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Article Dean Dorton

The fifth and final installment is somewhat of a smorgasbord of information that is relevant to the real estate industry, but not as tax law intensive as our previous installments.

Like-kind exchanges

Previously, taxpayers could elect to defer gains on the sale of assets used in a trade or business by making a qualified like-kind exchange (LKE), and following specific guidelines issued by the IRS. After December 31, 2017, LKEs are limited to real property not held primarily for sale, and tangible personal property no longer qualifies. While this seems like great news for those in real estate, it may add levels of complexity related to transactions in which there were previous cost segregations that pulled out tangible personal property from the purchase or construction of a building. Buyers and sellers may consider allocation of purchase price to interior items more closely, as it is possible there may be assets included in the sale that do not qualify for a like-kind exchange.

Rehabilitation credit

Under prior law, there was a 20% credit for qualified expenses to certified historic structures or structures in certified historic district, and a 10% credit for expenses related to a qualified rehabilitated building, subject to specific rules and reporting requirements.

Under the new Tax Cuts and Jobs Act, for amounts paid and incurred after December 31, 2017, the 10% credit is repealed, and the 20% credit is only eligible for certified historic structures. There is a transition rule for buildings that were owned prior to January 1, 2018 that may have qualified under the old law.

Qualified opportunity fund deferral of income

A new gain deferral was created by the new Act. Effective December 22, 2017, there is a temporary deferral from inclusion in income for gains that are reinvested in a “qualified opportunity fund” (QOF), and a permanent exclusion of gains on the sale of an investment in a QOF.

A qualified opportunity fund is an investment created for the purpose of investing in qualified opportunity zone property, and at least 90% of the assets in the fund is qualified opportunity zone property.

The Act designates certain low-income community population census tracts as qualified opportunity zones. Once designated, it remains in effect until the end of the tenth calendar year beginning on or after designation. A list of the census tract zones is located at https://www.huduser.gov/portal/sadda/sadda_qct.html.

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Article Dean Dorton

In our fourth installment, we will discuss the new expansion of the limitation on the deduction of interest expense. For tax periods beginning after December 31, 2017, the limitation has been expanded to include individuals (and businesses owned by individuals). One major consideration, however, is that taxpayers who have gross receipts under $25 million are exempt from this limitation. Real estate businesses that otherwise would have to apply this limitation can elect out by using the alternative depreciation system (ADS), rather than MACRS. ADS lives are longer than MACRS lives (although the residential real estate life has been reduced to 30 years), and assets using ADS lives are not qualified for the 100% bonus depreciation or Section 179 expensing. As such, if the business interest limitation applies to a taxpayer, they need to consider the financing terms and interest expense relative to net income, as well as the implications of cost recovery/expensing of assets, and the QBI deduction.

If the taxpayer is not exempt and does not elect out of the limitation, business interest expense will be limited to the sum of:

  1. Business interest income and
  2. 30% of adjusted taxable income.

Adjusted taxable income is taxable income adjusted for income and expenses not related to a trade or business, net business interest, NOLs, QBI deduction, and depreciation. The depreciation addback only applies until January 1, 2022.

This limitation is calculated at the partner level as well as the partnership level, so the partner’s share of income from a partnership will be excluded at the partner level (since the limitation would already have been calculated at the partnership level). Currently, there is little guidance on the potential that a partner might elect out and the partnership might not (or vice versa), and the interplay with the calculation at the partner level.

There is a concept that any “excess taxable income” generated by the partnership can be used to calculate the partner’s individual limitation. Conversely, if the partnership passes through excess business interest expense in a tax year which could not be deducted, the interest will be retained at the partner level and deducted if there is excess taxable income from the partnership in a future tax year.

Due to the fact that this will be considered at the entity as well as owner level, there will be more reporting requirements for the partnership to ensure all the information that is needed to calculate the applicability of this limitation is passed through to owners.

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Article Dean Dorton

For the third installment of our series, we will discuss excess business losses and net operating losses for individual taxpayers.

Previously, individuals offset business losses against all other income (subject to passive and basis limitations). Beginning after 2017, and applying to all taxpayers other than C corporations, there is a new concept of “excess business loss.” A taxpayer may now generate disallowed excess business losses, which will be treated as a net operating loss carryover subject to the new 80% limitation.

“Excess business loss” is defined as the excess of allowable deductions attributable to taxpayers’ trades or businesses over the sum of total taxable gross income attributable to the trades or businesses plus $500,000 for a joint return ($250,000 for all others). This is calculated after the passive activity rules limitations.

Essentially, this limits the ability to offset other income by trade or business losses; effectively, married taxpayers can only offset up to $500,000 of non-business income (e.g., investment income, wages, et cetera) with business losses.

Example for a single taxpayer:

2017 2018
Wages $100 $100
Investment income $200 $200
Eligible business losses $(500) $(500)
Taxable income/(loss) $(200) $50
Net operating loss $(200) $(250)

**Excess business loss converts to net operating loss (NOL)

This could have a significant impact on the real estate industry, particularly when considering the increased ability to expense capital assets, since the industry is depreciation-intensive.

The ability to deduct net operating losses (NOLs) will also change after December 31, 2017. For tax years beginning after that date, any NOL deduction generated will be limited to 80% of taxable income. Previously, NOLs could offset 100% of taxable income. NOLs that are being carried forward from a previous year will be allowed to offset up to 100% of taxable income, as the old law will still be applicable. Alternative minimum tax NOLs are still limited to 90% of taxable income, so there was no change in that deduction. While the deduction itself has been limited, the carryover of post-2017 NOLs is now indefinite; however, you cannot carryback NOLs after December 31, 2017. The pre-Tax Cuts and Jobs Act NOLs are limited to a 20-year carryover, and could be carried back two years.

The changes in the ability to deduct business losses and net operating losses could significantly impact planning, as it is possible that taxpayers who have been able to offset income with losses fully in the past will no longer be able to fully eliminate taxable income. Careful consideration of the cost recovery and capitalization of assets, as well as the new interest expense limitation rules, will be vital in tax planning for use of business losses and net operating losses. We will discuss the limitations on business interest expense in our next installment.

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Article Dean Dorton

Previously, we discussed changes to and expansion of existing tax law. In this installment, we will be addressing tax law that is entirely new. As such, there are still areas that will require further clarification from the IRS. We will discuss the law as passed on December 22, 2017 and our interpretation of the newly created Section 199A deduction, otherwise known as the “qualified business income deduction” or “20% business deduction.” The calculations as outlined in the Tax Cuts and Jobs Act are quite elaborate and involve a number of new definitions.

One of the most important new terms is “qualified business income” (QBI), which is defined as the income, gain, loss, or deduction from a qualified trade or business (defined below), in the U.S., and excludes investment income (short-term and long-term capital gains, dividends and interest, and a variety of other items).

Another new term is “qualified trade or business” (QTB). To be eligible for the QBI deduction, the income must be generated by a qualified trade or business. This is any trade or business other than “specified service trades or businesses,” which include the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financials services, brokerage services, any services related to investment management, and any trade or business where the principal asset is the skills and reputation of the employees or owners.

One important item to note: Even specified service trades or business are eligible for the deduction if the taxpayer’s income does not exceed certain thresholds. There is a phase-out for the specified service trades, so once taxable income exceeds $415,000 for joint returns, income generated from the specified service trades will not be considered QTB and therefore will not be considered for the QBI deduction.

There are two limitations on the deduction at the QTB level: the W-2 wage limitation and the W-2 wage and qualified property limitation. These limitations only apply if taxable income exceeds $315,000 for a joint return, or $157,500 for all other returns. If your income is less than this threshold, then none of the limitations apply, so the deduction calculation becomes less complicated.

The QBI deduction must be calculated separately for each QTB, then combined at the taxpayer level. Each QTB will calculate their QBI deduction as:

  1. The lesser of 20% of the QTB’s qualifying business income, or
  2. The greater of either
    1. 50% of W-2 wages of the QTB, or
    2. the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis of qualified property.

The unadjusted basis limitation will likely be of significant importance to the real estate industry. There will be additional tracking needed for assets placed in service, as there are limitations on the life for this deduction (which may differ from MACRS depreciation lives).

Once qualified business income is calculated at each QTB, it is then combined into one amount, the “qualified business income amount” (QBIA). The final QBI deduction is calculated as the lesser of the combined deduction for all QTBs or 20% of taxable income in excess of net capital gain.

If the net QBI is a loss, then it is carried forward to the next tax year to offset QBI. There is little guidance on how the carryover loss is applied to the separate QTBs, or the interaction with the other limitations.

This new 20% deduction from QBI is effective for taxable years beginning after December 31, 2017 through December 31, 2025. It applies to taxpayers other than C corporations, including trusts and estates, and is calculated at the owner level.

It does not reduce self-employment income, and is not modified for alternative minimum tax purposes. It also cannot increase a net operating loss.

One of the biggest unknowns at this time is how this QBI deduction will interact with the passive activity loss rules. This interplay will likely have significant impact to many involved in real estate. Another aspect, which has not been clarified at this point, is the impact of the aggregation rules for real estate, since the QBI deduction must be calculated for each separate trade or business.

While the word “simplification” was continuously mentioned during the negotiations and creation of the Tax Cuts and Jobs Act, it was definitely not considered with this new Internal Revenue Code section.

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Article Dean Dorton

This is the first in a five-part series that highlights the segments of the newly enacted Tax Cuts and Jobs Act and how it impacts the real estate industry.

We will focus on the following topics:

  1. Cost recovery and expensing of depreciable assets
  2. 20% deduction for qualified business income
  3. Excess business losses and net operating losses
  4. Business interest expense limitations
  5. Like-kind exchanges, rehabilitation credit, and qualified opportunity zone gain deferral

In our first installment, we will discuss highlights of the Act and how it impacts capitalization and cost recovery of assets.

First, let’s discuss a section of the Act which may impact assets placed in service during the 2017 tax year.

Bonus depreciation

Prior to September 27, 2017, new assets with modified accelerated cost recovery system (MACRS) lives of 20 years or less were eligible for 50% expensing in their first year in service. For assets acquired and placed in service after September 27, 2017, bonus depreciation has been expanded to include used assets (as long as the use is original to the taxpayer) and increased to 100% expensing. This means certain assets can be fully expensed in their year of purchase. Please note that assets that had a written binding contract prior to September 27, 2017will not be eligible for 100% bonus depreciation. Assets purchased from a related party or controlled group, or received through gift or inheritance, are not eligible for bonus depreciation.

Bonus depreciation at 100% of cost will be available for assets placed in service from September 27, 2017 to January 1, 2023. Then it will be phased out over the period from January 1, 2023 to December 31, 2026 and will be fully eliminated after December 31, 2026. Taxpayers will still be able to elect out of bonus depreciation if they choose.

States will have to decide whether they will follow the changes to federal depreciation rules. If they do not follow the federal law, then there will be adjustments for state purposes to be considered in tax planning.

The next two changes only impact assets placed in service after December 31, 2017.

Section 179 expensing

The Section 179 election allows for 100% expensing for eligible assets up to certain annual limits. The limit for expensing annually increases to $1 million for eligible assets placed in service after December 31, 2017. Section 179 expensing is limited based on the amount of total assets placed in service. This “phasedown” has been increased to $2.5 million after December 31, 2017. This election is only allowable up to net taxable income.

Eligible Section 179 property is tangible personal property, computer software and a newly created “qualified real property”. The inclusion of qualified real property will greatly expand the ability to expense fixed asset additions. Qualified real property includes the newly created qualified improvement property (discussed below), as well as certain structural improvements to the nonresidential real property. This includes roofs, HVACs, fire protection and alarm systems, and security systems. Qualifying property has also been expanded to include certain depreciable personal property used to furnish lodging (e.g., beds, refrigerators, ranges, et cetera). There has been no change related to residential rental property’s ability to take Section 179 on tangible personal property.

Qualified improvement property

Previously, there were three types of qualified improvements to real property—qualified leasehold improvements, qualified restaurant improvements, and qualified retail improvements. All three definitions varied and had different implications for the ability to currently expense improvements. The new law provides for a single qualified improvement property. This property is any improvement to the interior portion of a building placed in service after the original building is placed in service, and is effective for assets placed in service after December 31, 2017. Qualified improvement property has a 15-year recovery period (20-year ADS period), which means it will be eligible for the 100% bonus depreciation from January 1, 2018 through December 31, 2022, as well as Section 179 expensing.

We have not discussed the interaction of the new cost recovery options with the tangible asset regulations that were issued in 2014 that provided guidelines on capitalization of assets versus expensing as repairs. These will need to be considered when making elections related to 100% bonus expensing versus Section 179 expensing. There will also be interaction with the 20% deduction for qualified business income and the limitation on interest expense, which we will discuss in further detail in our next installment.

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