How the Tax Cuts and Jobs Act Impacts the Real Estate Industry
The Tax Cuts and Jobs Act (TCJA), signed into law on December 22, 2017 has the potential to offer those in the real estate industry substantial tax savings. Among the most significant includes last minute changes to the rules on pass through entities which were added to benefit the real estate industry. Visit our Web site to learn more about important changes that may impact your business. Please feel free to contact us or your tax professional for additional information.
Tax Breaks for Pass-Through Businesses
Under prior law, net taxable income from pass-through business entities — including sole proprietorships, S corporations, partnerships and limited liability companies (LLCs) that are treated as sole proprietorships or as partnerships for tax purposes — was simply passed through to owners and taxed at the owners’ rates.
For tax years beginning after December 31, 2017, the new tax law establishes a new deduction based on a noncorporate owner’s share of a pass-through entity’s qualified business income (QBI). This break is available to eligible individuals, estates and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
The QBI deduction isn’t allowed in calculating the noncorporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction.
Limitation on W-2 Wages
For pass-through entities, the QBI deduction generally can’t exceed the greater of the noncorporate owner’s share of:
50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
“Qualified property” means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.
Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married individual who files jointly. Above those income levels, the W-2 wage limitation is phased in over a $50,000 range or over a $100,000 range for married individuals who file jointly.
Limitation on Service Business Income
The QBI deduction generally isn’t available for income from specified service businesses, such as most professional practices. Under an exception, however, the service business limitation does apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married individual who files jointly. Above those income levels, the service business limitation is phased in over a $50,000 range or over a $100,000 range for married joint-filers.
Important note: The W-2 wage limitation and the service business limitation don’t apply as long as taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.
Corporate Tax Cut
Under prior law, C corporations paid graduated federal income tax rates of 15%, 25%, 34% and 35% on taxable income over $10 million. Personal service corporations (PSCs) paid a flat 35% rate.
For tax years beginning after December 31, 2017, the TCJA establishes a flat 21% corporate rate. That reduced rate also applies to PSCs.
Accounting for Long-term Contracts
For contracts entered into after December 31, 2017, the exception for small construction contracts from the requirement to use the percentage of completion method (PCM) is expanded to apply to contracts for the construction or improvement of real property if the contract:
- is expected (at the time the contract is entered into) to be completed within two years of commencement of the contract, and
- is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test.
Use of this PCM exception for small construction contracts is applied on a cut-off basis for all similarly classified contracts, so no adjustment for contracts entered into before January 1, 2018.
Bonus or Accelerated Depreciation
The amount that a business or taxpayer may expense under bonus depreciation is doubling from 50% to 100%. It also expands the definition of qualified property assets to include used assets. This will be effective for assets acquired and placed in service after September 27, 2017, and before January 1, 2023.
Expanded Section 179 Deductions
The limit on the amount a business may claim as an immediate deduction under Section 179 will double from $500,000 to $1 million. In addition, the limit on property eligible for the Section 179 deduction is increased to $2.5 million. The TCJA also expanded the definition of Section 179 property to possibly include roofs, HVAC property, fire protection and alarm systems, and security systems if these improvements are made to nonresidential real property.
Like-kind exchanges – Section 1031
Under the new law, Section 1031 was modified to limit like-kind exchanges to only real property. Effective 2018, like-kind exchanges for personal property assets are eliminated. However, if one leg of an exchange has been completed as of December 31, 2017, and one leg remains open, the prior law rules still apply.
Elimination of Section 199 Deduction
Commonly referred to as the domestic production activities deduction or the manufacturers’ deduction is being eliminated. The elimination is effective for tax years beginning after December 31, 2017, for noncorporate taxpayers and for tax years beginning after December 31, 2018, for C corporation taxpayers.
New Limits on Business Interest Deductions
The TCJA states that corporate and noncorporate businesses generally cannot deduct interest expenses in excess of 30% of “adjusted taxable income,” starting with tax years in and after 2018. There are exceptions, entities and individuals that own real estate can make an election to use a slower depreciation method for their real property and deduct 100% of their interest expense. However, this method could limit the amount of bonus depreciation you may be eligible for in the future.
Net Operating Losses
For tax years ending after December 31, 2017, the maximum amount of taxable income that can be offset with net operating losses deductions is generally reduced from 100% to 80%. Net operating losses incurred will no longer be carried back to an earlier tax year, however, they may be carried forward indefinitely.
Excess Loss Deductions
Deductions for “excess business losses” incurred by noncorporate taxpayers are subject to new limitations. The TCJA defines an excess loss as an amount in excess of $250,000 (individuals) or $500,000 (married filing joint). Under the new law, excess business losses are not allowed for the current tax year but are instead, carried forward and then treated as part of the net operating loss carryforward amount. This limitation applies after the application of the passive loss rules.
R & D Expenses
Under prior law, eligible research and development expenses can be deducted in the current period. Starting with tax years beginning after December 31, 2021, specified R&D expenses must be capitalized and amortized over five years, or 15 years if the R&D is conducted outside the U.S.
For amounts paid or incurred after December 31, 2017, the TCJA repeals the 10% rehabilitation credit for expenditures on pre-1936 buildings. The new law continues the 20% credit for qualified expenditures on certified historic structures, but the credit must be spread over five years. Certain transition rules apply.
Limits on Business Interest Deductions
Prior law generally allowed full deductions for interest paid or accrued by a business (subject to some restrictions and exceptions). Under the TCJA, affected corporate and noncorporate businesses generally can’t deduct interest expense in excess of 30% of “adjusted taxable income,” starting with tax years beginning after December 31, 2017.
For S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes, this limit applies at the entity level, rather than at the owner level.
For tax years beginning in 2018 through 2021, you must calculate adjusted taxable income by adding back allowable deductions for depreciation, amortization and depletion. After 2021, these amounts aren’t added back when calculating adjusted taxable income.
Business interest expense that’s disallowed under this limitation is treated as business interest arising in the following taxable year. Amounts that can’t be deducted in the current year can generally be carried forward indefinitely.
Important note: Some taxpayers are exempt from the interest deduction limitation, including:
- Taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three previous tax years,
- Real property businesses that elect to use a slower depreciation method for their real property, and
- Farming businesses that elect to use a slower depreciation method for farming property with a normal depreciation period of 10 years or longer.
Another exemption applies to interest expense from dealer floor plan financing. For example, this exemption applies to dealers that finance purchases or leases of motor vehicles, boats or farm machinery.
Deductions for Business Entertainment and Certain Employee Fringe Benefits
Under prior law, taxpayers could generally deduct 50% of expenses for business-related meals and entertainment. Meals provided to an employee for the convenience of the employer on the employer’s business premises were 100% deductible by the employer and tax-free to the recipient employee. Various other employer-provided fringe benefits were also deductible by the employer and tax-free to the recipient employee.
Under the TCJA, deductions for business-related entertainment expenses are completely disallowed for amounts paid or incurred after December 31, 2017. Though meals purchased while traveling on business are still 50% deductible, the 50% disallowance rule also now applies to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. After 2025, the cost of meals provided through an on-premises cafeteria or otherwise on the employer’s premises won’t be deductible.
In addition, the TCJA disallows employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service), unless the transportation is necessary for the employee’s safety. And the new law eliminates deductions by employers for the cost of providing qualified employee transportation fringe benefits (for example, parking allowances, mass transit passes, and van pooling). However, those benefits are still tax-free to recipient employees.
Deductions for Passenger Vehicles Used for Business
For new or used passenger vehicles that are placed in service after December 31, 2017, and used over 50% for business, the maximum annual depreciation deductions allowed under the TCJA are:
- $10,000 for the first year,
- $16,000 for the second year,
- $9,600 for the third year, and
- $5,760 for the fourth and subsequent years until the vehicle is fully depreciated.
For 2017, the limits under the prior law for passenger cars are:
- $11,160 for the first year for a new car or $3,160 for a used car,
- $5,100 for the second year,
- $3,050 for the third year, and
- $1,875 for the fourth and subsequent years.
Slightly higher limits apply to light trucks and light vans.