By passing the Tax Cuts and Jobs Act (TCJA) in late December 2017, Congress granted the holiday wishes of many involved in real estate. While the TCJA brought good cheer for the business community in general, the real estate industry is particularly likely to reap the rewards.
So-called pass-through entities (partnerships, limited liability companies, S Corporations and sole proprietorships) are common among real estate firms. Investors, developers, landlords and real estate investment trusts (REITs) that structure their businesses as pass-through entities have paid taxes on the income at individual tax rates as high as 39.6%.
For 2018 through 2025, the TCJA reduces the highest individual tax rate to 37% and raises the taxable income threshold for that rate to $500,000 for single filers and $600,000 for joint filers. Moreover, it creates a generous new business income deduction that slashes taxable income. The qualified business income deduction generally allows taxpayers to deduct 20% of income from a pass-through entity, as well as 20% of qualified REIT dividends. Once taxable income exceeds $157,500 for single filers or $315,000 for joint filers, a “wage limit” begins phasing in, whereby taxpayers can deduct the lesser of 20% of qualified business income or 50% of the W-2 wages paid by the business. The wage limit phases in completely at $207,500 for single filers and $415,000 for joint filers.
In addition, an alternative wage limit was added to the TCJA at the last minute — an alternative favorable to firms with few employees but extensive real estate holdings. Under this option, taxpayers will instead deduct the lesser of:
- 20% of qualified business income or
- the sum of 25% of wages and 2.5% of the unadjusted basis (meaning the purchase price) of tangible depreciable property.
It’s important to note that sales of underlying real estate at a gain will not benefit from the business income deduction, as capital gains are not included in qualified business income.
Interest Expense Exemption
The reduced tax on pass-through income isn’t the only welcome news for real estate businesses. While the TCJA introduces a significant new restriction on the interest expense deduction, generally limiting the deduction to 30% of adjusted taxable income, real estate business can elect to not apply this limitation. Loan interest remains fully deductible for them. Real estate businesses that make this election are required to use the less favorable alternative depreciation system.
Unfortunately, the Senate proposal to cut the recovery period for nonresidential real and residential rental property to 25 years didn’t make the final bill — the depreciation periods remain at 39 and 27.5 years, respectively. Real estate firms may, however, benefit from changes to the rules for depreciating other types of property.
The TCJA extends and modifies bonus depreciation for qualifying property (for example, software and qualified improvement property) placed in service after September 27, 2017. It allows businesses to immediately expense 100% of the cost of qualifying property in the year the property is placed in service, through 2022 (with an additional year for certain property with a longer production period). And the new law permits bonus depreciation for both new and used property.
Beginning in 2023, the amount of the allowable depreciation deduction will phase down, dropping 20 percentage points each year for four years and sunsetting completely in 2027, absent congressional action. Under a transition rule, for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50% allowance instead of the 100% allowance.
The TCJA expands Section 179 expensing, too. For qualifying property placed in service in tax years beginning in 2018, it boosts the maximum deduction for qualifying property to $1 million (up from $510,000 for 2017) and the phaseout threshold to $2.5 million (from $2.03 million for 2017). These amounts will continue to be annually adjusted for inflation. The TCJA expands the definition of qualified real property eligible for Sec. 179 expensing to include several improvements to nonresidential real property:
- Ventilation and air-conditioning property,
- Fire protection and alarm systems, and
- Security systems.
Further, it broadens the definition of Sec. 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging.
The Tax Cuts and Jobs Act (TCJA) has additional favorable provisions for real estate firms. The Act preserves Section 1031 like-kind exchanges for real estate investors, who can continue to defer their capital gains taxes by reinvesting sales proceeds in certain types of “investment properties.” Under the law, the exchanges can no longer be used for personal investment properties such as heavy machinery, boats and airplanes, and are now restricted to real property. However, real estate investors who regularly use this type of transaction take note: The TCJA restricts exchanges to real property that isn’t held primarily for sale.
The TCJA also retains several credits important to certain kinds of development projects. The House of Representatives’ tax bill would have repealed the New Markets Tax Credit (NMTC) and the rehabilitation credit. The final bill maintained the NMTC and modified the rehabilitation credit to repeal the 10% credit for pre-1936 buildings but keep the 20% credit for certified historic structures, claimed over five years beginning when the building is placed in service. The Low Income Housing Tax Credit also continues unchanged.
Developers, investors, landlords and REITs should be pleased with the new tax rules overall but should work closely with your tax advisors to maximize the benefits.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.