The Tax Cuts and Jobs Act (TCJA) is the most far reaching tax change to affect the real estate sector since the Tax Reform Act of 1986. Real estate fared pretty well under the new law, and real estate owners should consider the impact of the following changes.
Pass-through entities (partnerships, LLCs, and S corporations) and sole proprietorships for both individuals and trusts can deduct up to 20 percent of qualified business income. The deduction is limited to the lesser of (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. Real estate with little or no W-2 wages benefit from this latter test.
The new deduction is available to passive investors. REIT dividends are eligible for the deduction whereas interest and other dividends and gain from the sale of real estate (except for depreciation recapture) are not. It is unclear if a triple net lease property qualifies for the 20 percent deduction.
The TCJA improves the already favorable depreciation rules. Qualifying property placed in service after Sept. 27, 2017 is eligible for 100 percent bonus depreciation, but bonus depreciation drops by 20 percent per year beginning in 2023, until it is eliminated in 2027. For the first time, the 100 percent expensing is available for used property. Eligible assets are those with a depreciable life of 20 years or less – personal property and “qualified improvement property” defined as work done to the interior of a commercial building, excluding costs related to the enlargement of a building, an elevator or escalator, or the internal framework of the building. A drafting error failed to grant qualified improvement property the reduced 15-year class life necessary for bonus depreciation, but it is expected this will be corrected in the future.
Section 179 also permits the expensing of assets for commercial property. TCJA expands the annual Section 179 limitation from $500,000 to $1 million, with a phaseout beginning at $2.5 million for qualifying assets placed in service. For the first time, Section 179 property includes roofs, HVACs, fire protection and alarm systems, and security systems.
BUSINESS INTEREST LIMITATION
The TCJA limits the interest expense deduction for any business with more than $25 million gross revenue to its interest income plus 30 percent of its adjusted taxable income (essentially EBITDA). Excess unused business interest can be carried forward indefinitely. The new limitation could have a dramatic impact on large, debt-financed real estate property. Fortunately, a rental property owner can elect out of this rule, but the trade-off is that all depreciable property must be depreciated using ADS rules. Under ADS, bonus depreciation is not available, but Section 179 is available. Electing to avoid the interest expense limitation will likely be beneficial for most taxpayers.
EXCESS BUSINESS LOSSES
The TCJA adds a new loss limitation rule for individuals of $500,000 for joint filers ($250,000 single). A real estate owner with an overall tax loss can only use $500,000 of it to shelter non-real estate income (e.g., wages, interest, dividends, capital gains). Excess losses carry over. Passive loss limitation rules still apply, so the excess business loss provisions will have their greatest impact on qualifying “real estate professionals.”
The new tax law preserves Section 1031 likekind exchanges for income-producing or investment real estate. Exchanges of personal property were eliminated.
Holders of carried interests - real estate holders of a “promote” or “back end” interest – will continue to enjoy capital gains treatment with one significant change. The holding period for long-term capital gains tax treatment was extended from one to three years.
All real estate tax credits except the Rehabilitation Credit for non-historic buildings built before 1936 were retained under the TCJA.
TAKE THE TIME TO REVIEW THE LAW
The changes to business and individual tax provisions may affect tax planning strategies. It is recommended real estate professionals work closely with their tax advisors to evaluate the impact of the new tax law.
Paul Rosenkranz is a Lead Managing Director for the Los Angeles office of CBIZ and MHM. He has more than 35 years of experience in tax planning for individuals, family-owned and closely-held businesses, including significant experience in the real estate sector.
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