On the evening of December 15th, Congressional Republicans finally released the details of their Tax Cuts and Jobs Act legislation, a reconciliation of the conflicting tax bills previously passed by the House and Senate. It now appears they could have the votes to pass it and send to the President’s desk for signature by Christmas. The following is a discussion of key provisions in the proposed law that will most impact those in the real estate industry and are likely to trigger significant tax planning if they become law.
Individual income tax rates
Individual income tax rates on ordinary taxable income are temporarily reduced and bracket thresholds temporarily raised, so that taxpayers will be subjected to lower tax rates on a greater amount of their taxable income. The top marginal tax rate will be 37% and will apply once taxable income exceeds $500,000 (single) or $600,000 (joint). This change is effective for tax years thru 2025. While the greatest beneficiaries of this change may be taxpayers in the highest bracket, this will benefit all taxpayers to some degree.
Standard deduction and personal exemptions
The standard deduction is temporarily increased to almost double the current standard deduction, to $12,000 (single) and $24,000 (joint). However, personal exemptions (currently $4,050 for the taxpayer, his or her spouse, and any dependents) are temporarily eliminated under the proposal, offsetting the benefit of the larger standard deduction, especially those people with larger families. These two changes are effective for tax years thru 2025.
State and local tax deduction
The itemized deduction for nonbusiness state and local property and income tax (or sales tax in lieu of income tax) is permanently limited to an aggregate of $10,000 (single or joint). Taxpayers may not claim a deduction in 2017 for any prepayment of their 2018 state income tax made to avoid this dollar limitation in 2018. The rules for business state and local taxes remain unchanged. While this is certainly better than the complete elimination of the state and local tax deduction, taxpayers in states with higher income and/or property taxes face the loss of significant deductions. This limitation is effective for tax years thru 2025.
Mortgage interest deduction
Taxpayers may deduct interest on up to $750,000 of new mortgage debt incurred to purchase, build or substantially improve a personal residence. Interest is deductible on up to $1,000,000 of mortgage debt that was incurred prior to 12/15/17 to purchase, build or substantially improve a personal residence, even if such debt is subsequently refinanced after that date. Special transition rules apply for a taxpayer who has a binding written contract to close on the purchase of a primary residence before 1/1/18. Interest on home equity loans will no longer be deductible, regardless of when such debt was originally incurred. These changes are effective for tax years thru 2025.
Net operating loss
Currently, a taxpayer’s NOL can be carried back two years and carried forward 20 years to offset up to 100% of the taxpayer’s taxable income in those years. Under this provision, an NOL arising in tax years beginning after 12/31/17 can generally no longer be carried back (there are a limited number of exceptions) and when carried forward can only offset 80% of taxable income. This change will be an unhappy surprise for those taxpayers who have historically able to eliminate 100% of their taxable income due to large NOLs.
Alternative minimum tax (“AMT”)
The long-hoped for elimination of AMT unfortunately did not survive the reconciliation process. Instead, there is a temporary increase in both the exemption amount and the income level at which the exemption phases out ($0.5 million for single filers and $1 million for joint). It is expected that these increases, combined with the maximum deduction of $10,000 for state and local income and property taxes (a common trigger for AMT), will significantly decrease the number of taxpayers who are subject to AMT. These higher amounts are effective for tax years thru 2025. The individual AMT has been a source of confusion and frustration for taxpayers, so even this limited relief is certainly a welcome change.
Estate and gift tax
The estate and gift tax exemption for estates of decedents dying and gifts made after 12/31/17 is doubled from $5 million to $10 million (indexed for inflation occurring after 2011) for tax years thru 2025. A very small number of taxpayers have taxable estates that would have exceeded the previous $5 million exemption amount, assuming they have done the appropriate estate planning, so this change benefits very few taxpayers.
Taxation of pass-thru business income
The reconciliation legislation went with the Senate’s version of this provision which allowed a deduction, rather than the House’s version which taxed pass-thru income at a lower tax rate. However, the reconciliation legislation added an extremely valuable last minute “tweak” to the Senate’s version that will result in rental income being eligible for the deduction, regardless of a taxpayer’s income level. For high-income taxpayers with rental properties generating taxable income, this is huge!
Owners of pass-thru entities and sole proprietors will still be taxed at their individual tax rates on pass-thru business income, but will be able claim a deduction for 20% of their net qualified business income. Qualified business income does not include the taxpayer’s wages from an S corporation, guaranteed payments for services from a partnership, or most types of investment income that come from a pass-thru entity.
For taxpayers with income above $315,000 joint or $157,500 single, the 20% deduction otherwise allowed is subject to the phase-in of two limitations. Under the first limitation, the deduction would be limited to the greater of (a) 50% of the entity’s W-2 wages or (b) the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis (i.e., not reduced by accumulated depreciation) of all the entity’s qualified property. Since option (a) is often $0 for rental properties, since most of them generally have few if any W-2 employees, option (b) is the wonderful last minute “tweak” that was added to the reconciliation legislation. Under the second limitation, the 20% deduction would not apply to pass-thru income from certain specified service business or any business where the principal asset is the reputation or skill of one or more of its employees or owners.
We anticipate that this provision will perhaps generate the most activity with respect to analyzing the potential tax savings that would result from the restructuring of business operations and/or entity changes (including the factor that the tax rate on C corporation income is 21% under the compromise legislation).
Excess business losses
Under current tax law, a taxpayer’s ability to deduct losses from a business activity is limited by their tax basis in the activity, their amount at-risk in the activity and the passive loss rules. Taxpayers who can overcome these three hurdles will now be confronted with a surprising fourth limitation. For tax years thru 2025, excess business losses are no longer allowed to be deducted in the current tax year. Instead those losses must be carried forward and treated as part of the taxpayer’s net operating loss in the subsequent tax year. An excess business loss is the excess of the taxpayer’s total trade or business deductions and losses over the sum of (a) their total income and gains and (b) $250,000 (single) or $500,000 (joint). Given the new 80% limitation on the use of NOLs, this provision looks like a large piece of coal.
Method of accounting
The number of taxpayers that can use the cash method of accounting for income tax purposes, rather than being forced to use the accrual method, is significantly increased.
The current $5 million average gross receipts threshold for corporations and partnerships with corporate partners that are not allowed to use the cash method would be increased to $25 million.
The current $1 million average gross receipts threshold ($10 million for certain industries) for businesses with inventories that are not allowed to use the cash method would also be increased to $25 million.
Since the use of the cash method is simpler and generally allows greater control over their taxable income, these are both extremely favorable changes for taxpayers.
Depreciation lives – real property
While the depreciable lives for nonresidential real property and residential rental property remain at 39 and 27.5 years respectively, qualified improvement property will now be eligible for a 15-year life.
Qualified improvement property is any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building itself was first placed in service. Qualified improvement property does not include any improvement that relates to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.
The current favorable depreciation rules for qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property are eliminated.
Bonus depreciation allows a taxpayer to immediately deduct a certain percentage of the cost of qualifying property in the year the property is acquired, rather than capitalizing that cost and depreciating it over a period of years. For qualified property acquired and placed in service between 9/28/17 and 12/31/22, the bonus percentage is 100%. Beginning in 2023, that bonus percentage will decrease by 20% each year.
In addition to increasing the bonus depreciation percentage, the definition of qualifying property was expanded to include used property, a significant benefit for taxpayers.
Sec. 179 allows a taxpayer to immediately deduct a certain amount of the cost of qualifying property in the year the property is acquired, rather than capitalizing that cost and depreciating it over a period of years. The maximum amount that can be expensed is increased to $1 million. This $1 million amount is reduced by the amount that the taxpayer’s total qualifying assets placed in service in the taxable year exceeds $2.5 million.
The definition of qualifying property is also expanded to include the following improvements to nonresidential real property placed in service after the date the property was first placed in service: roofs, HVAC property, fire protection and alarm systems, and security systems.
The deduction of business interest expense is limited to 30% of the taxpayer’s adjusted taxable income. ATI is business income computed without the deduction of depreciation and amortization for tax years 2017-2021. After 2021, business income is reduced by depreciation and amortization. Taxpayers with average annual gross receipts that do not exceed $25 million are fortunately exempt from this limitation. Special computations of this interest expense limitation apply in the case of partnerships (not S corporations). Any disallowed interest is carried forward indefinitely.
The taxpayer may elect to not have the interest expense limitation apply to any business involving real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. However, if such an election is made, the taxpayer is required to depreciate their nonresidential and residential rental real property using a 40-year life and their qualified improvements using a 20-year life.
Contributions to capital
Previously, a C or S corporation (but not a partnership or LLC) could receive amounts from any governmental entity or civic group on a tax-free basis. Common examples of such tax-free amounts were tax incremental funds, the sale of land to the taxpayer for $1, incentive grants, etc. However, beginning with the date that this new law is enacted, such amounts will now be taxable, unless they are made pursuant to a master development plan that was approved by the governmental entity prior to the enactment date of this law. Since many developers rely on such funds to close their financing gap, this provision is truly a “lump of coal”.
The current provision allowing the nonrecognition of taxable gain in the case of a like-kind exchange of property held for productive use in a trade or business or for investment, is modified to limit its application only to real property that is not held primarily for sale. Thus, personal property is no longer eligible for tax-free exchange. This new limitation generally applies to exchanges completed after 12/31/17. However, if the taxpayer has already disposed of the old property or received the new property on or before 12/31/17, the limitation does not apply to that exchange. Since the use of like-kind exchanges has been under attack for some time, and was expected by some to be completely repealed, having it continue to apply to real property exchanges is a taxpayer win.
To qualify for long-term capital gain on the sale of a partnership interest that was received by a taxpayer in exchange for the provision of services, the taxpayer must have held that partnership interest for a three-year period. The fact that an individual may have included an amount in taxable income upon their acquisition of the partnership interest, or that the taxpayer may have made what is known as a Sec. 83(b) election with respect to the partnership interest, does not change this new three-year holding period requirement. For taxpayers who generally hold their real estate investment for at least three years, this holding period will not be an issue. However, many developers will build and sell after a year or two and will therefore need to take this new holding period into consideration when calculating the after-tax economics of a sale of the property.
Rehabilitation tax credit
The 10% credit for pre-1936 buildings is repealed, but the 20% credit for certified historic structures remains – although the credit must now be claimed ratably over a five-year period rather than being claimed in the year the rehabilitated building is placed in service. This new rule applies to amounts paid or incurred after 12/31/17. However, a taxpayer-favorable transition rule applies to rehabilitation expenditures for either a pre-1936 building or a certified historic structure that are paid or incurred after 12/31/17, so long as the building is owned by the taxpayer at all times on and after 1/1/18 and the 24-month (or 60-month period in the case of phased rehabilitation) begins no later than 180 days after the date of the enactment of this law. This transition rule gives taxpayers a very limited window of opportunity to get the necessary property ownership in place by year end.
As you can tell from the above discussion, whether the new Tax Cuts and Jobs Act will deliver what you wished for or a lump of coal are highly dependent upon your specific situation – your income level, your net worth, the type of entity you utilize for your business operations, the nature of your real estate business (service, rental, development, capital vs labor intensive), the nature of your real estate transactions, etc. Here’s hoping you get what you wished for as we look forward to the New Year!