This week Bruce Norris is joined again by Matt MacFarland and Amanda Han with Keystone CPA. They are the owners of Keystone CPA in Orange County. Matt has over 20 years of experience in public accounting as a CPA and tax strategist. He has worked for both the Big 4 and regional CPA firms. Amanda has over 18 years of experience as a CPA with a special emphasis in real estate, self-directed investing, and individual tax planning. Amanda has extensive Big 4 public accounting experience, and you can catch her book on BiggerPockets Tax Strategies for Savvy Real Estate Investors.
- Are these new tax law changes friendly to business above anything else?
- How have C Corporations been affected?
- What will the new rules allow you to do in regards to business investments and deductions?
- How will income from a pass-through business be treated in 2018 versus 2017?
- What is flow through income, and can you have an LLC for this?
- Where does estate tax come into play, specifically in regards to the size of the estate?
- Will these changes have any ramifications on people migrating from California?
Bruce started this part by asking if they consider the tax law change most friendly to business over any category. Amanda said yes since most of the clients are in the real estate side of things. Amanda said they do not have many clients who operate in the C Corporation since there are downsides to holding appreciating assets. In the past, the C Corp. has double taxation. They have lowered the corporate rate, but they haven’t taken away double taxations. If you are trying to shift your income into a C Corporation, it will pay 21%. Then, when you take the money out of dividends, you will pay 15+ percent. It will not be too much of tax savings.
Amanda said for most of their clients, where there is a C Corp. involved they have had to shift income from a flow-through entity taxed at 39% down to a 15% rate. Most of the C Corporations, at least the ones Keystone CPA works with, are not making $1 million. It is making $20-$40,000 of management fees. The change is detrimental to some of these smaller C Corporations since now the flat rate has stepped up from 15% to 21%. It is definitely a huge windfall to large corporations to have the 35% plus dividends go down to 21%. From a real estate perspective where investors, flippers, or property management companies won’t really be sending people out for C Corporations in the near future.
Bruce said one of the rule changes applies to new investment purposes for businesses and how they are deducted. Bruce asked if you had a $1 million piece of equipment you are buying, what will the new rules allow him to do? Amanda said there are two new changes, including the Section 179 expensing and 100% bonus depreciation. Both of these tax benefits coming out are available whether you have a C Corp., S Corp., LLC, or sole proprietorship. Matt said right now the two big loopholes in terms of accelerating depreciation with respect to equipment both currently exist, they are just being tweaked somewhat going forward.
In the Section 179, you can deduct it all right away subject to some income limits. Going forward, they have increased that $500,000 threshold to $1 million. Theoretically, if you buy $1 million worth of equipment and the business adds at least $1 million of income, you can deduct that all in the first year. They have also changed Section 179 to expand the definition to include certain improvements made to real property, or non-residential property. This could be commercial real estate, strip centers, or office buildings. Now you can include certain improvements such as roofs, heating, ventilation, and air conditioning. Amanda said in the past for real estate investments, those types of improvements generally had to be depreciated over multiple years. This is the first time where they are allowing improvements on the real estate side to get an immediate expensing up to $1 million.
Bruce asked how income from a pass-through business is treated in 2017 versus 2018. Matt said people had been asking about that for a week, and they were still trying to wrap their arms around it. This goes back to them not simplifying things. Amanda and Matt had been running their own scenarios to see how it would play out; and generally speaking, currently the flow-through entities (partnerships, LLCs, and corporations) don’t pay taxes at all. The income from the entities flows through to the individual tax returns. The tax is assessed at the personal level one time. If you have an LLC that created rental income of $10,000, the LLC pays 0 tax while you would have $10,000 of taxable income paid at your personal tax rate.
In the past, it was 0%, 15%, and all the way up to 39.6%. A lot of time you will hear about flow-through entities taxed at the highest rate, and they are really looking at your highest personal rate. Under the new change coming up, they are not looking to change the tax rates or how the entities are taxed. The income will still flow through, and the entity won’t be paying taxes on its own. What you can potentially do is pay zero tax on the first 20% of income that is generated by the flow-through entity or business.
As an example, if you are a realtor and made $100 of flow-through income, 20% of the $100,000 would be at 0 tax rate. You would pay the remaining 80% on your personal tax return, whatever your marginal rate is for that particular year. For every strata of tax, it is a 20% discount. Matt said there are limits they put in place to curve the benefit; but the first way they looked at it was if your taxable income is below $315,000 for a married couple, you take the 20% free income tax cut for your business income. If your income is above $315,000, then the question to look at is whether your business is a service-based business or non-service-based business.
Examples of service-based businesses would be attorneys, CPAs, doctors, and brokerage firms. If you are a service-based business and your income is above the threshold, then your 20% tax-free tier starts to get phased out and does so quickly. When you are above $415,000, you essentially don’t get any benefits. If you are in the non-service business, there you have other calculations to figure out whether you can use the 20% benefit. They would look at how much wages you are paying to other people or to yourself. These include wages within your “business.” They would also look at how much you own in depreciable assets at the entity level. Essentially what they are saying is if your income is high, over $400,000, then you may get to exclude 20% of the income but have to make sure you have enough wages, assets, or are paying other people.
The question they have been asked the most is what flow-through income is. Can you have an LLC, or do you have to be a corporation or partnership? One of the most interesting pieces that came out was that when flow-through income was defined, they were not really referencing flow-through entities. At this point, it looks like the 20% deduction would apply to somebody in an LLC, corporation, or partnership, but also somebody who is operating in their individual name as a sole proprietorship. If Amanda, for example, were flipping properties in her name, she would be eligible for this.
This applies to rental income as well. If you owned a property on Main Street, for example, and you still had taxable income after depreciation, this looks to be one of the additional benefits you could take. The entity distinction is not really as important as it is to stay under the $300-$400,000 income threshold to get the maximum benefit. This would include trust as far as you holding title. It would depend on the trust. A lot of what Keystone CPA sees of their clients are land trusts and title holding trusts, and these are all considered flow-through in terms of the particular tax change.
Bruce asked if trust deed investment income is part of this as well. Amanda said the types of income they have excluded specifically from this are interest income, dividend income, and capital gains income. These are currently not eligible for this 20% tax-free exclusion. However, rentals are, which is shocking.
Bruce next asked where estate tax comes into play, specifically estate tax and the size of the estate that has become not taxable. Bruce asked what it is currently and to what it is changing. Matt said right now the top rate is 40%, and this is with above $5.6 million for a single person and $11.2 million for a married couple. They are essentially doubling the amount before the rate kicks in. Now a single person can die with assets up to $11.2 million rather than $5.6. When you say the top rate, it is like the only rate. You don’t have 15% for $2 million, you just have zero until you get to that rate. The ultra-wealthy and people with estates of $10 million or more may still have a state tax, but for a lot of people the state tax issue may go away.
Amanda said when they were talking about the repeal of the state tax or doubling it, one of the things they were looking out for what would go away. In the past, if you bought a property for $1 million and was worth $5 million when you passed away, the $4 million of appreciation in your lifetime was essentially tax-free. When it gets to your beneficiary, they inherit it at the $5 million mark. They can then sell it the next day, and their cost basis would be $5 million and create zero gain.
One of the greatest things on the estate side for Keystone CPA is that they have not only doubled the exemptions, but they also retained the step of faith system. Now, essentially, you can hold $11 million of assets per person, pass away with it, and have all of that be essentially tax-free gain when you leave it to your beneficiary. This is a powerful benefit they were able to keep and increase.
Bruce asked if you were a California resident and paying a particular amount, 12% or more in tax not being deducted, and you think about what that will cost you now, would it have any ramifications for high tax states to lose migration? Matt and Amanda speak in front of audiences every year, and one thing they see is the mood transition. Bruce wondered if any of their clients say it’s not worth and will live half their lives somewhere else. Matt said they have seen this, though not to the extent people make it out to be. They have definitely had people who leave California because they are tired of paying the 12-13% tax rate.
Amanda said 50% of their clients are actually outside of California, but what is interesting is how looking back over the past two years, out of all the clients they worked with they only had two people who have moved into California from a different state. One was from Texas, the other was from New York. She was not surprised about New York, but she was with Texas because she felt like they were moving the wrong direction. The vast majority of their clients who are moving out are moving into states like Texas, Florida, and Georgia where the tax rates are much lower. She does not know if the removal of state deductions is necessarily the deciding factor. If California would just increase rates even more, that might be a factor and you may see more businesses moving out.
At the end of 2017, Amanda encouraged everyone to look ahead. Some of the usual year-end strategies they talk about in terms of accelerating expenses and deferring income and capital gains are still great strategies. They are more important than ever since this is a year where in a rare situation we know tax rates will be going down for a lot of people. By pre-paying expenses and deferring income, not only do you defer the associated tax, but you also get a permanent tax savings just by playing with the difference in the tax rates. This could mean getting a saving at 39% versus taking a deduction at 32% in 2018. Amanda said this was the main thing she encouraged everyone to think about as they were heading into the Christmas season.
Retirement planning is a big thing in terms of tax-planning and wealth-building as well as self-directed retirement accounts. Going forward, one thing changing is ROTH IRA conversions. You can still do conversions going forward; but using an example from 2017, if you converted somebody to a ROTH that year, between then and whenever you file your 2017 return you have the ability to look back on transaction and undo it since your income was a lot higher than you thought it would be. You will end up paying more on the ROTH conversion than you were planning. You have that ability to re-characterize or undo the ROTH conversion as long as you do it before you file your 2017 return.
Going forward, what is changing is if you do a conversion in 2018 or beyond you can no longer undo it after that. The takeaway is if anybody was thinking of doing ROTH conversions in the next 1-24 months, you may want to get some serious consideration to doing it in the next week. After that, hit the undo button later on before filing your 2017 return if it does not make sense to keep it as is.
Bruce asked if there are any changes to the amounts you can set aside for entities like SEP IRAs. Matt said this was not touched on with respect to the new tax law. Every year they increase it based on inflation, and they came out with these new numbers for 2018 a few months ago. However, this did not change with the new tax reform bill.
The verbiage they used was along the lines of it expiring in 2024. In fact, the exact word they used was sunset. This means that with respect to certain provisions of it, it will go away after that year. A lot are going away after 2025, although it’s not known why they picked that year as opposed to earlier. There are certain changes that are permanent changes that are never set to expire. Unless there is new legislation to change it, like corporate rates, for example, things like exemptions and bonus depreciation will expire after a certain number of years. All of this is subject to re-negotiation during the process.
In the next 5 years, there could be a new president or repeals or changes that we have no idea are coming. None of this is locked in stone. It does not mean, for example, we will have a corporate rate of 21%. What is really interesting is regardless of what you see on the news, for the vast majority of Americans they will see some amount of tax savings starting in 2018. Historically speaking, once the tax law passes different constituencies will speak with the IRS on how everything works realistically. What we will likely see is there will be some audits on the side of the IRS that will go after people who try to abuse the system. Historically this is what happens. From there, we will see some tax court cases and get updates on what they mean exactly by “services business” and what it includes. There will be plenty of changes and refinement in the next 1-5 years likely from what the vote passed on the previous day. The excitement will be around for quite some time.
For more information, you can call Keystone CPA at 1-877-975-0975.
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