Forming a Tax Plan
Follow these tips to capitalize on tax reform.
The real estate industry generally fares well under the Tax Cuts and Jobs Act of 2017, but many new provisions heighten the importance of advance tax planning for real estate investors.
Taxation of Pass-Through Entities
The Tax Cuts and Jobs Act permits a deduction of up to 20 percent of qualified business income from pass-through entities such as partnerships, limited liability companies, and S corporations, including real estate owned directly or through a single-member LLC. Both individuals and trusts can take the 20-percent deduction. It is limited to the lesser of 20 percent of an individual's adjusted taxable income or the greater of:
• 50 percent of wages paid in the pass-through entities, or
• 25 percent of wages paid and 2.5 percent of the unadjusted basis net of any 1031 deferred gain of qualified depreciable property used in the qualified business.
A qualified property has a depreciable period that ends on the later of 10 years from the date it was placed in service or the end of its regular depreciable tax life. For example, a five-year asset placed in service in 2011 expired in 2016, but it is still a qualified property because 10 years from the date it was placed in service expires in 2021. The 2.5-percent property provision clearly benefits owners of real estate who often pay low or no wages. Guaranteed payments - a common form of compensating partners or LLC members for services rendered by them to the entity - are not considered wages.
Proposed regulations establish aggregation rules that allow taxpayers to combine properties used in separate trades or businesses to maximize the qualified business income deduction. Investors can combine a high-income, low-depreciable-basis property under the aggregation rules with a low-income, high-depreciable-basis property to potentially increase the 20-percent deduction. Individuals must consistently report the aggregated group in subsequent tax years once aggregating multiple trades or businesses into a single trade or business.
Gain from the sale of real estate, except for depreciation recapture, is not considered qualified business income and, therefore, is not available for the 20-percent deduction. Dividends from real estate investment trusts are eligible for the deduction, whereas interest, dividends, and capital gains are not.
Planning to maximize use of the deduction, particularly in light of the new irrevocable aggregation election, is crucial.
The Tax Cuts and Jobs Act has continued the trend of favorable depreciation changes, which may encourage more real estate owners to make improvements to their properties. Qualifying property acquired and placed in service after Sept. 27, 2017, is eligible for 100-percent deduction in the first year. Bonus depreciation will be phased out by 20 percent per year beginning in 2023, until it is gone in 2027. Qualifying property generally includes new and used assets with a depreciable life of 20 years or less, which applies to the majority of a building's interior assets.
Section 179, which allows the immediate expensing of assets that otherwise would need to be capitalized and depreciated, provides additional opportunities for commercial property owners. The Tax Cuts and Jobs Act expands the annual Section 179 limit from $500,000 to $1 million, with a phaseout beginning at $2.5 million of qualifying assets placed in service. Section 179 is available for qualified improvement of property, which now includes roofs; heating, ventilating, and air conditioning; fire protection and alarm systems; and security systems.
Excess Business Losses
Taxpayers must balance depreciation benefits with the new excess business loss limitation rule, which annually limits the amount of an individual's business losses to $500,000 for joint returns or $250,000 for single returns. Any excess is carried forward as a net operating loss for up to 20 years. The passive loss rules still apply; in the real estate sector, this provision mainly affects taxpayers qualifying as real estate professionals.
Business Interest Limitation
The Tax Cuts and Jobs Act also limits the net interest expense deduction to a business's interest income plus 30 percent of its adjusted taxable income for an entity (including related entities) with average annual gross receipts exceeding $25 million. This new limitation becomes even more onerous after 2021, when the adjusted taxable income number will lose the depreciation and amortization add back. Excess interest expense carries forward indefinitely. Most real estate entities can elect out of this business interest limitation; however, the cost for making this election - inability to claim 100 percent bonus depreciation on many assets - is potentially quite costly.
Determining whether the irrevocable election is beneficial requires detailed modeling and projections.
The Tax Cuts and Jobs Act is anything but tax simplification, particularly because not all states conform to federal tax rules. Working with a tax professional can help real estate owners capitalize on opportunities for 2019 and beyond.