Tax Act Changes Impacting Real Estate
On December 22, 2017, President Trump signed the “Tax Cuts and Jobs Act” (the “Act”) after its passage by Congress earlier in the week. The Act represents the first major revision to the Internal Revenue Code of 1986 in over 30 years. Several of the changes included in the Act will impact taxpayers engaged in the real estate business or who otherwise own real estate. This alert highlights proposals enacted by the Act, most of which are effective as of January 1, 2018.
The following provisions of the Act will have the most impact on real estate investments:
- Limitation on Like Kind Exchanges. Section 1031 is amended to limit like kind exchanges to exchanges of real property. As a result of this change, personal property can no longer be exchanged on a tax deferred basis for other like kind personal property.
- Limitation of Deduction of Interest. The Act disallows the deduction for net business interest expenses to the extent it exceeds the sum of business interest income plus 30% of the business’s adjusted taxable income. However, at the taxpayer’s election, any real property trade or business will not be subject to this limitation, i.e., the interest expense will remain fully deductible. Guidance has yet to be issued as to when and how this election out will be made. Real property trades or businesses include real property development, redevelopment, construction, reconstruction, acquisition, rental, operating, management, leasing, or brokerage. Operating or managing a lodging facility will also qualify as a real property trade or business. The election comes at some cost to taxpayers. Rather than using the modified accelerated cost recovery system (“MACRS”), taxpayers making the election must use the alternative depreciation system (“ADS”) to depreciate assets. For nonresidential buildings the ADS life is 40 years (as opposed to MACRS of 39 years), for residential property it is 30 years (as opposed to MACRS of 27.5 years) and for qualified real property improvements it is 20 years (as opposed to MACRS of 15 years). Additionally, any electing real property trade or business is not eligible to use the new 100% expensing rules described below.
- Implementation of deduction equal to 20% of domestic “qualified business income" (“QBI”) allocated to individual holders in pass through entities. Generally, taxpayers who have QBI from a partnership, S corporation, or sole proprietorship are entitled to deduction of the lesser of such QBI or 20% of taxable income. The deduction reduces taxable income, not adjusted gross income, and eligible taxpayers are entitled to the deduction whether or not they itemize. QBI is all domestic business income other than investment income (e.g., dividends (other than qualified REIT dividends and cooperative dividends)), investment interest income, short-term capital gains, long-term capital gains, commodities gains, foreign currency gains, etc. If a taxpayer’s taxable income exceeds a threshold amount, the deduction is generally limited to the greater of either: (a) 50% of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. Qualified property only includes property for which the “depreciable period” has not ended. For this purpose, the depreciable period is 10 years or, if longer, the depreciable life of the property. Clause (b) will prove helpful to real estate businesses that may not have many employees but tend to be capital intensive. The threshold amount is $157,500 or $350,00 in the case of a joint return.
- Implementation of 100% temporary expensing for certain business assets. The current 50% bonus depreciation is increased to 100% for qualified assets placed in service after September 27, 2017 and before December 31, 2022. However, after 2022, the amount of bonus expensing allowed will decline by 20% each year until it phases out completely for qualified property placed in service after December 31, 2026.
- Increasing Expensing under Section 179. Section 179 allows a taxpayer to elect to deduct the cost of qualifying property as opposed to recovering such costs through depreciation deductions. The Act increases the amount that a taxpayer may expense under Section 179 to $1,000,000 and increases the phase-out threshold to $2,500,000. The Act also expands the definition of qualified property to include all qualified improvement property (see below) and certain improvements (roofs, heating, ventilation, and air-conditioning property, fire protection and alarm systems, and security systems) made to nonresidential real property. In addition, the Act expands the definition of section 179 property to include depreciable tangible property used predominately to furnish lodging such as beds or other furniture, refrigerators, ranges, and similar equipment.
- Qualified Improvement Property. The Act (i) provides a 15-year recovery period for “qualified improvement property.” Qualified improvement property is defined as any improvement made to the interior portion of a nonresidential building which is made after the date such building was first placed in service. The term does not include any expenditure which is attributable to (i) the enlargement of the building, (ii) any elevator or escalator of (iii) the internal structural framework of the building.
- Reduction in rehabilitation credit. The Act provides a 20% credit (to be claimed ratably over a five-year period beginning in the tax year when the structure is placed in service) for qualified rehabilitation expenditures with respect to a historic structure. The Act generally is effective for amounts paid or incurred after Dec. 31, 2017, with a transition rule for qualified buildings which have been owned or leased at all times after January 1, 2018 and which the rehabilitation of which commences within a specified period. Coupled with the decrease in the corporate tax rate, there will likely be a decline in rehabilitation credit deals/investments.
- Contributions to Capital. If an entity, including a corporation, receives a governmental grant after January 1, 2018, the grant will be fully taxable. Under prior law a governmental grant received by a corporation was not subject to tax.
- Repeal of the technical termination rule for partnerships. A partnership will be treated as continuing even if more than 50% of the total capital and profits interest of the partnership are sold or exchanged. Previously, a technical termination would terminate partnership tax elections, e.g., accounting method, bad debt elections, 754 elections, etc., and restart depreciable lives of property for cost recovery deductions.
- Limitation on a Profit or Carried Interest. The receipt of a profits or carried interest in a LLC taxed as a partnership is generally not subject to tax and when that interest is sold, the holder of the interest generally receives capital gains treatment. The Act imposes an additional requirement that in order to be entitled to capital gain treatment the interest must be held for at least three years.
If you require further information regarding the content of this Legal Alert, please contact Erika D. Wood at email@example.com, Nicholas A. Scarfone at firstname.lastname@example.org or Christopher J. Centore, Chair of the firm's Real Estate Practice Area, at email@example.com.