Impact of Tax Reform for Real Estate Owners and Developers
Signed into law on December 22, 2017, the Tax Cuts and Jobs Act is the most comprehensive reform in three decades. Here are six key provisions in the tax law that owners and developers of real estate should be aware of.
100% Expensing for Certain Business Assets
Pre-reform law – For 2017, 50% expensing (bonus depreciation) is allowed on qualified property (only new property qualifies). For 2018 and 2019, expensing would be phased out and then disappear thereafter. New law – 100% expensing (bonus depreciation) is allowed on qualified property (both new and used) purchased and placed in service after September 27, 2017 and before January 1, 2023. The expensing is then phased down to 80%, 60%, 40%, and 20% in the years 2023 - 2026 and is gone thereafter. Section 179 Expensing Pre-reform law – Most taxpayers are eligible to deduct, in lieu of depreciation, the cost (subject to dollar limits) of most tangible personal property, and certain other property, used in the active conduct of a trade or business. The maximum amount that can be expensed is $510,000 for property placed in service in tax years beginning in calendar year 2017, and is reduced dollar for dollar by the amount of Section 179 property placed in service during the tax year in excess of the investment ceiling ($2,030,000 for 2017), also subject to taxable income limitations of the company. New law – Beginning in 2018, the maximum amount that can be expensed is increased to $1,000,000 and the phase out increased to $2,500,000. In addition, the definition of Section 179 property is expanded to include certain depreciable tangible personal property (property used to furnish lodging). Also, the definition of qualified real property is expanded to include all qualified improvement property and certain improvements (roofs, heating, ventilation, air-conditioning property, fire protection systems, alarm systems, and security systems) made to nonresidential real property. 20% Deduction of Qualified Income from Flow Through EntitiesPre-reform law – No special deduction is in place related to income from a pass-through entity. New law – Beginning in 2018, taxpayers who have domestic qualified business income (QBI) from a partnership, S corporation, or sole proprietorship are entitled to a deduction of the lesser of such QBI or 20% of taxable income. The deduction is taken “below the line”, meaning it reduces taxable income but not adjusted gross income. QBI is defined as the net amount of income, gain, deductions, and losses with respect to a trade or business. The business must be conducted within the U.S. to qualify for purposes of this definition and the deduction. Specified investment-related items are not included within the definition of QBI, such as capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). Further, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business. The pass-through deduction is available regardless of whether the taxpayer itemizes deductions or takes the standard deduction. In general, the deduction cannot exceed 20% of the excess of taxable income over net capital gain. If QBI is less than zero, it is treated as a loss from a qualifying business in the following year.For pass-through entities, other than sole proprietorships, the deduction cannot exceed the greater of:
• 50% of the W-2 wages with respect to the qualified trade or business, or
• The sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.“Qualified property” is defined as tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages of the entity for the tax year. A partner’s or shareholder’s allocable share of W-2 wages is determined in the same way as the partner’s or shareholder’s allocable share of wage expenses. For an S corporation, an allocable share is the shareholder’s pro-rata share of an item. However, the W-2 wage limit begins phasing out in the case of a taxpayer with taxable income exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals). The application of the W-2 wage limit is phased in for individuals with taxable income exceeding these thresholds, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals). There are certain rules designed to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for a deduction. For single taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI begins to be phased in for income of “specified service” trades or businesses, which are those involving the performance of services in the fields of health, law, consulting, athletics, financial, or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. For single filers, if taxable income is $50,000 above the $157,500 phase-in threshold ($207,500), all net income from the specified service trade or business is excluded from QBI. The full exclusion trigger for joint filers is $100,000 above the $315,000 phase-in threshold ($415,000). If taxable income is between the phase-in threshold and the full exclusion from QBI threshold (meaning, between $157,500 and $207,500 for single filers and between $315,000 and $415,000 for joint filers), the taxpayer would exclude only a percentage of income. The applicable percentage is derived from a fraction; the numerator being the excess of taxable income over the phase-in threshold, and the denominator being the full exclusion threshold. Limitation on Business Interest Expense Deduction Pre-reform law – Business interest is generally deductible with no limitations. New law – For tax years beginning after December 31, 2017, the deduction for business interest expense is limited to the taxpayer’s business interest income for the tax year plus 30% of the taxpayer’s adjusted taxable income for the tax year plus the taxpayer’s floor plan financing interest for the tax year (for the motor vehicle industry). Businesses with average annual gross receipts for the three preceding tax years of $25 million or less are exempt. Because the business interest limitation ties the amount of deductible business interest to the taxpayer’s adjusted taxable income, it can hurt a business that has had an unsuccessful year. The reduction in the taxpayer’s adjusted taxable income in the off-year will reduce the amount that the taxpayer can deduct in that year. This effect is partly, but not fully, mitigated by the carryforward of disallowed interest. More specifically, any business interest that is not deductible because of the business interest limitation is treated as business interest paid or accrued in the following year, and may be carried forward indefinitely, subject to the restrictions applicable to partnerships.The business interest limitation applies at the taxpayer level (i.e. at the corporate level for C corporations and at the partner/shareholder level for partnerships and S corporations, respectively). For an affiliated group of corporations that file a consolidated return, it applies at the consolidated tax return filing level. Real property trades or businesses can elect out of this rule. However, if this election is made, the consequence is that the business must depreciate its assets under the alternative depreciation system (ADS) which has longer depreciable lives. Further, under ADS, the 100% expensing previously discussed is unavailable. Qualified Property Reduced from Four Categories Down to OnePre-reform law – Qualified leasehold, qualified restaurant, and qualified retail improvement property each have unique rules and all have 15 year lives. An additional category of property called qualified improvement property* (QIP) is any improvement to the interior of a building that is nonresidential real property if the improvement is placed in service after the date the building is first placed in service. QIP has a life of 39 years. * Qualified improvement property does not include any expenses attributable to the enlargement of the building, an elevator or escalator, or the internal structural framework of the building.New law – Beginning in 2018, the individual definitions of qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property are eliminated. Qualified improvement property is maintained and Congress intended to shorten the life of this property from 39 years to 15 years and thus QIP is eligible for bonus depreciation. Due to an apparent oversight by the drafters of the legislation, the provision generally describing the property to which a 15-year recovery period applies was not amended to include QIP. QIP placed in service on or after January 1, 2018 is recovered over 39 years and is not bonus eligible until such point as a technical correction to the new law is enacted.Rehabilitation CreditThe Rehabilitation Credit is a federal tax incentive to encourage real estate developers to renovate, restore and reconstruct old and historic buildings. Pre-reform law – A credit is available for qualified rehabilitation expenditures incurred to rehabilitate and modernize qualified buildings. The credit is 20% of the amount spent on rehabilitation of certified historic structures and 10% for commercial buildings constructed before 1936. The credit is allowed for the tax year that the qualified rehabilitated building is placed in service. New Law – The 20% credit is maintained but is now claimed ratably over a five-year period beginning in the tax year the structure is placed in service. The 10% credit is now repealed. Contact a Withum real estate professional to help guide you through the implications of tax reform regarding your real estate activities.At WithumSmith+Brown, PC, Mike West, CPA is a Real Estate Services Group team member, and C. J. Stroh, Esq. is a National Tax Service Group team member.