How the Tax Cuts and Jobs Act Affects Landlords

The Tax Cuts and Jobs Act (TCJA), the massive tax reform law enacted by Congress in 2017, took full effect in 2018. Landlords have been among the biggest winners under this law. Most landlords are saving on taxes because of the TCJA and will continue to do so, at least through 2025.

The main provisions of the TCJA affecting landlords are discussed below.

The 20% Pass-Through Deduction

For landlords, the most stunningly good provision of the TCJA was a new tax deduction for owners of pass-through businesses. This includes the vast majority of residential landlords who own their rental property as sole proprietors (who individually own their properties), limited liability companies (LLCs), and partnerships.

With these entities, any profit earned from the rental activity is "passed through" to the owner or owners' individual tax returns, and they pay tax on it at their individual income tax rates.

The TCJA created a new tax deduction for individuals who earn income through pass-through entities. (New IRC Sec. 199A.) If your rental activity qualifies as a business for tax purposes, as most do, you might be eligible to deduct an amount equal to 20% of your net rental income.

This deduction is in addition to all your other rental-related deductions. If you qualify for this deduction, you'll effectively be taxed on only 80% of your rental income. So, the effective rate for taxpayers in the top 37% tax bracket is 29.5%.

This complex deduction is scheduled to end on January 1, 2026. It works as follows (2022 amounts below; subject to annual inflation adjustment):

Taxable Income Below $170,050 for Singles ($340,100 for Married Couples)

You qualify for an income tax deduction equal to 20% of your rental income if:

• you operate your rental business as a sole proprietor, LLC owner, partner in a partnership, or S corporation shareholder, and
• your total taxable income for the year from all sources after deductions is below $170,050 if you're single or $340,100 if you're married filing jointly (these thresholds are for 2022 and are adjusted each year for inflation).

This deduction is phased out if your income exceeds the $170,050/$340,100 limits. It disappears entirely for singles whose income exceeds $220,050 and marrieds filing jointly whose income exceeds $440,100.

This deduction is a personal deduction you can take on your return whether or not you itemize. But it is not an "above the line" deduction that reduces your adjusted gross income (AGI).

Income Above $220,050 for Singles ($440,100 for Married Couples)

If your 2022 annual taxable income is over $220,050 if you're single or $440,100 if you're married filing jointly, you are still entitled to a pass-through deduction of up to 20% of your rental activity income. However, your deduction can't exceed:

• 50% of your applicable share of the W-2 employee wages paid by your rental business, or
• 25% of your share of the W-2 wages paid by your business, plus 2.5% of the original purchase price of the depreciable long-term property used in the production of income—for example, the real property you rent.

Because most residential landlords have no employees, the 25% plus 2.5% deduction will be of most benefit to them.

The 2.5% deduction can be taken during the entire depreciation period for the property, which is 27.5 years for residential property. But it can be no shorter than 10 years.

Rental Activity Must Be a Business

As mentioned, a landlord may take advantage of the pass-through deduction only if the rental activity qualifies as a business for tax purposes. This is determined under the general tax rules used for all businesses.

For any activity to be a business, you must engage in it regularly and continuously, primarily to earn a profit. A "sporadic" activity doesn't qualify. Most rental activities qualify as businesses, especially large ones. However, questions might arise whether a landlord who owns only a single unit or a few units is in business or operating an investment activity.

To help allay these questions, the IRS adopted a special rule for the pass-through deduction. Under this "safe harbor" rule, a rental activity is automatically deemed to be a business for purposes of the pass-through deduction if:

• you keep separate books and records showing income and expenses for each rental real estate enterprise you own
• you perform 250 hours of real estate rental services each year, and
• you keep records documenting the real estate services performed. (IRS Notice 2019-7.)

Expanded Section 179 Expensing

A provision of the tax code called "Section 179" enables rental business owners to deduct in one year the cost of personal property used in a rental business, such as furniture and appliances. The TCJA doubled the maximum amount that can be deducted under Section 179.

For 2022, the annual limit is $1,080,000. The $1,080,000 amount is reduced (but not below zero) by the amount by which the cost of property placed in service during the year exceeds $2,700,000.

One significant limitation on Section 179 is that it was never available for rental property owners to use to deduct the cost of personal property used in residential rental units. In a major victory for landlords, the TCJA eliminated this restriction starting in 2018.

100% Bonus Depreciation Through 2022

Currently, business owners may deduct in a single year up to 50% of the cost of personal property they purchase for their business. The TCJA increases this amount to 100% for property acquired and placed into service from September 27, 2017 through December 31, 2022.

Moreover, 100% bonus depreciation would apply for the first time to both new and used property, instead of new property only. The bonus depreciation amount will be phased down in 2023 and later years as follows:

• 80% for property placed in service during 2023
• 60% for property placed in service during 2024
• 40% for property placed in service during 2025
• 20% for property placed in service during 2026
• 0% for 2027 and later.

Bonus depreciation may not be used for real property, except for real property improvements such as landscaping or grading, and other components that have a depreciation period of 20 years or less. So, landlords may not use it to deduct the cost of their rental buildings or major building components.

However, landlords can use bonus depreciation to fully deduct in one year the cost of personal property they use in their rental activity, such as appliances, laundry equipment, gardening equipment, and furniture. But landlords can often do this already under existing provisions in the tax law—for example, the de minimis safe harbor enables landlords to fully deduct in one year any personal property that costs $2,500 or less. Section 179 can also now be used.

Listed property must be used over 50% of the time for business to qualify for bonus depreciation. Listed property includes cars and entertainment property like televisions and cameras. Computers were classified as listed property as well, but the TCJA removes them from this classification starting in 2018. So, bonus depreciation may be used to deduct computers used less than 50% of the time for a rental business.

Lower Individual Tax Rates

As mentioned above, almost all residential landlords pay income tax on their rental profits at their individual tax rates. The TCJA reduces these individual rates. For 2022, the individual tax rates are as follows:

These tax rates are scheduled to expire and revert to their pre-2018 levels after 2025.

No Deductions for Not-For-Profit Rental Activities

The vast majority of rental activities qualify as businesses or investment activities. However, rentals that aren't profit-motivated must be classified as not-for-profit activities, also called "hobbies."

Under prior law, expenses from a hobby could be deducted as a personal itemized deduction on IRS Schedule A to the extent they exceeded 2% of the taxpayer's adjusted gross income. But such deductible hobby expenses couldn't exceed hobby income. The TCJA completely removed the personal deduction for hobby expenses.

So, while the income from a rental activity classified as a hobby must be reported and tax paid, no expenses may be deducted.