Real Estate, Construction, and the New Tax Law
The business community is beginning to digest the broad reach of the Tax Cuts and Jobs Act (“TCJA”). For our clients in the real estate and construction industries, we see new opportunities for tax savings, new complexities, and new reasons to engage in conversation and consultation.
Businesses with less than $25 million in annual revenue may benefit the most under the TCJA. The simplification provisions that apply to these taxpayers permit use of the cash method of accounting, simplified inventory accounting methods, and the completed contract accounting method for long-term contracts. These accounting methods can create more flexibility in tax planning and will provide for easier recordkeeping and reporting requirements for these businesses. Additionally, businesses with less than $25 million in annual revenue will not be subject to any limits on business interest expense deductions.
Bonus Depreciation and Section 179 Expensing
Enhancements to bonus depreciation are the only provisions in the TCJA that are retroactive to September 28, 2017. The TCJA extends and modifies the availability of first-year additional depreciation for qualified property placed in service after September 27, 2017, and through December 31, 2022. The first-year percentage increased to 100 percent, and it now applies to both new and used property. The first-year bonus percentage will phase down beginning in 2023 and will sunset at the end of 2026.
The TCJA enhanced section 179 expensing by increasing the maximum annual amount a taxpayer can expense up to $1 million (with the phase-out threshold increased to $2.5 million). It also expanded the definition of qualified real property eligible for expensing to include:
- Tangible personalty in residential rental properties furnishing lodging (e.g., appliances, furniture)
- Certain improvements made to nonresidential real property after the property was first placed in service (e.g., roofs, HVAC property, fire protection, security systems)
- Qualified improvement property
Qualified Improvement Property
The TCJA streamlines the multiple definitions for improvements to nonresidential real property. The sometimes overlapping definitions of qualified leasehold, restaurant, and retail improvement property are eliminated in favor or one definition – qualified improvement property.
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 was first placed in service. Certain improvements, however, are excluded from this definition including: a) enlargements to the building, b) improvements to elevators and escalators, and c) work on the internal structural framework of the building.
In brief, qualified improvement property placed in service on or after January 1, 2018, is eligible for straight line depreciation over 15 years, section 179 expensing and first-year bonus depreciation.
Caution: Due to the hurried drafting of the law, a key provision was omitted from the final bill that permits the 15-year depreciable life. Congressional leaders and staffers have indicated that it was their intent to establish the 15-year life, and the missing provision will be added in a technical corrections bill later.
Sigh of Relief
There is also good news for the real estate and construction industry with respect to federal tax credits. The TCJA left intact or made minor changes to the New Markets Tax Credit, the Research & Development Tax Credit, the Rehabilitation Tax Credit, and the Low-Income Housing Tax Credit.
Key provisions beneficial to the residential real estate market were retained. The itemized deduction for residential mortgage interest was preserved with adjustments to new mortgages, limiting loan principal to $750,000 acquisition value. The gain exclusions from the sales of personal residences were retained with no adjustments.
New Section 199A Deduction
Section 199, the Domestic Production Activities Deduction (DPAD), was repealed by the TCJA. In its place, one of the more complex provisions of the new law was added: Section 199A, Qualified Business Income (“QBI”). In brief, a noncorporate taxpayer may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation or sole proprietorship. There are limits on the QBI deduction due to income from specified service businesses and limits that are derived from W-2 wages and the costs of depreciable tangible property.
Many questions surround this new section of the Internal Revenue Code, and the Internal Revenue Service (“IRS”) has been asked to provide guidance for a number of these questions as soon as practical. A full discussion of QBI is beyond the scope of this article. However, it is important for pass-through business owners, managers, and investors to develop a working knowledge of the law and develop an understanding of its impact to their business operations. In addition to identifying those partners and S corporation shareholders that can happily claim the 20 percent deduction and those that unhappily may not, the partnership or S corporation business will need to maintain new tax reporting records and section 199A information to supply along with their Schedules K-1 each year.
Interest Expense Limitation
For tax years beginning on or after January 1, 2018, the TCJA limits the deduction for business interest expenses to no more than the sum of:
Business Interest Income
+ Floor Plan Financing
+ 30 Percent of Adjusted Taxable Income
Any disallowed interest expense is generally carried forward indefinitely. In the case of a partnership or S corporation, the deduction limitation applies at the entity level. However, disallowed interest of the entity is allocated to each partner or shareholder as excess business interest.Adjusted taxable income is basically taxable income before interest, depreciation, amortization and depletion. Beginning in 2022, depreciation, amortization and depletion will not be added back.
Fortunately, a real property trade or business can elect out of the 30 percent business interest expense limitation. A real property trade or business is a business engaged in real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.
The election not to apply the limit to business interest expenses has its costs, however. An election out requires the business to apply the Alternative Depreciation System (“ADS”) to depreciate its nonresidential real property, residential real property and qualified improvement property. ADS provides for straight line depreciation over a slightly longer life. The IRS will provide guidance on how the election can be made and when. Once made, the election is irrevocable.
New Reasons to Engage in Conversation
Choice of Business Entity
No discussion of the new tax law is complete without mentioning the need to evaluate the type of business entity in use – sole proprietorship, partnership, S corporation, C corporation, trust and others. Dramatically lower corporate tax rates, changes to deduction limits, new individual tax brackets, section 199A, plus the temporary nature of so many of these new tax rules, all work together to raise a question: Is there a better entity for your business than the one it currently operates in?
For most existing businesses, there may be no compelling reason to change entity types. For others, the tax savings may be important.
Whatever your questions are about the new tax law, we invite you to reach out to a Cherry Bekaert advisor and start the conversation. We welcome your questions and will be happy to talk with you. This will be a year-long journey as we all work through this major transition in tax law together.