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Tax Reform for Real Estate Businesses and Investors by John G. Ebenger, CPA

Posted on January 17, 2018 by John Ebenger

The Tax Cuts and Jobs Act (TCJA) that overhauls the U.S. Tax Code represents new, often more-favorable tax treatment for real estate business owners and investors. However, the full benefit of these provisions will require careful evaluation and planning as the IRS catches up to the new law and provides technical guidance.

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 percent and 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 permanent corporate tax rate of 21 percent, down from 35 percent, while also eliminating the corporate Alternative Minimum Tax (AMT).

Pass-Through Business Structures

Businesses that are structured as pass-through entities, such as partnerships, LLCs, S corporations and sole proprietorships, may, subject to limitations, receive a deduction as high as 20 percent on U.S.-sourced “qualified business income” (QBI) that flows through to their owners’ personal tax returns. The deduction, which also applies to property rental businesses, trusts and estates and to taxpayers who receive qualified REIT dividends, qualified cooperative dividends, and/or qualified publicly traded partnership income, is available only through 2025; in 2026, the law calls for pass-through business income to be taxed using the standard individual tax rates and brackets that are in effect at that time.

In general, the 20 percent deduction is capped at the greater of the following:

1) 50 percent of wages paid to employees and reported on W-2s; or

2) 25 percent of W-2 wages plus 2.5 percent of a business’s original cost of qualifying, tangible depreciable property that generate trade or business income, including buildings, equipment, furniture and fixtures.

When determining the allowable deduction, many rental real estate operations will need to consider that while they may have limited W-2 wages, they may also have significant qualifying tangible and depreciable property to help maximize the 20 percent deduction.

Real estate businesses may need to reassess their existing operations in order to realize the potential benefits they may gain from the new pass-through deduction. This can include a review of their existing structures and the tax liabilities or savings they may potentially receive from restructuring, perhaps as C corporations. In addition, applicable businesses should assess how they pay employees and independent contractors and 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

Under the new law, qualified tangible property acquired and put into service after Sept. 27, 2017, and before Jan. 1, 2023, may be eligible for 100 percent “bonus” depreciation in the year of purchase. This first-year bonus depreciation deduction will begin to decrease after 2023 until it will no longer be available in 2027. Prior to the TCJA, businesses were permitted to expense only 50 percent of the price they paid to acquire and put into service qualifying property or to make non-structural improvements to the interiors of nonresidential buildings in 2017.  The rate was scheduled to decrease to 40 percent in 2018 and to 30 percent in 2019.

By effectively doubling the amount that businesses can write off in the first year for the purchase of all eligible assets, the new rules provide qualifying businesses with an immediate tax-saving opportunity to reduce the amount of profits that are subject to tax. Moreover, the law expands the availability of bonus depreciation in 2018 to “previously used” assets.

However, the new law specifically excludes from the definition of bonus-depreciation-eligible property qualified leasehold improvements; qualified restaurant and retail improvements; and replaced it with non-leased “qualified improvement property” (QIP), which the PATH Act identified as structural improvements to the interiors of nonresidential property that was placed in service after Sept. 27, 2017. It may appear that Congress intended to provide a 15-year recovery period for QIP and for it to be bonus-depreciation-eligible. However, until the IRS issues some form of technical correction, QIP will be depreciated over 39 years.

Section 179 Expensing

Beginning with the 2018 tax year, 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, including computer software and qualified leasehold, retail and restaurant improvements. The amount of the deduction will be 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 property, fire protection and alarm systems, and security systems) made to nonresidential real property.

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. Carryforwards will be limited to 80 percent of a business’s taxable income, but these NOLs may be applied against taxable income indefinitely. As a result of the tax reform law, businesses will need to adjust carryovers from prior tax years to account for the 80 percent limitation.

Business Interest Deduction

Generally, the TCJA limits the interest payments that businesses may deduct to 30 percent of adjusted gross taxable income beginning in 2018. The law reduces that limit further beginning in 2022. However, the law does provide a number of exceptions to this limit that are specific to real estate businesses and investors. For example, eligible taxpayers may elect to fully deduct interest accrued in the development, construction, acquisition, operation, management, leasing or brokerage of real property. In addition, there is an exception for taxpayers that are considered “small business” with average annual gross receipts of $25 million or less for the three most recent prior tax-year periods.

Under the new law, amounts not allowed as a deduction for a taxable year may be carried forward to future years, indefinitely, subject to restrictions that apply specifically to partnerships.

Carried Interest

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 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. The law, however, did eliminate the availability of tax-deferred exchanges of personal property, such as art work, 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 info@bpbcpa.com.

 

Property Owners Can Expedite the Recovery of More Capital Improvement Expenses UPDATED with Tax Reform News by John G. Ebenger, CPA

Posted on January 11, 2018 by John Ebenger

The Internal Revenue Code permits owners of business- and income-producing real estate to deduct from their taxable income an allowance for the wear and tear, deterioration or obsolescence of property over time. In addition, some businesses have been able to accelerate depreciation deductions to more quickly recover the cost and other basis of certain capital investments in property improvements. However, unbeknownst to many property owners, the laws changed in 2015 and extended the potential application of first-year bonus depreciation to a broader range of nonresidential property improvements. When real estate owners and investors miss out on these deductions, they may be leaving significant tax and cost savings on the table while also losing out on opportunities to improve the long-term value of their investments.

With the passage of the Tax Cuts and Jobs Act (TCJA) on Dec. 20, 2017, the technical implementation of bonus depreciation will change as the IRS issues guidance in 2018 to confirm to the provisions contained in the new tax reform law.

Then and Now

Under the U.S. tax code, businesses are typically allowed to deduct most “ordinary and necessary” business costs from their taxable income in the year they accrue those expenses. In contrast, a business’s capital investments in tangible property, including equipment, machinery and buildings, are deductible over several years of the property’s useful life, unless it qualifies for an immediate first-year bonus depreciation.

In 2002, Congress introduced the concept of bonus depreciation to apply to new property with a recovery period of 20 years or less, including off-the-shelf computer software, water utility property, and qualified leasehold improvement property (QLHI). This final category applied only to improvements businesses made to commercial property, excluding land, that they leased and made available for use at least three years after the building itself was placed in service. For the next 13 years, businesses were left in a state of uncertainty as Congress either allowed bonus depreciation to lapse or extended it temporarily to cover as much as 100 percent of expenses for qualifying assets, depending on the tax year for which the property was placed in service.

With the 2015 passage of the Protecting Americans from Tax Hikes (PATH) Act, 50 percent bonus depreciation was revived and extended to cover non-leased, qualified improvement property (QIP) acquired and placed in service after Dec. 31, 2015, and until Dec. 31, 2017, the impact of TCJA has not been addressed.

A Broader Range of Assets Now Qualify for Bonus Depreciation

Building improvements are typically very large expenditures that can stagnate a business’s cash flow. The logic behind bonus depreciation is that the quicker businesses are able to deduct and recover the costs of investments in real property improvements, the more money they will free up to invest in other assets that can expand their operations and improve their profit potential.

The PATH Act allowed property owners to apply bonus depreciation to a broader range of improvements to nonresidential property, regardless of whether or not the underlying property is leased. Moreover, the law lifted a prior restriction that limited the application of bonus depreciation to property that was at least three-years-old.

Under guidance issued in 2017, businesses received the ability to immediately write off a portion of QIP only when they made the improvements after the date the building was first placed in service. Therefore, deductions would apply to qualifying improvements that were made as soon as one day after a building was placed in service. The only exceptions to bonus-eligible property are 1) enlargements of an actual building, 2) changes to the internal structural framework of a building, or 3) any improvements to the building’s elevator or escalator.

Therefore, consider a taxpayer that completed construction on a new, 50,000-square-foot office building in January 2017 and subsequently expended $500,000 to build out 1,000 square-feet of a new tenant’s space in November 2017. Under this definition of QIP, the building owner could in 2017 deduct from taxable income 50 percent of the costs he or she incurred to build out the new tenant’s space, simply because the building predates the improvements.

If the building is 30-years old, and the owner completed a $1 million renovation to update the property’s common areas in 2017, 50 percent of those costs ($500,000) would qualify for bonus depreciation if the renovations maintained the structural integrity of the building and did not involve improvements to elevators or escalators. Not only would the building owner reduce 2017 tax liabilities, he or she will also be able to recover one-half of the costs incurred to improve the value and future marketability of the building.

Planning Opportunities

The short-term certainty of these relaxed and less restrictive rules for bonus depreciation represents significant savings for owners of commercial real estate, businesses that invest heavily in equipment and machinery, such as manufacturers and distributors, as well as those entities that rely on frequent software updates. The only limit to the benefit of applying bonus depreciation is a business owner’s reluctance or failure to plan ahead with the guidance of experienced tax advisors.

Not only will property owners be able to use the immediate tax deductions to offset improvement costs in the current year, they will also free up cash flow to invest in other income-producing business activities. Moreover, because there is no spending or investment threshold on QIP used in a trade or business or for the production of income, some businesses may be able to create taxable losses to further reduce their tax liabilities

In some instances, businesses that failed to plan ahead or who put QIPs into service in 2016, may file amended tax returns to retroactively apply bonus depreciation to those activities they failed to report in that tax year. This assumes that businesses did not formally elect out of bonus depreciation on their 2016 income tax returns.

Businesses have an additional opportunity to qualify for both first-year bonus depreciation and Section 179 property deductions, especially when they make improvements to qualifying leasehold property, and/or retail or restaurant property. A cost segregation study is key to helping taxpayers identify all of the assets associated with the purchase, construction, repair and renovation of a property that may qualify for accelerated depreciation deductions and cost recovery.

 

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 info@bpbcpa.com.

 

754 Elections Have Immediate Impact when Selling, Buying or Liquidating Partnership Interest – UPDATED Under Tax Reform by Dustin Grizzle

Posted on January 05, 2018 by Dustin Grizzle

The sale, exchange or liquidation of partnership interest in appreciated property, such as real estate, is a common occurrence among partners and members of partnerships and LLCs taxed as partnerships. Whether due to disagreements among the partners, the death or divorce of a partner, or the addition of new partners, these transactions can result in a discrepancy between a property’s fair market value (FMV) and its basis, which can ultimately affect the tax treatment of each partner’s reported income, gains and losses. To remedy this, a partnership may make a 754 election under Internal Revenue Code sections 743(b) and 734(b) to equalize the buyer’s basis in the purchased partnership interest in property (outside basis) and the buyer’s share of the basis of the assets inside the partnership net of liabilities (inside basis).

 

While this election can be somewhat complex and time-consuming, it provides an incoming partner with a step-up or step-down in basis to reflect the FMV of the property at the time of the transfer; failing to make a 754 election can represent a missed opportunity for a partner to accelerate deductions and recover basis in a shorter period of time.

 

Understanding the Basics of Basis

When an entity or person buys an interest in a partnership with appreciated assets, its “outside basis” in the property increases to the purchase price. Subsequently, the entity or person may reduce or even eliminate taxable gains when it sells the property in the future.

 

In general, partners or members of pass-through entities will typically increase their basis in partnership interests through partnership contributions and taxable and tax-exempt income; their basis in the property will decrease due to distributions, nondeductible expenses and deductible losses. Therefore, when existing partners sell their interests in property owned by the partnership, they will typically recognize a gain or loss, while the new partner’s basis in the property will become the purchase price that he or she paid. If the property is highly appreciated, the buyer’s outside basis in the partnership interest will far exceed the inside basis in those assets. Ultimately, this can remove the new partner’s rights to immediate depreciation deductions and defer his or her benefit of additional basis until the underlying property is sold.

 

A 754 election bridges the gap between inside and outside basis by immediately stepping-up or stepping-down the basis of the remaining partnership assets. This permits the entity the option to equalize the partners and provide them with a tax asset. This tax asset allows the new partner to reduce or eliminate the tax on gains and losses already reflected in the price he or she paid for the partnership interest when the asset is sold. In addition, when the adjustment relates to depreciable or amortizable property, such as real estate, the new partner may begin taking those deductions in the year the election is made rather than waiting to recoup his or her basis when the property is transferred or sold in the future.

 

Exceptions to these rules exist for “substantial basis reductions” and “substantial built-in losses” that require a step-down in basis, even in the absence of a 754 election, when one of either of the following criteria are met:

the partnership has a built-in loss of $250,000 or more;
there is a downward basis adjustment of $250,000 or more; or
The transfer or sale involves an electing investment partnership, such as a hedge fund.
In addition, the tax reform package that President Donald Trump signed into law effective Jan. 1, 2018 updates this language to include the following:

 

The partnership has a substantial built-in-loss with respect to a transfer of partnership interest if either a) the partnership’s adjusted basis in the partnership property exceeds by more than $250,000 the fair market value of the property (Code Sec. 743(d)(1)(A) as amended by 2017 Tax Cuts and Jobs Act §13502(a)), or b) the transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to their fair market value immediately after the transfer.

 

 

Under all of these circumstances, anti-stuffing rules will apply in order to limit a buyer’s ability to benefit from overvalued net operating losses (NOLs) and NOLs earned in years prior to the date of the purchase.

 

How a 754 Election Works

Assume that in 2000, partners A, B and C contribute $100 each in exchange for a 1/3 interest in Donut LLC. Donut purchases a $300 asset depreciable over 10 years on the straight line method and earns $900 income before depreciation over the first 5 years. Donut distributes $600 of that amount to each partner in 2005, providing it with an inside basis of $450 ($300 asset – $150 depreciation + $900 income – $600 distribution). This amount equals the total of each partner’s individual outside basis ($150 X 3) in her or her partnership interests.

 

Now consider that in 2006, Partner C sells his entire 1/3 interest in Donut LLC to New Partner D for $250 cash. Partner C will incur a $100 long-term capital gain on his 2016 personal tax returns ($250 sales price – $150 basis). Subsequently, Partner D will take over Partner C’s capital account of $150, which exceeds by $100 his proportionate share of his basis ($250) in Donut LLC’s assets.

 

If Donut breaks even in years 2006 through 2016 and disposes of the property without a Section 754 election on Jan. 1, 2017, Partner D will not recover his outside basis or $100 (purchase price in excess of “inside basis”) until the year of liquidation.

 

Had Donut LLC made a Section 754 election in its 2006 tax returns, Partner D would have recovered his inside/outside basis difference of $100 as a $10 ordinary depreciation deduction each year until the additional basis was fully recovered. The ultimate sale of the asset in 2017 would result in the same capital gain to all partners. Without the 754 election, Partner D would have missed the benefit of timely deductions during the years 2006 through 2016.

How to Make a Section 754 Election

 

Section 754 elections are available only to partnerships and LLCs taxed as partnerships for which the entity’s income and losses pass through to each partner. A valid election requires strict adherence to procedural guidelines, including the filing of a written statement with the partnership’s tax return in the year that the distribution or sale occurred. Because the election is made at the entity level, the statement must specify the name and address of the partnership, and it must contain a declaration that the partnership elects under section 754 to apply the provisions of section 734(b) and section 743(b). Once the election is made, it will remain in effect for all future years, unless the partnership applies for and receives IRS approval to revoke it.

 

The decision to make a Section 754 election can be complicated and burdensome, but it may be well worth the effort for accelerating a partner’s tax deduction following a sale, exchange or liquidation of partnership interest. However, making this determination is best accomplished under the guidance of professional accountants.

 

The advisors and accountants with Berkowitz Pollack Brant work with domestic and international businesses to meet regulatory compliance obligations, optimize profitability and maintain tax efficiency.

 

About the Author: Dustin Grizzle is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax-planning and compliance services to high-net-worth individuals and businesses in the manufacturing, real estate management and property investment industries. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at info@bpbcpa.com.

Republican Tax Bill Proposes End of Like-Kind Exchanges for Art Collectors by Barry M. Brant, CPA

Posted on December 05, 2017 by Barry Brant

Current tax laws allow business owners and investors to defer recognition of capital gains tax when they use the proceeds from the sale of one asset to purchase a similar asset of equal or greater value within a period of 180 days. Traditionally, this reinvestment of capital has allowed qualifying taxpayers to avoid or defer significant federal and state income taxes on the sale of appreciated investment property, such as artwork and other valuable collectibles, the gains from which are taxed at 28%. However, under the Republican’s proposed tax reform plan, this preferential treatment of 1031 like-kind exchanges would be limited solely to real estate investment property and no longer apply to collectibles effective with sales on or after Jan. 1, 2018.

 

This does not bode well for art investors, because the GOP bill aims to eliminate tax-deferred treatment for the exchange of appreciated personal property. Therefore, collectors of art, coins, cars and other collectibles should consider accelerating any planned asset sales and lodging the proceeds with a qualified intermediary before year-end. This will provide ample time to purchase replacement property within the required 180 day period (even though it will fall into 2018) and defer tax on sales occurring prior to December 31, 2017.

 

The advisors and accountants at Berkowitz Pollack Brant have significant experience assisting collectors with tax-free exchanges of art and other types of collectible personal property. Our team works to bring the best solutions to clients for their income and estate planning needs.

 

About the Author: Barry M. Brant, CPA, is director of Tax, Consulting and International Services with Berkowitz Pollack Brant, where he leads the firm’s private client group and provides guidance on complex tax matters, including multi-national holdings, cross-border treaties and wealth preservation and protection.  He can be reached in the CPA firm’s Miami office at (305) 379-7000, or via email at info@bpbcpa.com.

 

When is a Building Considered “Placed in Service”? by John G. Ebenger, CPA

Posted on November 29, 2017 by John Ebenger

In order for businesses to take advantage of bonus depreciation on qualified improvement property (QIP), they must first understand how to determine the date that a building is considered to be “placed in service.”

In 2015, the PATH Act extended 50 percent bonus depreciation to non-leased QIP that is acquired and “placed in service” after December 31, 2015, and before December 31, 2017. The bonus rate will begin to phase out in 2018 when a 40 percent rate will apply to buildings placed in service during that year, and 30 percent in 2019 (or 2020 for aircraft and longer-production year property).

Many businesses seeking to apply this incentive during its short window of availability will face intense IRS scrutiny when they claim a building’s “placed in service” date is on the day it receives a certificate of occupancy, even if the building is not yet “ready and available for a specifically assigned function,” as required by the Treasury Department.

The IRS considers a building to be ready and available for use when the following benchmarks are achieved:

•           It receives approval of all required licenses and permits;

•           Control of the facility passes to the taxpayer;

•           It completes critical tests; and

•           It commences daily or regular operations.

 

However, in 2015, a U.S. District Court ruled in favor of a taxpayer who challenged the IRS’s definition of “placed in service” to include “open for business.”

In the matter of Stine, LLC v. United States, the court ruled that a taxpayer could begin deducting depreciation on a retail store when the property received a certificate of occupancy and was “in a condition of readiness and availability” even though it was not yet officially open to the public. While the court’s opinion opened the door for taxpayers to accelerate a placed in service date, the IRS in 2017 announced that it will not comply the court’s ruling and will instead continue to litigate the issue.

The IRS argues that property may be consider placed in service only after it is “ready and available for regular operation and income producing use.” Therefore, it is critical that property owners consult with tax advisors experienced in real estate matters in order to properly assess whether or not their buildings and qualified improvement property satisfy the IRS’s narrow definition of placed in service.

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 info@bpbcpa.com.

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