The bill introduced as the Tax Cuts and Jobs Act (TCJA) was signed into law by the President on Dec. 22, 2017, and it is the most far reaching tax change to affect the real estate sector since the Tax Reform Act of 1986. Generally speaking, real estate fared well under the new law.
It is important to note that the TCJA was passed quickly and left many questions unanswered and contained some drafting errors, so we expect that there will be a technical corrections bill to clarify some of the provisions in the initial law. Bear in mind that any technical corrections may be hampered by the Senate reconciliation rules; the same rules that allowed the bill to pass with a simple majority. It is likely that uncertainties will remain at the time 2018 tax returns are filed next year, and positions taken on those returns may later prove to be incorrect when further guidance is eventually published. Furthermore, many of the provisions discussed below are set to expire at the end of 2025, setting the stage for a new set of “Extenders” similar to the annually expiring Bush Tax Cut provisions. For states that do not adopt the TCJA changes, the disparity between federal and state taxable income will likely increase.
TCJA permits a deduction of up to 20 percent of the qualified business income from pass-through entities (partnerships, LLCs, and S Corporations) and sole proprietorships – individuals who own their real estate directly or through a single member LLC. The deduction is available to both individual owners and trusts, and is computed at the individual or trust level. It is limited to the lesserof (a) 20 percent of qualified business income, or (b) the amount that is the greater of (i) 50 percent of W-2 wages paid by the qualified business or (ii) 25 percent of W-2 wages paid plus 2.5 percent of the unadjusted basis of qualified depreciable property used in the qualified business.
W-2 wages are defined as total wages subject to wage withholding, elective deferrals and deferred compensation. Not included in the definition are guaranteed payments – a common form of compensating partners or LLC members for services rendered by them to the entity. Furthermore, W-2 wages exclude amounts that are not properly allocable to qualified business income. This provision would appear to also exclude compensation paid to an S corporation shareholder from the definition of W-2 wages; however, commentators are divided over this treatment, and it may require clarification in a technical corrections bill or new regulations.
Qualified depreciable property includes property that has a depreciable period that ends at the later of 10 years from the date the property is placed in service, or the end of its regular depreciable tax life. Property that has a MACRS depreciation period shorter than 10 years is treated (solely for this purpose) as being depreciable over 10 years.
To illustrate, an asset placed in service in 2011 with a five-year depreciable tax life that expired in 2016 is still qualified property for this test, because the 10-year period from the date it was placed in service runs through 2021. The addition of the test involving 2.5 percent of the basis of depreciable property was added by the Conference Committee to address concerns of real estate owners who may employ property management companies in lieu of paying wages to employees. One of the many unanswered questions in the law is whether the unadjusted basis of property acquired in a Section 1031 like-kind exchange is reduced by the deferred gain for purposes of this provision. Congress has directed the IRS to issue guidance on this, but the timing of any such guidance is uncertain.
Note that the new deduction is available without regard to the level of owner participation in the business, so passive investors are also eligible to claim the deduction. Gain from the sale of real estate, except for depreciation recapture, is not considered qualified business income, and is therefore ineligible for the 20 percent deduction. REIT dividends are treated as qualified business income, whereas interest, dividends, and capital gains are not.
The new law does not purport to redefine the nature of a trade or business for tax purposes. Many real estate entities are structured to own and lease a single rental property. Because the new deduction is available only against qualified business income, existing nuances and ambiguities regarding the determination of an activity’s status as a trade or business will remain. For example, the IRS has historically challenged whether a “triple-net lease” of a single rental property rises to the level of a trade or business. In that case, the income would not be qualified business income eligible for the new deduction.
Since the beginning of the decade, Congress has implemented many favorable depreciation changes that affect all industries, including real estate. The TCJA has continued this trend, where qualifying property acquired and placed in service after Sept. 27, 2017 is eligible for 100 percent bonus depreciation in the year it is placed in service. The 100 percent rate drops by 20 percent per year beginning in 2023, until it is eliminated in 2027. Also, now for the first time, the 100 percent expensing is available for both new and used property. Eligible assets are those with a depreciable life of 20 years or less and are expected to include the expanded definition of “qualified improvement property.” This includes property previously defined as qualified restaurant, retail and leasehold improvement property.
Qualified improvement property under the TCJA comprises work done to the interior of a commercial building and placed in service any time after the date the building was first placed in service. It does not include costs related to the enlargement of the building, an elevator or escalator, or the internal framework of the building. A significant drafting error, however, failed to grant qualified improvement property the reduced 15-year class life (from the 39-year class life it had under the prior law) and therefore, it will also not qualify for 100 percent expensing without correction. This is expected to be addressed in a future technical corrections bill, although that is not certain.
An additional depreciation benefit for commercial property is available under Section 179, which permits expensing of assets that otherwise would need to be capitalized and depreciated. TCJA expands the annual Section 179 limitation from $500,000 to $1 million, with a phase out beginning at $2.5 million of qualifying assets placed in service. Section 179 is available for qualifying improvement property, property that is required to be depreciated under the Alternative Depreciation System (ADS), and now under the TCJA, property that includes roofs, HVACs, fire protection and alarm systems, and security systems.
Cost segregation studies will be more valuable than ever as a result of these changes to 100 percent bonus depreciation and Section 179.
Business Interest Limitation
The TCJA limits the interest expense deduction for any business to its interest income plus 30 percent of its adjusted taxable income (essentially EBITDA). Businesses whose average annual gross receipts for the prior three years are less than $25 million are exempt from this new limitation. Excess unused business interest can be carried forward indefinitely. The new limitation could have a dramatic impact on large, debt-financed real estate operations which are common in the industry.
However, a real property trade or business (RPTB) has the option to elect out of the business interest limitation, thereby allowing it to deduct its interest expenses in full. An RPTB includes development, construction, rental, management, leasing and brokerage activities. The trade-off for this election is that the RPTB must depreciate its assets, including qualified improvement property, using ADS rules, which means bonus depreciation is not available. As noted above, ADS property is still eligible for Section 179 expensing; however, with the $25 million average annual gross receipts threshold and the Section 179 phase out starting at $2.5 million, this may be less valuable. Despite this trade off, electing to avoid the interest expense limitation will still likely be worthwhile for larger mortgaged properties.
Excess Business Losses
The TCJA added a new loss limitation rule applicable to non-corporate taxpayers, whose trade or business losses are now limited to $500,000 annually for joint returns ($250,000 single). Any excess loss is carried forward as a net operating loss. This means, for example, if interest expense, 100 percent bonus depreciation or enhanced Section 179 deductions have helped generate an overall pass-through loss of $1 million, an individual can only use $500,000 of it to shelter other income (e.g., wages, interest, dividends, or capital gains) in that year. Remember, the passive loss limitation rules still apply, so the excess business loss provisions are most likely to affect taxpayers qualifying as “real estate professionals.” The limitation applies to the aggregate of all personal and pass-through losses for the year.
Net Operating Losses
Net operating losses can no longer be carried back two years, and instead are now carried forward indefinitely. The deduction is limited, however, to 80 percent of taxable income (determined without regard to the NOL deduction) for losses arising in taxable years beginning after Dec. 31, 2017.
Despite initial discussions to the contrary, the new tax law left intact the tax deferred Section 1031 like-kind exchanges for real estate held for rental or investment. The ability to use like-kind exchanges for personal property (e.g.,aircraft, automobiles, yachts, artwork, etc.), however, was eliminated under the TCJA.
Politicians engaged in a great deal of discussion over the past few years about preventing the holders of carried interests from enjoying capital gains tax treatment for profits interests in partnerships granted without corresponding capital contributions. Ultimately, the TCJA made a fairly modest change in this area by increasing the holding period to qualify for the long term capital gains tax rate from the normal one year to three years. In real estate, carried interests are typically seen as “promote” or “back end” interests, and the change to a three year holding period—while moderate compared to an outright ban—can be significant in today’s real market where rapid appreciation is common.
The Low-Income Housing Tax Credit, Historic Rehabilitation Tax Credit and New Markets Tax Credit are all preserved under the TCJA. However, the Rehabilitation Credit for non-historic buildings built before 1936 has been repealed.
Estate and Gift Planning
The TCJA doubled the lifetime death and gift exemption to $11.2 million per person (this is an estimated amount – the final amount that is indexed for inflation has not yet been released). Discounts for lack of marketability and control were not affected by TCJA. A proposed regulation issued in 2016 that would have greatly reduced the ability to use discounts was withdrawn, making real estate an excellent asset to consider transferring as part of an overall estate plan.
For the real estate world, the TCJA did not result in tax simplification. That being said, the new law offers many tax benefits for real estate owners, and some trade-offs in other areas. Please contact your CBIZ tax professional for information on how the new law affects your particular tax situation.
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