By: Marcia Nally, Co-Author and Tax Director at Moore Colson CPAs and Advisors
The 2017 Tax Cuts & Jobs Act contains several major changes to the tax landscape for both businesses and individuals. Below are seven key areas where the new policies will impact the real estate industry.
- Taxation of pass-through entities
A deduction is available to investors who invest in real estate through partnerships or LLCs taxed as partnerships. The deduction is equal to 20% of qualifying business income. Earlier versions of the bill limited the deduction to 50% of W-2 wages paid. The final bill added the provision limiting the deduction to the greater of 50% of wages paid or the sum of 25% of W-2 wages paid, plus 2.5% of the cost of tangible depreciable property.
The deduction should be widely available to real estate firms. The deduction is also available to REIT investors on REIT dividends subject to ordinary tax rates.
2. Bonus depreciation
The previous bonus depreciation requirement for property to be “original use” has been eliminated. Bonus depreciation is now available to both new and used property acquired after September 27, 2017. Qualifying fixed assets acquired between September 27, 2017, and December 31, 2022, can be expensed in their entireties. The bonus depreciation phases out between 2023 and 2026.
Cost segregation studies will continue to provide meaningful tax benefits for the real estate industry. Benefits include identification of immediately deductible repairs, significantly shorter depreciable lives and the availability of bonus depreciation on assets that would not have otherwise qualified.
3. Qualified improvement property
Beginning in 2018, there will no longer be separate definitions of Qualified Leasehold Improvements, Qualified Retail Improvements, and Qualified Restaurant Property. Only Qualified Improvement Property remains. Its definition was expanded to include any improvement to an interior portion of a building, regardless of whether or not space is leased. Qualified Improvement Property has a 15-year life, making it eligible for 100% bonus depreciation. Building enlargements, elevators, escalators and internal structural framework are excluded from the definition.
“With proper planning, the after-tax returns of owning real estate can be significantly improved as a result of the potential for accelerated depreciation deductions on Qualified Improvement Property and the 20% deduction on pass-through income,” said Steve LaMontagne, Partner and Real Estate Practice Leader at Moore Colson CPAs and Advisors. “These changes will benefit small investors, as well as major institutions.”
4. Net interest expense limit
The interest expense limitation could have a material impact on real estate investors. It is not uncommon for real estate projects to generate annual tax losses. Where projects generate tax losses, interest deductions could be disallowed in their entirety.
Although disallowed interest is carried forward, the annual limitations on deductions can be material and meaningful. A taxpayer’s net interest expense deduction is limited to 30% of income before interest, taxes, depreciation, and amortization. After four years, the 30% limit is applied to income before interest and taxes.
Any excess interest deductions allocated to a partner will serve to reduce that partner’s basis in its partnership interest in the year allocated, regardless of when the deduction is utilized. Real estate companies can circumvent the interest deduction limitation with an annual election to use the Alternative Depreciation System (ADR).
ADS is a system the IRS requires to be used in special circumstances to calculate depreciation on certain business assets. ADS generally increases the number of years over which property is depreciated, decreasing the annual depreciation deduction. Listed property used 50% or less for business purposes, tangible assets used primarily outside of the U.S. and farming equipment require ADS.
5. Historic tax credits
Owners of historic properties have access to a tax credit for Qualified Rehabilitation Expenditures (QRE). Owners can still take a 20% credit for QREs in the same year of the expenditures for historic structures listed in the National Register.
The previous bill allowed 10% credit on QREs with respect to a qualified rehabilitated building other than a historic structure, provided the building was placed in service before 1936. That provision has been repealed in the new tax bill.
6. Carried interest | Pass-through entities
Under the previous bill, profits paid to private equity fund managers that were generated from investments held for more than one year were taxed at favorable long-term capital gain rates. Under the new tax law, the investment must be held for more than three years in order to receive long-term capital gain treatment. However, investments held by corporations, other than S-Corporations, are exempt from the three-year holding requirement.
7. Tax-exempt investors
The new tax law produced mixed results for tax-exempt investors in real estate. Under previous policies, a tax-exempt organization could aggregate all profits and losses from its various unrelated business activities and pay unrelated business income tax (UBIT) only on any resulting net income. Under the new tax provisions, losses from one activity cannot offset profits from another, subjecting some tax-exempt entities to unrelated business income tax. To the extent subject to UBIT, a tax-exempt entity will enjoy the lower corporate tax rate of 21% enacted under the new law.
Marcia Nally, CPA, has over 20 years of experience in tax compliance and planning services for closely-held businesses and their owners in the real estate industry. She is a Tax Director at Moore Colson’s Real Estate Practice and a proud member and volunteer of CREW Atlanta.
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