With contributions by Marcus Atherly
No real estate is permanently valuable but the grave, at least according to Mark Twain. Ouch. But that certainly underscores the apparent risk and volatility of the real estate sector. Boom and Bust. Or more recently, Boom and Boom.
Adding to the potential for future volatility is a radical change in the tax rules affecting real estate. Just before the December holidays, Congress passed and the President signed the Tax Cuts and Jobs Act (renamed An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018).
The Act is a complex, 500-page piece of legislation that will have a major impact on how real estate is taxed in the U.S., affecting individual investors and real estate-related businesses. Many of its provisions are helpful to real estate owners, investors and businesses. Others not so much.
It’s important to note that the Act’s provisions affecting corporate taxpayers are permanent. Provisions for individuals and pass-through businesses generally expire after 2025.
Tax Rates and Brackets
A reduction in tax rates has the potential to decrease costs and increase returns for real estate investors and businesses.
The Act reduces the federal individual income tax rate to 37 percent while retaining the number of tax brackets. However, the top income levels that apply to each tax bracket are increased, further reducing the applicable tax rate. These changes apply only through 2025.
The Act reduces the corporate tax rate from 35 percent to 21 percent. This change is permanent.
Currently, income from pass-through entities — e.g. partnerships, LLCs and S corporations — is taxed on the owners’ personal tax returns at their individual tax rates, as is income from sole proprietorships. As a result, the reduction in individual tax rates reduces the amount of tax due on this form of business income.
The Act also changes the tax rules for pass-through income by creating a new deduction. The calculation is a complicated one, but it is essentially equal to 20 percent of qualified business income (subject to wage limitations), plus 20 percent of REIT dividends and qualified publicly traded partnership income.
The wage limitations are generally 50 percent of W-2 wages for the year, or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of tangible depreciable property — i.e., buildings but not land.
This pass-through deduction is not available to most professional service businesses, including lawyers, accountants, actuaries, health professionals, brokers, investment managers, financial planners, athletes and performing artists, to name a few. An exception was made for engineers and architects on the basis of their perceived role in facilitating capital investment.
The Act also makes an exception for owners of pass-through businesses and sole proprietorships with incomes less than $157,500 ($315,000 if married and filing jointly). They are eligible for the deduction.
This deduction expires after 2025.
Alternative Minimum Tax (AMT)
The Act eliminates the AMT for corporations while providing a refundable credit to those with an existing minimum tax credit. This credit, subject to limitations, applies through 2021.
The Act does not eliminate AMT for individuals, but limits its impact by increasing the exemption amounts. Changes to the personal AMT apply only through 2025.
Partnership Carried Interest
Carried interest refers to the preferential tax treatment given to the income earned from an investment that is paid to the investment manager of a hedge or private equity fund or the general partner of a real estate development. The income is taxed as a capital gain rather than ordinary income.
The Act triples the time certain partnership interests received in connection with the performance of services must be held to qualify for preferential capital gains treatment (from one year to three years). It does not change the tax rate.
Deduction of Business Interest
Under the Act, a business’ net interest expense deduction is limited to business interest plus 30 percent of adjusted taxable income. Any disallowed amounts can be carried forward indefinitely. For pass-through entities, the limit is determined at the entity level — e.g., partnership, not partner.
Adjusted taxable income is computed without regard to deductions allowable for business interest, depreciation, amortization and depletion; the net operating loss deduction; and the new qualified business income deduction.
Beginning in 2022, depreciation, amortization and depletion will be included in the adjusted taxable income calculation, significantly increasing the likelihood that the deduction will be limited for many businesses.
Businesses with average annual gross receipts of $25 million or less for the prior three years are exempt from this provision.
Real property businesses can elect out if they use the alternative depreciation system (ADS) to depreciate applicable business-related real property. For qualified improvement property, this increases the cost recovery period to 20 years from 15 years.
A 1031 exchange (or like-kind exchange) allows the owner of a business or investment asset to sell the asset and replace it with another, similar asset without paying tax on the capital gain until the new asset is sold.
The Act limits the use of 1031 exchanges to real estate, eliminating 1031 exchanges for tangible personal property after 2017.
Bonus Depreciation / Expensing
The Act increases the bonus depreciation percentage from 50 percent to 100 percent through 2022 and decreases each subsequent year by 20 percent.
Bonus depreciation now applies to both new and used property. There are limited exceptions for property that is not subject to the limitation on interest expense and property with certain types of debt.
Section 179 Expensing
The Act increases the current expensing limit of $500,000 to $1 million.
It expands the definition of Section 179 property to include certain lodging-related depreciable tangible personal property.
Also expanded is the definition of qualified real property eligible for Section 179 expensing which now includes a range of improvements to nonresidential real property, such as security systems, fire protection and alarm systems, roofs, and heating/ventilation/air-conditioning systems.
Depreciation Recovery Periods
Under the Act, certain depreciation recovery periods are shortened.
The 39- or 27.5-year recovery periods for nonresidential real property and residential rental property are maintained. However, various categories of qualified improvement properties are consolidated and depreciated over 15 years under the Act and become eligible for Section 179 expensing. This allows improvements to the interior of a nonresidential building made after the building is placed in service to be depreciated over a shorter period.
Qualified improvement property does not require that improvements be made pursuant to a lease. However improvements to enlarge the building or that are made to an elevator, escalator or the internal structural framework of the building are excluded.
Partnership Technical Terminations
The Act permanently repeals the tax rule on partnership technical terminations.
Under the now-repealed technical termination rule, if one or more partners sold or otherwise disposed of 50 percent or more of the partnership’s capital or profits in a twelve-month period, the partnership was considered to have been terminated. One consequence of such a termination was that the depreciation periods were reset. For example, consider the technical termination of a real estate partnership with nonresidential real property that had already been depreciated for 20 years. Under the technical termination rule, the remaining undepreciated basis of the property had to be depreciated based on a new 39-year recovery period.
It is important to note that, while the technical termination rule no longer exists at the federal level, the Washington state excise tax still applies to the transfer of 50 percent or more of the capital or profits in a partnership within a twelve-month period.
Net Operating Losses
For net operating losses (NOLs) that arise after 2017, the Act limits the deduction to 80 percent of taxable income.
With limited exceptions, it eliminates the two-year carryback and the special carryback provisions for NOLs but allows them to be carried forward indefinitely.
The majority of itemized deductions for individuals are eliminated under the Act.
Mortgage Interest Deductions
The Act caps the ability to deduct mortgage interest at the first $750,000 of mortgage debt, down from the current $1 million. The change applies only to new home purchases after December 15, 2017. However, for those refinancing a mortgage taken out before December 15, 2017, the old rules continue to apply to the refinanced amount, excluding any additional debt involved.
The deduction for interest on home equity loans is eliminated as of 2018.
The Act limits property tax deductions. The combined total deduction for property taxes, state and local income and sales taxes cannot exceed $10,000.
Exclusion of Gain on Sale of Primary Residence
Unlike provisions proposed in earlier versions, the Act does not change the existing tax rules for excluding gain on the sale of a primary residence or second home.
Low Income Housing Tax Credits
The Act maintains the nine percent and the four percent Low Income Housing Tax Credits for developers.
Private Activity Bonds
The Act maintains the tax-exempt status of private activity bonds, including the use of private activity bonds to fund professional sports stadiums.
The Act doubles the federal estate tax exemption (from the current inflation-adjusted $5.49 million, and double for married couples).
It preserves the stepped-up basis rules for beneficiaries. If you receive real estate as the beneficiary of an estate, your basis is generally the fair market value at the time of death. As a result, the difference between the decedent’s basis and your stepped-up basis as a beneficiary is never subject to tax.
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