2023 Year-End Tax Planning Strategies for the Real Estate and Construction Industry
Contributor: Chelsea Payne, Senior Manager, Tax Services
As the end of the year approaches, strategic planning remains crucial for taxpayers looking to optimize their financial positions and set the stage for a strong start in the upcoming fiscal year. The discussion below focuses in on tax planning opportunities tailored specifically for the real estate industry: deferring revenue, maximizing deductions, and utilizing available credits and incentives. The effectiveness of each strategy can vary based on the specific circumstances of a company and the current tax position of its owners. It’s important to work with a qualified tax consultant or financial advisor who can provide guidance tailored to your unique situation.
Section 1031 exchanges allow investors to defer capital gains tax on the sale of real property used in a trade or business or held for investment. A 1031 exchange requires the taxpayer to reinvest the proceeds from the property given up into like-kind property. This technique provides for the deferral of tax, freeing up the cash flow from the unpaid tax for more capital investment and growth. Generally, taxpayers must identify the replacement property within 45 days of selling the relinquished property, and then acquire the replacement property within 180 days of the sale transaction or by the due date of the tax return.
Another tax deferral option is to invest realized gains in a Section 1400Z Opportunity Zone (OZ), a program that aims to stimulate economic development in distressed communities. Taxpayers can defer tax on capital gains and Section 1231 gains from sales of real estate, stocks and bonds, and business assets by reinvesting the gains into a Qualified Opportunity Fund (QOF). Generally, taxpayers must reinvest the gains realized within 180 days of the transaction. The capital gains tax is deferred until the QOF investment is sold or December 31, 2026, whichever is earlier.
Taxpayers who can take advantage of financing a sale of assets to a buyer may have an opportunity to defer tax on the sale over time. The seller recognizes gains as the buyer makes payments of principal on the note. Not all sales and not all taxpayers can qualify to use the installment sale method.
Depreciation is based on the idea that the cost of assets should be recovered when assets are generally more productive and valuable in their earlier years. Accelerated depreciation provides tax benefits in the form of higher depreciation deductions in the earlier years of an asset’s life, therefore reducing current year taxable income and, reducing the taxes a company or individual must pay and increasing cash flow.
Effective January 1, 2023, Section 168(k) bonus depreciation has begun to phase out over the next five years. For eligible assets acquired and placed in service in 2023, taxpayers can deduct 80% of cost in the first year and then depreciate the remaining basis over the next several years under MACRS depreciation rules.
Section 179 Expenses
No significant changes related to a Section 179 expensing election occurred this year. Taxpayers can expense 100% of the cost for eligible assets acquired and placed in service in 2023. Section 179 expensing is still subject to annual limitations on the total investment in qualifying assets and the amount of taxable income. Qualified improvement property and certain real property improvements such as roofs and HVAC, can qualify for Section 179 expensing.
Cost Segregation Studies
Cost segregation is a strategic cash tax planning tool that allows property owners to increase their cash flow through the acceleration of depreciation deductions and deferral of tax payments. The process involves separating a portion of the building’s costs into shorter lived assets. The ideal timeframe in which to conduct a cost segregation analysis is within the same year a building is constructed or an existing structure is purchased. However, this planning tool can also be implemented on a structure that was constructed or acquired several years earlier, thanks to the IRS “catch-up” provision that allows a taxpayer to realize any missed depreciation without filing an amended tax return.
Consider a cost segregation study to identify assets and building components that can be depreciated over a shorter time frame than 27.5- or 39-year lives. A cost segregation study identifies costs of assets and various components of real property to classify with 5-, 7- and 15-year tax lives for accelerated depreciation. This allows for larger depreciation deductions in earlier years.
Pass-through Entity Tax Elections
The pass-through entity (PTE) tax election allows partnerships and s-corporations to elect to be taxed at the entity level for state income tax purposes. The key benefit to a PTE election is the federal deductibility of the entity’s state income taxes paid. Individual owners of PTEs can realize a federal tax deduction of state taxes via their pass-through income allocation, thereby avoiding the $10,000 Federal 1040 Schedule A limit on itemized deductions of state income tax payments, commonly known as the state and local tax (SALT) cap. Each state has different eligibility requirements and PTE election regimes.
Utilize Tax Credits and Incentives
The Inflation Reduction Act of 2022 (IRA) enhanced and extended existing tax credits and incentives and introduced new tax credits related to clean energy. These incentives are intended to encourage the adoption of clean energy technology, reduce energy consumption and support the domestic clean energy economy.
Multifamily and single-family contractors may be eligible to claim the Section 45L Energy-Efficient Home Credit (Section 45L). The IRA extended this credit until the end of 2032, adjusted the credit amount and energy savings requirements, and tied the credit to prevailing wage requirements.
The IRA expanded the value and availability of the Section 179D Energy-Efficient Commercial Buildings Tax Deduction (Section 179D). The IRA lowered the threshold for demonstrating building components reduce energy consumption and expanded the availability of the deduction to certain tax-exempt entities.
For buildings placed into service after 2022, qualifying taxpayers may claim a deduction of up to $5 per square foot for eligible properties. In addition, the IRA now permits a Section 179D deduction every three years for qualifying improvements to existing buildings. To qualify for this increased deduction amount, companies must meet the new prevailing wage and apprentice program requirements.
Section 45 Investment Tax Credits
Businesses and building owners that install solar panels, wind turbines, geothermal devices, battery storage equipment or other qualifying energy equipment may be eligible for an investment tax credit. The base credit is generally 6% of costs incurred, but the credit is increased five times over when meeting prevailing wage and apprenticeship hour requirements. The credit can be increased further with boosters for domestic content and the location of the energy property in certain energy communities or lower income communities.
Historic rehabilitation credits set forth in Section 47 are designed to stimulate investment in the rehabilitation of historically significant properties, thereby fostering the retention of cultural heritage and promoting economic development within communities. The credits typically allow owners or developers to offset a portion of the costs associated with the qualified rehabilitation expenditures for the historic property. The 20% credit is based on qualified rehabilitation expenditures incurred for the renovation, restoration or reconstruction of a qualified historic property.
The low-income housing tax credit (LIHTC) program provides incentives to developers or investors for the development and rehabilitation of affordable rental housing for low-income households. The credit, which is claimed pro rata over 10 years and can be either 4% or 9%, is determined by a projects-qualified basis.
The LIHTC program is administered by state and local housing finance agencies, which allocate the Section 42 tax credits through a competitive application process. In return, developers agree to reserve a certain percentage of the housing units for low-income tenants, ensuring that the properties remain affordable for an extended period. The amount of the credit is based on eligibility and location variables.
Let Us Guide You Forward
By planning ahead and taking advantage of the opportunities discussed above, companies that own, operate, develop or construct real properties can position themselves for better tax outcomes. Given the complex nature of tax law, regulations, administrative guidance and the potential implications of each decision, Cherry Bekaert Real Estate and Construction Industry group professionals are ready to assist companies and their owners with tax planning.