Tax Reform for Real Estate Businesses and Investors by John G. Ebenger, CPA
Posted on January 17, 2018
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.
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 firstname.lastname@example.org.