10 Tax Reform Takeaways Impacting the Real Estate Industry
On December 22, the largest change to U.S. tax policy since the 1980s was signed into law. Overall, the real estate industry fared well, but each real estate business should be considered individually to really understand the impact and plan to maximize the benefit. The way several changes interact with each other, and whether to make certain elections, will be influenced by the amount of leverage, cost of and timing of improvements, the age of the property, the timing of dispositions, and so on.
Here are some real estate specific items to consider and, of course, discuss with a tax advisor:
20% Deduction for Pass-through Income – A new deduction was created equal to 20% of certain pass-through income for individuals, trusts and estates. This is a big win for real estate given the tendency to be structured as pass-through entities. Income from select service businesses is excluded, including consulting, brokerage and asset/investment management. Other limitations apply but those are real estate industry-friendly.
Limitation on Interest Deduction – The interest expense deduction is limited to 30% of “adjusted taxable income”, but any disallowed interest expense is carried forward indefinitely. Fortunately, real property businesses have the option to elect out of the limitation for a nominal reduction in annual depreciation and elimination of some bonus depreciation. The election to opt out is irrevocable so careful consideration needs to be given.
100% Bonus Expensing – Bonus depreciation was increased to allow for full expensing of qualified property (up from 50%). Increased expensing applies to property placed into service after September 27, 2017, and before January 1, 2023. The expensing allowance starts to phase out after 2022 and is eliminated after 2026.
Depreciation – Regular depreciation rules are essentially the same. The alternative depreciation system reduced residential rental property from 40 years to 30 years which is a favorable change given the interest expense limitation election.
Like-Kind Exchanges – Like-kind exchanges were eliminated except for real property. However, many exchanges involve property that is both real and personal property. Without deferral on personal property, some gain is likely to be recognized. This will put pressure on the allocation of purchase price to minimize any potential gain.
Carried Interest – Partners who receive an interest for providing services to a partnership will now be taxed at ordinary income tax rates if partnership property is sold within three years. However, sales of business real property still receive the more favorable 20% long-term capital gain rate if held one year.
Contributions to capital – Contributions to the capital of a corporation by a governmental entity, often received to aid in construction, are no longer excluded from income.
Historic Rehabilitation Tax Credits – The 10% tax credit (pre-1936 buildings) was repealed. The 20% tax credit for certified historic structures was retained but is now claimed ratably over a five-year period.
Expanded Section 179 Expensing – The expense election was increased to $1 million, with phase-out beginning when the cost of qualifying property placed in service reaches $2.5 million. The definition of property eligible to be expensed under Section 179 was expanded to include roofs, HVAC, fire protection and alarm systems, security systems and certain property used in furnishing lodging.
Reduced Tax Rates – All C corporations are now subject to a flat 21% federal tax rate on net income. The seven individual tax brackets shift in scope with a 37% maximum rate (down from the current 39.6%). No change in capital gain rates.
The new tax law significantly affects all taxpayers. With most provisions effective January 1, 2018, it’s important to understand the impact. CASTO prides itself on being proactive with tax planning and analysis is well underway. Hopefully, these real estate industry takeaways will be helpful for others’ planning, but of course check with a tax advisor to see how the new tax laws will impact you.
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