tax cuts and jobs act

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

As we continue our analysis of the Tax Cuts and Jobs Act (TCJA), we will address a provision that has not been widely reported, but could have an immediate impact in 2018 to certain taxpayers.

Effective for tax years beginning after December 31, 2017, an excess business loss of a non-corporate taxpayer will be disallowed in the current tax year and converted into a net operating loss to be carried over to the following tax year. An excess business loss is the excess of the taxpayer’s aggregated net active business losses over $250,000 ($500,000 MFJ). To illustrate:

H and W are married taxpayers filing a joint return. In 2018, H generates a net tax loss from his business of $600,000 and W generates a net tax loss from her business of $200,000. Both H and W actively participate in their businesses. Their aggregated net tax losses from trades or business is $800,000. Their excess business loss for 2018 is $300,000 ($800,000 – $500,000).

How does this limitation impact the taxable income of H and W?

Let’s assume that, in addition to the losses generated from their businesses, H and W have other investment income totaling $1,000,000. The following table illustrates how taxable income is calculated before and after the TCJA:

Before TCJA After TCJA
Investment income $1,000,000 $1,000,000
H’s active business loss (600,000) (600,000)
W’s active business loss (200,000) (200,000)
Excess business loss (see above) 0 300,000
Net taxable income $200,000 $500,000

While H and W cannot reduce their 2018 taxable income by the $300,000 excess business loss, this loss is converted to a net operating loss and carried over to the following year. H and W can use the net operating loss in 2019 to offset up to 80% of their taxable income. To illustrate, let’s assume that H and W have the exact same facts as above for 2019. Their 2019 taxable income would be calculated as follows:

2019
Investment income $1,000,000
H’s active business loss (600,000)
W’s active business loss (200,000)
Excess business loss (see above) 300,000
Net taxable income before net operating loss carryover $500,000
Net operating loss carryover from 2018 (lesser of NOL of $300,000 or 80% of taxable income before NOL ($400,000)) (300,000)
Net taxable income after net operating loss $200,000

This illustrates that the excess business loss limitation is merely a timing issue. Affected taxpayers, however, may be in for a surprise in this first effective tax year if not aware of this provision.

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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Article Dean Dorton

As we continue our analysis of the TCJA, this week’s newsletter will focus on some of the more important individual tax changes, specifically those pertaining to itemized deductions.

Every deduction indicated on Schedule A of your individual income tax return has been modified to some extent under the TCJA. Accordingly, if you’re a taxpayer that has historically itemized deductions, the changes discussed below will, to some degree, have an impact to your taxable income in the coming years.

Unless otherwise noted, these changes are in effect for tax years beginning after December 31, 2017 and before January 1, 2026.

Changes to deduction for medical and dental expenses

Under pre-TCJA tax law, the deduction for qualified medical expenses was allowed for qualified medical expenses exceeding 10% of adjusted gross income (“AGI”). This floor was reduced to 7.5% of AGI for taxpayers 65 and older, however that provision expired on December, 31, 2016.

Under TCJA tax law, for tax years beginning after December, 31, 2016 and before January 1, 2019, a taxpayer that itemizes may deduct qualified medical expenses, so long as they exceed 7.5% of AGI. As such, the new law extends the 7.5% through 2018 and retroactively makes it available to taxpayers that itemize, regardless of age, during this period.

Changes to state and local tax deduction

Under pre-TCJA tax law, taxpayers were entitled to a deduction equal to the state and local taxes (“SALT”) paid during the year. The deduction consisted of the following types of taxes paid:

  • State, local, and/or foreign real property taxes
  • State and local personal property taxes (i.e. cars, boats) and
  • State, local, and/or foreign income taxes

It is also worth noting that there were no caps or limitations on the amount of SALT deducted on Schedule A (unlike medical expenses).

Under the new tax law, no changes were made with regard to the types of taxes that a taxpayer may deduct, so long as they fall under one of the aforementioned tax types. However, the same cannot be said of the amount of deduction allowable on Schedule A. Unfortunately, the new tax law places a $10,000 ceiling on the SALT deduction. Since this has traditionally been one of the largest itemized deductions, it is anticipated that it will have one of the greatest impacts to taxable income.

Changes to mortgage interest deduction

Under the TCJA, mortgage interest on loans used to acquire a principal residence and/or a second home remains deductible, but only on debt up to $750,000. This represents an unfavorable increase of $250,000 since the limitation was $1 million under prior tax law. Taxpayers with existing acquisition debt, that is, debt acquired on or before December 15, 2017, would remain subject to the $1 million limitation, as the new law is not applied retroactively. Additionally, mortgage refinances after 2017 will be considered incurred on the date of the original mortgage so long as the refinanced debt does not exceed the original debt. This will afford taxpayers with existing debt the option to refinance without being encumbered by the new limitations.

Interest on home equity loans, regardless of when the debt was acquired, is no longer deductible under the TCJA. However, based on current guidance, it is not yet clear whether proceeds from home equity loans used for business purposes may be deductible elsewhere on a taxpayer’s return (i.e. Sch. E in the case of a rental or Sch. A in the case of investment interest). It is anticipated that the IRS will provide further clarification on this in future guidance.

Changes to charitable contributions deductions

Under the TCJA, the limit for cash contributions has been extended from 50% to 60% of the contribution base, which is generally a taxpayer’s adjusted gross income (AGI). However, payments made to a college or university in exchange for the right to purchase tickets to an athletic event are no longer deductible. This represents a divergence from pre-TCJA tax law, under which 80% of such payments were treated as deductible contributions.

Changes to miscellaneous itemized deductions

Under the new law, all miscellaneous itemized deductions that are subject to the 2% of AGI floor are no longer deductible. Such expenses include, but are not limited to, the following:

  • Unreimbursed employee expenses
  • Investment expenses (i.e. brokerage fees)
  • Tax preparation fees
  • Hobby expenses

Changes to personal casualty loss deduction

Under the TCJA, casualty and theft losses are generally only deductible to the extent they are attributable to a “federally declared disaster”. There is a limited exception for taxpayers who have personal casualty gains, whereby losses not attributable to a disaster may be used to offset such gains, but not below zero. For the purposes of this provision, a “federally declared disaster” is one that has been determined by the President to warrant federal assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.

Additionally, the TCJA retroactively provides relief to taxpayers who incurred a disaster loss in tax years 2016 and 2017 by raising the $100-per-casualty limitation to $500 and waiving the 10% of AGI floor.

Changes to the deduction for gambling losses

Historically, gambling losses have only been deductible to the extent of gambling winnings. However, a 2011 tax court ruling in Mayo vs. Commissioner (136 TC 181) allowed taxpayers engaged in the trade or business of gambling to exclude certain non-wagering expenses (i.e. travel, meals, entry fees, etc.) from “gambling losses” and report them on Schedule C.

Given that this has long been a point of contention by the IRS, it should come as no surprise that the TCJA, for purposes of the limitation, broadens the definition of “losses from wagering transactions” to include any and all non-wagering expenses. As such, it is no longer possible to create a loss from gambling, regardless of whether it is considered a trade or business of the taxpayer.

Changes to the overall limitation on itemized deductions

Under pre-TCJA tax law, this provision, also known as the “Pease limitation”, was an overall limit on otherwise allowable itemized deductions of high income taxpayers. In an effort by congress to “simplify” the internal revenue code, this overall limitation has been completely repealed under the TCJA. It is unclear at this point whether taxpayers will really benefit from this change, since almost all itemized deductions have been limited or repealed individually (i.e. SALT, miscellaneous itemized deductions, et cetera).

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Article Dean Dorton

By: Mike Shepherd

Is the recent Tax Cuts and Jobs Act a simplification or complication?

The short answer is yes. But how can it be both simplification and complication you ask? Congress works in mysterious ways.

The flagship change of the Tax Cuts and Jobs Act (TCJA) is that it cuts corporate rates from 35 percent to 21 percent in order to bring the United States more in line with corporate rates in the rest of the world. This is supposed to stimulate the economy and increase job growth, which in turn is supposed to increase the individual income tax base to help pay for the corporate rate decrease. At the same time the TCJA is supposed to simplify the tax code for most Americans.Simplification

Depending on where you pull the statistics, approximately 40 percent of U.S. taxpayers will itemize when filing their 2017 income tax returns. The TCJA implements changes that should drop that number to approximately 10 percent.

So when you hear the politicians touting simplification, they are referring to this large drop in itemized filing. The TCJA accomplishes this with some of the following changes:

  • Increase the standard deduction from $6,500 to $12,000 for single filers and $13,000 to $24,000 for married filing jointly
  • Increase the child tax credit from $1,000 to $2,000 per qualifying child, and increase the phase-out of these credits from $75,000 for single filers and $110,000 for married filers to $200,000 for single filers and $400,000 for married filers
  • Personal exemptions are suspended
  • Home equity line interest deductions are suspended
  • Charitable contributions for amounts paid for college athletic seating rights are suspended
  • Miscellaneous itemized deductions are suspended
  • Alimony deductions are suspended
  • Itemized deduction limitation is suspended
  • Casualty and theft losses are suspended
  • Moving expense deductions are suspended

Complication

For those left in the 10 percent itemization bucket and those with small businesses (which is most likely a lot of the readership of this publication), things get more complex. The TCJA will be a tax cut for most; however, many taxpayers—particularly those with high wages—will end up with a tax increase. A few of the complex changes are as follows:

  • The state and local tax deduction (income and property) is capped at $10,000. This change is particularly tough on those in high income tax states. Many don’t think of Kentucky as a high income tax state, but when you add in the local tax, taxpayers in Kentucky’s two most populous counties of Jefferson and Fayette pay between 8 percent and 9 percent, which is not low in relation to many other states.
  • The top individual tax rate is reduced to 37 percent from 39.6 percent, but the cap on the state and local deduction may still cause tax increases for some highly compensated Kentuckians.
  • The complicated individual alternative minimum tax (AMT) is retained with higher exemption amounts.
  • A new limitation is placed on “excess business losses.” This complex calculation is likely to hurt some small business owners and those with equine businesses by limiting the amount of currently deductible losses from those businesses.
  • A new qualified business income (QBI) deduction is added which creates a potential 20 percent deduction for businesses that qualify. A recent Forbes article did a Q&A on how this deduction and the related limitations work. The printed article is 39 pages long.

Anytime the tax law is changed dramatically, there are “ripples” in the new law which cause unintended consequences. It’s likely to take years for a lot of those items to be completely sorted out which adds to the complication.

Many CPA firms will be running side-by-side 2018 versus 2017 comparisons with their 2017 tax preparation process to help taxpayers better understand the implications of the TCJA. Further, many taxpayers may want to make changes during 2018 to adjust to the new law.

Time will tell if the TCJA accomplishes its goals. However, one thing is for certain; the TCJA is the most sweeping tax legislation we’ve had in over 30 years.

As always, please consult with your tax adviser regarding the changes that might be applicable to your specific situation.

As originally featured in Louisville’s Business First

Article Dean Dorton

There were some changes made to the child tax credit rules in the new tax bill. The amount of the credit was increased, the adjusted gross income phase-outs were increased, a new non-child dependent tax credit was added, and limits were added to the refundable portion of the tax credit. The changes are summarized in the below table.

Old Law New Law
Qualifying Child Tax Credit $1,000 per child UNDER age 17 $2,000 per child UNDER age 17
Qualifying Dependent Tax Credit N/A A $500 nonrefundable tax credit is added for qualifying dependents other than qualifying children
AGI Phase-Outs The child tax credit is reduced $50 for each $1,000 of modified gross income (AGI) over $75,000 for single individuals or heads of households, $110,000 for married individuals filing jointly, and $55,000 for married individuals filing separately. The child tax credit is reduced by $50 for each $1,000 of modified gross income (AGI) in excess of $400,000 for married individuals filing jointly, and $200,000 for all other taxpayers. The phase-outs are not indexed for inflation.
Refundable Credit If the child tax credit exceeds the taxpayer’s tax liability, the taxpayer is eligible for a refundable credit (also known as the “additional child tax credit”) equal to 15% of earned income in excess of $3,000 (the “earned income” formula).

The maximum refundable tax credit cannot exceed $1,000.

 Same as the old law, except the additional child tax credit is equal to 15% of earned income in excess of $2,500 instead of $3,000.

The maximum refundable tax credit cannot exceed $1,400. This amount will be indexed for inflation in increments of $100.
Alternative Formula Families with three or more children may determine the additional tax credit using the alternative formula if it results in a larger credit under the earned income formula. Under this formula, the additional child tax credit equals the amount by which the taxpayer’s Social Security taxes exceeds the taxpayer’s earned income credit. Same as old law
Social Security Numbers No credit will be allowed unless the taxpayer includes the name and Social Security number of the qualifying child on the taxpayer’s tax return. The Social Security number must be issued on or before the filing due date (including extensions) of the taxpayer’s return. There is still a Social Security number requirement for the qualifying child tax credit, but there is not a Social Security number requirement for the $500 non-child dependent tax credit. If a qualifying child does not have a Social Security number, they are still eligible for the $500 non-child dependent credit.