.1 million.
Over the years, Silicon Valley homeowners have grown accustomed to deducting the mortgage interest on the first $1.1 million of debt secured to purchase their primary residence. However, as mentioned above, the TCJA reduced the interest deduction to only the interest on the first $750,000 of the loan balance.
While this is certainly unfortunate, we do not expect to see a dramatic decrease in demand because many buyers are already used to taking a significant “hair cut” on their interest deduction.
STATE AND LOCAL TAX DEDUCTIBILITY
For many taxpayers, a far more detrimental change enacted as part of the TCJA is the dramatic reduction of deductibility of state and local taxes, which includes both the California income tax and real property taxes.
State Income Taxes
Many California taxpayers find that their single biggest historical deduction has been for state and local taxes paid. As a result of Prop 30, which was enacted in 2012, California residents pay up to 13.3% state tax on income and capital gains.
Historically, California taxpayers have received the benefit of a corresponding federal tax deduction for the state tax paid. Thus, this federal tax deduction resulted in an effective state tax rate of approximately 8.4% (net of federal tax benefit) for taxpayers not under the Alternative Minimum Tax (“AMT”).
The TCJA reduced the total deductibility of state and local taxes to only $10,000 – a mere drop in the bucket for most Silicon Valley homeowners.
We have already seen a negative impact related to this change in the form of homeowners thinking about selling their homes and moving out of state. Although some of these sellers, primarily those approaching retirement age, have already listed their homes and moved out of state, it is too soon to know whether a material portion of the other people with whom I have met will follow through with their plans.
At DeLeon Realty, we do anticipate seeing at least some increase in inventory as a result of this tax change. We expect the increase will be more significant in the luxury market (homes priced from $5 million to $15 million).
Property Taxes
Unfortunately, the TCJA effectively eliminated the entire deduction of property tax for the vast majority of Silicon Valley homebuyers. Over the past year, I have heard countless people, including many real estate agents, say that buyers can still deduct the first $10,000 of property tax. However, this is almost always inaccurate.
Given the extremely high cost of buying a home in Silicon Valley, most homebuyers have combined incomes well in excess of $100,000. As a result, they are already paying more than $10,000 worth of state taxes, which is not discretionary.
Therefore, these potential buyers will receive no tax benefit for the property tax they would pay on a new purchase. Thus, one of the most frequently cited advantages to homeownership has been eliminated by the TCJA.
Unfortunately, this will likely result in some level of decreased demand.
THE GOOD NEWS — INVESTMENT PROPERTIES SHOULD NOT BE IMPACTED
The United States Treasury Department allows for the deduction of expenses which are “ordinary and necessary” to the production of income.
While there are certainly inherent ambiguities in this overarching rule, I.R.C. Section 163(d) and Rev. Rul. 95-16 provide that non-corporate taxpayers, which includes individuals and individuals operating their real estate operations through a disregarded entity, such as a single-member LLC, may deduct interest paid on investment debt to the extent of the taxpayer’s Net Investment Income. Therefore, these taxpayers should not be limited to the debt on the first $750,000 of their mortgage amount.
This deduction is calculated on IRS Form 4952. To the extent that the taxpayer does not have sufficient Net Investment Income so as to utilize the entire deduction, it may be carried over to a succeeding tax year.
Naturally, the debt needs to be directly tied and traceable to the investment, but that should not be a difficult standard to maintain.
As a result of the interplay between the interest deductibility on a primary residence mortgage verses the uncapped deductibility of interest on investment properties, we expect to see investors leveraging their investment acquisitions to the greatest extent possible.
Similarly, real estate property taxes on investment properties should remain fully deductible as an ordinary and necessary business expense.
Overall, we expect to see an increase in inventory as a result of the new tax rules, coupled with a modest decrease in demand from homebuyers and an increase in demand from investors.
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