How tax reform affects the commercial real estate industry
Published January 24, 2018
On December 22, 2017, the President finalized historic federal income tax legislation, a bill known as the Tax Cuts and Jobs Acts (the “2017 Tax Act”). The 2017 Tax Act is the most sweeping income tax law change since 1986. Many income tax provisions in the new legislation are new rules that have never existed before, and as such, they provide a host of new income tax planning and structure opportunities across many industries, including commercial real estate.
Substantially unchanged are the rules regarding depreciation tax lives of commercial real property (39 years) and residential real property (27 1/2 years). Also unchanged are the long-term capital gain tax rates, generally 20%, the application of the 3.8% Medicare Surtax, or the Section 1250 unrecapture rules/tax rate of 25%. The tax rules regarding Low Income Housing Tax Credits are also unchanged.
Here is a summary of the key income tax changes impacting commercial and residential real estate developers and the industry in general.
100% Bonus depreciation beginning 9/28/2017 through 12/31/2017.
Normal qualified real estate categories remain through 12/31/2017, along with their historical tax lives – Qualified Leasehold Improvement Property (“QLHI”), Qualified Improvement Property (“QIP”), and Qualified Restaurant Property and Qualified Retail Property.
Used commercial property is now eligible for bonus depreciation, beginning 9/28/2017. This means that QLHI and QIP property that is acquired during the above-referenced period of time is now eligible for 100% bonus depreciation.
Embedded personal property/Section 1245 property acquired during this period of time, pursuant to a cost segregation study, qualifies for 100% bonus depreciation, new and used.
You can elect a lower 50% or 0% bonus depreciation rate, per class, as well.
100% Bonus depreciation beginning 1/1/2018 through 12/31/2022. Bonus depreciation is scheduled to phase-out over a few years beginning 1/1/2023.
The only qualified real estate property provision that survived, beginning 1/1/2018, is QIP. QIP’s tax life is now 15 years.
Note: There is an anticipated Technical Correction to be issued to permit the tax life of QIP at 15 years and make it eligible for bonus depreciation. Many believe this was the intent of the legislation.
Section 179, beginning 1/1/2018, is $1 million/year.
Certain non-residential real property items qualify: QIP, HVAC, roof, security systems, and fire protection systems.
NOTE: Normal Section 179 limitations apply. You need formal trade or business income; commercial rental real estate income typically does not qualify for Section 179 unless rising to the level of a formal trade or business activity.
New 20% Deduction and 2.5% Deduction, beginning 1/1/2018 through 12/31/2025.
Beginning 1/1/2018, a new non-cash deduction exists for pass-through taxpayers, reflected at the owner level. The new 20% and 2.5% non-cash pass-through deduction applies to commercial and residential rental real estate pass-through ventures—individuals with Schedule E, S corporations, and partnerships/LLCs.
The new 20% deduction and 2.5% deduction is generally calculated by taking the greater of 20% of the activity’s net profit, limited to 50% of the activity’s wages, OR, 2.5% of qualifying fixed asset cost (generally building and land cost, which is available to be used in the 2.5% calculation through the final year of its tax life) plus 25% of wages from the activity. If a taxpayer’s taxable income is $315,000 or less, the wage limit does not apply. The impact of bonus depreciation on these calculations, plus wage limits, will require careful attention.
Also, commercial and residential rental real estate activities, for this purpose only, will generally be considered a trade or business unless in the form of a triple net lease arrangement. Self-rental arrangements will need to be carefully reviewed for eligibility of the 20%/2.5% deduction. Economic Unit self-rental arrangements will require further guidance.
Owners who are passive, with passive income, will be entitled to this new 20%/2.5% deduction.
Beginning 1/1/2018 a NEW 30% EBIDTA Interest Expense limitation applies.
A new 30% of EBITDA interest expense limitation applies to commercial rental real estate activities. The 30% interest expense limit is determined at the entity level. Entities with less than $25 million in annual sales are exempt from the new 30% interest expense limitation.
Real estate development activities with sales in excess of $25 million can elect ADS depreciation deductions instead, and avoid the new 30% interest expense limitation – 40-year tax life for commercial rental real estate; 30-year tax life for apartments/single rental residences; and 20-year tax life for QIP.
Real estate developers that elect ADS depreciation will not be able to take bonus depreciation.
Like-Kind Exchanges – effective 1/1/2018 only commercial/investment real estate activities are eligible for tax-free exchange treatment. Personal property is no longer eligible.
If the real property (building) has Section 1245 property (personal property) embedded, especially pursuant to a cost segregation study, that portion of the property is ineligible for Section 1031 tax-fee treatment.
As such, it will be important to determine the value of Section 1245 property embedded in real property upon pursuing a Section 1031 exchange. Cost segregation studies on the replacement property, identifying Section 1245 personal property, with 100% bonus depreciation expense (especially on used property) should assist in minimizing the impact to this tax-free treatment limitation.
$500,000 Trade or business loss – new annual loss limitation, effective 1/1/2018 through 12/31/2025.
Losses incurred by trade or business activities will continue to have basis limitations and the historical passive loss limitations apply. New, however, is the $500,000 (MFJ)/$250,000 (MFS/Single) loss limitation. This rule limits total trade or business losses, at the owner level, to $500,000/$250,000 for purposes of offsetting other non-trade or business income such as interest, dividends and wages. Excess loss amounts will be carried forward.
This will require real estate developers to analyze further the net benefit/limitation to pursuing cost segregation studies.
Energy Efficient Incentives – Congress Extender Package – as of the date of this article this legislation has NOT yet passed. Meaning, as of 1/1/2017, the below two real property tax provisions have expired.
- Section 179D – if the Extender Package legislation passes, it would make this rule available for the period 1/1/2017 through 12/31/2018. Not yet in the law.
- Section 45L – if the Extender Package legislation passes, it would make this rule available for the period 1/1/2017 through 12/31/2018. Not yet in the law.
New Qualified Opportunity Zone declarations – 12/22/2017.
State Governors will declare areas as qualified opportunity zones (“QOZ’s”). These QOZ areas will permit certain deferral of capital gains from the sale of commercial real property.
Watch for new built in loss rule – applies if $250,000 loss is allocated to an incoming member.
Historic Tax Credit (HTC).
- The 10% credit was repealed for pre-1936 buildings.
- The 20% credit for Qualified Rehabilitation Expenses (QRE) was retained with a modification. The credit is now allowable over a 5-year period beginning with the year the building is placed in service, effectively making the credit 4% per year of the QREs.
There is a transition rule that will determine if the HTC is claimed under the old law, which was the full 20% in the year placed in service or under the new law, 4% per year over 5 years. The taxpayer has a 24- or 60-month window to claim expenditures during rehabilitation. If the taxpayer selects to start the window outside of 180 days after December 22, 2017, then the new law applies, otherwise the old law is still in effect.
Effective 1/1/2018 – No longer evaluate technical termination of partnership issues. These rules have expired.
Effective 1/1/2018 – Sale of partnership ownership interest – gain on sale of partnership interest traced to the location of the business activity – foreign rule. This tax law change follows a recent Tax Court case.
This might have states follow a similar rule, whereby gain of membership interest is traced to location of property, not the state where the security is held.
Cash basis method of accounting – reminder for commercial rental real estate activities.
The new 1/1/2018 $25 million revenue threshold does not apply to commercial rental real estate ventures, since rental real estate ventures do not have inventory, the cash basis method of accounting is generally available to pass-through commercial rental real estate ventures regardless of the level of sales revenue.
However, syndicates are generally required to use the accrual basis method of accounting. Meaning, if 35% or more of the commercial rental real estate venture is owned by passive investors, and losses exist, generally, the activity must be accrual basis method of accounting.
For more information about how these changes may affect you and your real estate business, please reach out to your MCM tax professional or contact Partner Stephen Lukinovich, CPA, CVA, PFS via e-mail or phone at 812.670.3455.