Tax reforms introduced as the Tax Cuts and Jobs Act and signed into law last December are generally agreed to be the most comprehensive in more than three decades. They include several major changes affecting real estate investment. In general, these changes are beneficial to real estate professionals and investors. To reap the maximum benefits, however, it’s important to understand how best to structure your business in light of these new provisions of the law.
Enhanced depreciation opportunities
Previously, qualified business property was eligible for an immediate bonus depreciation of 50 percent, which effectively allowed the buyer to deduct 50 percent of the cost for the year the property was placed in service, a 40 percent deduction the next year and a 30 percent deduction the year after that. Under the new law, investors can claim a 100 percent bonus depreciation for qualified properties placed in service after Sept. 27, 2017 and before 2023. So, property owners can now take an immediate deduction rather than spread it over several years.
After 2022, the bonus depreciation will decrease by increments—to 80 percent for properties placed in service in 2023, 60 percent for properties placed in service in 2024, 40 percent those placed in service in 2025 and 20 percent for those placed in service in 2026.
The definition of a qualified property has also loosened. For the first time, the 100 percent deduction applies to both new and used properties, as long as they are not purchased from a related party. Importantly, bonus depreciation is available only for short-lived capital investment property such as machinery and equipment.
In addition, the Section 179 deduction, which allows businesses to deduct the full purchase price of qualifying equipment and/or software purchased or financed during the tax year, increased from $510,000 to $1 million and the phase out threshold increased from $2 million to $2.5 million. Qualifying equipment and/or software includes almost all types of business equipment that a company buys and uses in its ordinary course of business. Importantly, the deduction limitation amounts will be indexed for inflation after 2018.
To take full advantage of these enhanced depreciation opportunities in some instances it may be advisable to perform a cost segregation analysis to identify personal property assets that are grouped with real property assets, and separating them for tax purposes.
Retention of interest deductibility
The new law enforces a 30 percent limit on interest deductibility for businesses with average gross receipts greater than $25 million. A real property trade or business–– spelled out as one involved in development, construction, rental, management or leasing and brokerage activities–– has the option to elect out of this limitation. However, doing so does change the depreciation rules for businesses that do. Therefore, before opting out, any business or entity should conduct a careful analysis of the cost/benefit on a case-by-case basis.
While it’s been widely reported that the new law introduced a flat corporate tax rate of 21 percent, this applies only to tax-paying C-corporations (typically large public companies) and not to the majority of U.S. businesses, which are predominantly conducted as pass-through entities such as partnerships; limited liability companies taxed as partnerships; and S corporations, whereby the attributes of income or loss are passed through the owner. This discrepancy potentially creates a tremendous imbalance between large businesses and others.
To level the playing field, owners—including investors regardless of their level of participation—can deduct 20 percent from qualified income earned through pass-through entities. While this might not seem momentous, real estate entities could realize significant benefits through restructuring, particularly on the support side. For example, the 20 percent deduction combined with enhanced depreciation could reduce the income tax rate from 39.6 percent to just under 30 percent.
While this deduction is generally equal to 20 percent of the owner’s allocable share of qualified business income, there are some payroll limitations that should be taken into consideration. Specifically, the deduction cannot exceed 50 percent of the individual’s allocable share of W-2 wages paid by the business, or 25 percent of the individual’s allocable share of W-2 wages paid by the business plus 2.5 percent of the individual’s share of the unadjusted basis (i.e. the original purchase price) of property used in the production of income. These limitations underscore the importance of proper tax planning in order to take full advantage of the pass-through deduction.
Significantly, this 20 percent deduction does not apply to “personal service businesses” unless the individual earns less than $157,500 (single) or $315,000 (married filing jointly). Personal service businesses include businesses in the fields of accounting, health, law, consulting, financial services, brokerage services or any other business in which the principal asset of the business is the reputation or skill of one or more of its employees. Two notable exceptions are architectural and engineering services.
Residential real estate
The deduction for single-family or multifamily properties is now limited to $10,000 for the combination of both property and income (or sales) taxes. In other words, taxpayers who pay both property and income (or sales) tax will be able to deduct up to $10,000 total per return. This deduction will impact individuals who itemize their deductions on Schedule A of their 1040 and will be particularly detrimental to those individuals who live in high real estate tax states and in high income tax states such as New York, Connecticut or New Jersey.
For the most part, the new law applies solely to properties within the U.S., however investors do need to be mindful that the rules governing foreign investment are also in flux. In many respects the Tax Act is still a work in progress. Clarifications and refinements are inevitable, and will require ongoing monitoring and analysis.
At the same time, real estate remains a very strong investment vehicle, and one that can be sheltered for the first several years. Creative restructuring that takes advantage of the new law can be an added bonus in helping improve an investor’s tax situation dramatically.
Steven F. Klein is a partner at Gerson Preston Klein Lips Eisenberg Gelber, a Miami-based accounting firm.