How is Tax Reform Shaping Up for Real Estate Businesses and Investors? by John G. Ebenger, CPA
Posted on October 26, 2018 by John Ebenger
There’s no question that the Tax Cuts and Jobs Act (TCJA) provides a big win for real estate businesses and investors. However, realizing the full benefit of these provisions will require careful evaluation, strategic planning and flexibility, as the IRS and U.S. Treasury continue to trickle out guidance that taxpayers may apply to their unique circumstances. Here’s a brief overview of some of the new regulations that taxpayers should be addressing with their accountants and advisors.
Lower Income Taxes for Individuals and Businesses
For starters, the new law reduces the top marginal income tax rate for high-income earners from 39.6 percent to 37.0 percent and more than doubles the estate tax exemption, which allows individual taxpayers to exclude from estate tax up to $11.2 million in assets, or $22.4 million for married couples filing jointly. At the same time, the TCJA establishes a corporate tax rate of 21 percent, down from 35 percent, while also eliminating the corporate Alternative Minimum Tax (AMT).
Potential Deduction for Pass-Through Entities, Trusts and Estates
Businesses that are structured as pass-through entities, such as partnerships, LLCs, S corporations and sole proprietorships, may qualify to deduct annually as much as 20 percent of U.S.-sourced “qualified business income” (QBI) that flows through to their owners’ personal tax returns. While the deduction is subject to a myriad of restrictions, based on taxpayers’ lines of business and their taxable income, the consensus is that investors and professionals involved in the real estate industry can reap significant tax savings. Realizing these benefits may require taxpayers to reassess and perhaps restructure their existing operations, including how they pay employees and independent contractors, and evaluate more closely how the new law will treat specific items of income, such as triple net leases or ground lease real estate rentals.
First-Year Bonus Depreciation
The TCJA allows businesses to immediately write-off 100 percent of the costs they incur for an expanded list of qualifying tangible personal property, including previously used assets that they purchased or financed during the tax year. Under prior law, bonus depreciation was limited to 50 percent and applied only to new property. As a result, qualifying businesses may now immediately recover the full costs of more investments they make to grow their operations. Yet, because additional guidance is still forthcoming from the IRS, taxpayers should plan carefully.
Section 179 Expensing
Eligible businesses may take an immediate deduction of up to $1 million per year for the costs they incur to acquire qualifying improvement property and business assets. The amount of the deduction is reduced dollar-for-dollar when acquisition costs exceed $2.5 million. Previously, the Section 179 deduction was limited to $500,000, and it began to phase out at $2 million.
As an added benefit, the TCJA also expands the definition of Section 179 property to include other improvements made to nonresidential real property, including roofs; heating, ventilation, and air-conditioning; fire protection; and alarm and security systems.
Net Operating Losses
Prior to the TCJA, businesses were permitted to carry back net operating losses (NOLs) two years or carry them forward 20 years to offset table income. Effective for the 2018 tax year, however, NOLs can longer be carried backward. NOL carryforwards, which are now limited to 80 percent of a business’s taxable income, may be applied against taxable income indefinitely. As a result of the tax reform law, businesses will need to adjust 2018 carryovers from prior tax years to account for the 80 percent limitation.
Business Interest Deduction
The TCJA generally limits the interest payments that businesses may deduct to 30 percent of “adjusted” gross taxable beginning in 2018 and further limits the deduction beginning in 2022. However, the law does provide real estate businesses and investors with a number of exceptions to this limit. For example, eligible taxpayers may elect to fully deduct (after any required capitalization) interest accrued in the development, construction, acquisition, operation, management, leasing or brokerage of real property. In addition, there is an exemption for certain taxpayers considered “small business” with average annual gross receipts of $25 million or less for the three most recent prior tax-year periods.
Congress spent the past several years debating the preferential tax treatment of management fees and other forms of compensation (in excess of salaries) paid to partners, managers and developers for a share of a business or a project’s future profits. This concept of carried interest treatment survived Congressional wrangling over tax reform and will continue to be taxed at the favorable long-term, capital gains rate of 20 percent rather than the maximum ordinary income rate, which under the TCJA is 37 percent. However, the new law does limit the tax treatment of these gains to apply only to assets held for more than three years or sold after three years.
Section 1031 Like-Kind Exchanges
Thanks, in large part, to the lobbying efforts of the National Association of Realtors and National Association of Real Estate Investment Trusts, Section 1031 exchanges of like-kind real estate property will continue to receive tax-deferred treatment under the TCJA. Nevertheless, the law eliminates the availability of tax-deferred exchanges of personal property, including items such as artwork, coins and other collectibles.
About the Author: John G. Ebenger, CPA, is a director of Real Estate Tax Services with Berkowitz Pollack Brant, where he works closely with developers, landholders, investment funds and other real estate professionals, as well as high-net-worth entrepreneurs with complex holdings. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.