Well, it is now the law of the land. On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law, giving the Republicans their first major legislative win since President Trump took office. The sweeping reform will have a significant impact on California.
As Silicon Valley's top listing agent, a high-income taxpayer and a tax attorney, I have been watching the various proposals for tax reform with a keen eye. I'm not alone. Silicon Valley residents are nervous and worried.
Taken as a whole, and in general terms, the new tax legislation should be very good for corporations, shareholders, the very wealthy, and the middle class in the heartland of the country. On the other hand, there may be negative consequences for the "working wealthy," with combined incomes between $400,000 and $1.5 million in high tax states, such as New York and California. Unfortunately, the "working wealthy" group makes up a significant portion of the buyer pool of expensive Silicon Valley real estate.
First, let's clear up some of the confusion about the new rules, starting with the good news.
Highest tax rate lowered
The highest tax bracket now starts at $600,000 and comes with the benefit of lowering the highest rate to 37%. This nets out to be a very positive change for the extremely wealthy, but may be particularly hard on Silicon Valley families, where it is not uncommon to have both spouses employed at high-paying jobs.
Step-up in basis on death of one spouse
The new legislation retains the step-up in basis rule. Under this rule, homeowners with highly appreciated real estate receive forgiveness of the capital gains taxes that would have been due upon sale, if these assets are still held by the taxpayer on the date of his/her death. As a result, many Silicon Valley homeowners are wisely advised not to sell their highly appreciated real estate prior to their death. Thus, any change to this rule could have resulted in a rapid increase to the number of homes coming onto the market and a corresponding decrease in home values.
Like-kind exchange rules remain in place
"Like-kind exchanges" remain materially unaltered with regard to real property. Taxpayers are still permitted to defer the capital gains tax on appreciated real property by purchasing qualifying replacement property. The seller still has 45 days to identify the replacement property and 180 days to close. Under the new rules, however, this provision is only applicable to real property—personal property no longer qualifies for the deferral.
Exclusion of capital gains kept at $500K
Although the House and Senate Bills called for substantial limitations on taxpayers' ability to exclude up to $500,000 in gain in the sale of their primary residence, the final legislation leaves this rule untouched. Thus, taxpayers can still exclude up to $500,000 (married, filing jointly) in gain if they have owned the property for more than two years and have lived in the property for at least two of the past five years. There is no phase-out of this deduction. It should be noted that this taxpayer-favorable rule appears to be on Congress's radar screen, and could be repealed at some point in the future.
And now for the bad news...
How the reduced SALT deduction could hurt long term
Without question, the most significant change facing California homeowners is the dramatic limitation on the deductibility of state and local taxes ("SALT"), including both state income taxes and county real property taxes. Although, under the newly enacted rules, taxpayers are permitted to deduct up to $10,000 in state and local taxes, most people that can afford to purchase real estate in Silicon Valley already pay over $10,000 in state income taxes so this change effectively eliminates the deductibility of all property taxes. This change will reduce the incentive for the purchase of real estate.
Longer term, this change may make it more difficult to attract top talent to the state. As a result, we are likely to see businesses locate high paid operations out of state to the extent practicable. Naturally, these concerns will be counterbalanced, to some degree, by the overall desirability of the state and the robust business environment.
Although we expect this provision to have an immediate and significant impact on the buyers' desire to purchase homes, this impact should diminish over time as some taxpayers realize that state and local taxes were a "preference item" under the AMT rules, and, as such, were already added back. In other words, not all taxpayers were getting a benefit from the SALT deduction so the loss of it will not hurt them as much as they may fear at first.
Reduced mortgage interest deduction unlikely to dissuade buyers
Under the new law, mortgage interest on loans used to purchase property will only be deductible up to the first $750,000 of principa, down from $1 million. An allowance for deducting interest on up to $100,000 of home equity credit was also dropped.
We do not expect this change to have significant impact on the psyche of potential buyers because interest rates are so low and buyers of expensive real estate have proven undaunted by the non-deductibility of a portion of their mortgage interest.
Overall reduction in incentives to buy homes
The near doubling of the standard deduction, and the reduction of the deductibility of state taxes and mortgage interest, will have the unintended consequence of reducing the incentive for people to buy rather than rent. We expect this impact to be most pronounced on lower priced homes, but the entire market should feel some sort of effect. While there are both benefits and detriments associated with entry level homes becoming more affordable, current homeowners may want to be prepared for a turbulent ride.
AMT exemption increased
The new legislation raises the point at which the AMT exemption is phased out, from $164,100 for joint filers to $1,000,000 for joint fillers. This increased limit, coupled with the reduction of available deductions, should result in a much lower percentage of the population paying AMT.
Individual tax changes to sunset after 2025
Much has been made about the fact that the changes to personal income taxes will sunset after 2025, whereas the corporate changes are permanent. However, I believe this is more of an administrative requirement rather than the long-term intent of the legislation.
Under the "Byrd Rule," any plan for tax reform cannot add to the deficit beyond a 10-year budget window. If it does, a super-majority of 60 votes would be required to pass the Senate, which would require bipartisan support. By including the sunset provision, only a simple majority was required. Congress could extend these changes by simple majority as the 2025 date approaches.
Thus, we believe that the sunset provision was one of legislative convenience, rather than a telegraphing of a long-term intent to eliminate the tax changes for individuals.
No change to capital gains rates
Many had hoped that there would be a decrease to the capital gains tax rates, which start at 15% for federal purposes and increase to 23.8%, inclusive of the 3.8% tax on Net Investment Income to fund the Affordable Healthcare Act (i.e., "Obamacare"). Unfortunately, the new legislation leaves these rates in place, including the 3.8% surtax.
Personal exemption suspended
While the Standard Deduction was increased from $12,700 to $24,000, the personal exemption of $4,150 per dependent was suspended. Thus, the net effect of these two provision will vary from family to family. It should be noted that the old personal exemption was phased out for couples making over $320,000 whereas the phase-out of deductions has been eliminated under the new legislation.
Conclusion
Overall and nationwide, most taxpayers will see a net decrease in their federal taxes as a result of the recently enacted Tax Cuts and Jobs Act. However, there will be a net increase to taxes for many highly paid people in Silicon Valley. This could result in some businesses deciding to form, or move operations, to states with low or no state taxes if otherwise economically feasible. The extremely high cost of living in the Bay Area, most notably with regard to housing, and the non-deductibility of state taxes, may make it more challenging for employers to recruit to this area.
However, the reduction in corporate income taxes and the incentives to move money back to the United States, should have a positive effect on businesses. Silicon Valley's Tech economy is extremely strong, and the area is very attractive. Ultimately, only time will tell whether the strength of the local economy, and the desirability of the area, are sufficient to weather these tax changes that hit us particularly hard.
*This is a high- level summary of the recently released tax rules. Readers are advised to discuss the new rules with their tax advisors to determine how the changes will impact their personal circumstances. This article may not be relied upon as tax or legal advice.
DeLeon Realty offers a higher level of service and a greater depth of competency than any other real estate organization in Silicon Valley.
