In the lead-up to the great reveal of the House republication tax plan, named the Tax Cuts and Jobs Act, there was much uncertainty about various tax incentives that largely benefit the real estate industry. With the release of the plan on November 2nd, those in real estate trades or businesses can breathe a huge sigh of relief. Many of the much discussed and well publicized changes specifically exclude real estate trades and businesses and many other benefits enjoyed by those in real estate trades and businesses were not touched with this version of tax reform. This article will explore the changes from the perspective of the real estate industry.
Throughout the last election cycle, much was made of immediate expensing of trade or business assets. Talking points repeated on the campaign trail lead most people to believe that the proposed tax reform would call for immediate expensing of all fixed assets and the end of depreciation as we currently know it. The Tax Cuts and Jobs Act does vastly expand the ability to immediately deduct trade or business assets, however that change specifically excludes real property assets acquired by real estate businesses.
The Tax Cuts and Jobs Act calls for immediate expensing of assets with a class life of 20 years or less. This immediate expensing would apply to all assets placed in service before January 1, 2023, giving businesses a 100% depreciation rate for qualified assets for the next five years. As it relates to real estate trades and businesses, building assets would not fall under this immediate expensing as the class life is longer than 20 years. However certain shorter lived property, such as qualified leasehold improvement property and land improvements, would qualify for immediate expensing under the Tax Cuts and Jobs Act. Unfortunately, the legislation specifically excludes assets used in certain types of trades or businesses from its provisions. The excluded trades or businesses are defined in the section of the legislation covering interest expense.
One of the give backs that was regularly discussed in conjunction with immediate expensing was the disallowance of the net interest expense deduction (excess of interest expense over interest income). The Tax Cuts and Jobs Act does limit the net interest deduction for businesses with average annual gross receipts of $25,000,000 or more. The proposal provides that interest expense in excess of 30% of a company’s EBITDA would be disallowed as a deduction. Any disallowed deduction is carried forward for five tax years. As written, the legislation would exempt certain businesses from the definition of a trade or business for interest limitation purposes. One such exemption goes to real property trades or businesses as defined in the current IRC Sec. 469(c)(7)(C). This includes real property development, construction, rental and management. With this reference to real estate trades or business, the new legislation excludes real property trades or business from the opportunity for the immediate deduction of acquired assets, but also excludes those same businesses from the limitation on deductible interest.
In addition to concerns of immediate expensing and the deduction of interest expenses, one of the real estate industry’s sacred cows was on the chopping block as tax reform was debated in Congress. In discussions, there was some concern regarding the continued availability of tax deferred exchanges under IRC Sec. 1031. Fortunately for those in real property trades or businesses, the Tax Cuts and Jobs Act, while limiting the applicability of Sec. 1031, does nothing to change its applicability to real property. Thus, taxpayers in real property trades or businesses may continue to use the provisions of Sec. 1031 to replace property in a tax-deferred way.
On the Senate side, there were some significant differences in the proposal. With respect to the net interest expense deduction, the Senate proposal extends that limitation to real property trades or businesses. It does, however, give real property trades or businesses the opportunity to continue to deduct their net interest expense on election. Under the Senate plan, real property trades or businesses would be able to decide whether they wanted to be subject to the net interest expense limitation. Not surprisingly, for businesses that elect out of the limitation, there is a give-back included related to depreciation. Real property trades or businesses that elect out of the net interest expense limitation would need to use the ADS method for depreciation of its assets. ADS class lives are longer than traditional MACRS class lives and require the use of the straight-line method, meaning those businesses would be foregoing the significant benefits of accelerated depreciation in exchange for electing out of the net interest expense limitation.
The Senate proposal includes a similar provision for immediate expensing of trade or business assets for the next five years, but makes substantial changes to other depreciation provisions. Like the House plan, immediate expensing would apply to all assets with a class life of 20 years or less placed in service before January 1, 2023. In a move that will have a significant impact on the real estate industry, the Senate plan significantly reduces the class life of some property and makes changes to a few types of property commonly found in real property trades and businesses. Under the Senate proposal, the depreciable life of residential and nonresidential real property will be shortened to 25 years. In addition, the Senate proposal would eliminate the distinction between qualified leasehold improvement property, qualified retail improvement property and qualified restaurant improvement property and would include these property types into a new qualified improvement property designation. Qualified improvement property would be depreciable over 10 years, using a straight-line method. Clearly, if enacted, these proposals would have a substantial impact on cost recovery within the real estate industry.
Finally, like the House proposal, the Senate proposal does not impact the applicability of tax-deferred exchanges under IRC Sec. 1031 as related to real property. While the tax-deferred exchange would no longer be available for other types of property if this proposal is enacted, real property trades or businesses would not be impacted.
The proposed Tax Cuts and Jobs Act makes significant changes to the Internal Revenue Code of the last 30 years, and some of those changes may have significant impact on the real estate industry. It will be important to monitor any changes to the legislation as it works its way through the law-making process and is potentially signed into law. If you have questions about how these tax changes may affect your business, contact your Withum advisor.
By Brian T. Lovett, CPA, CGMA, JD is a tax partner based in Withum’s New Brunswick office and is a certified public accountant in the states of New Jersey and Pennsylvania.