tax cuts

Article Dean Dorton

By Erica Horn, CPA, JD

While it is possible you missed it, it’s doubtful. The first major reform of the federal tax code in 30 years was enacted into law at the end of December. Promising tax cuts for everyone, the bill is called the Tax Cuts and Jobs Act (TCJA). This article highlights some of the changes made to individual income taxation.

Individual tax rates

Under the new tax law, the individual income tax brackets are structured as follows:

Tax Rate Single Married Filing Jointly
10% $0 – $9,525 $0 – $19,050
12% $9,526 – $38,700 $19,051 – $77,400
22% $38,701 – $82,500 $77,401 – $165,000
25% $82,501 – $157,500 $165,001 – $315,000
32% $157,501 – $200,000 $315,001 – $400,000
35% $200,001 – $500,000 $400,001 – $600,000
37% $500,001+ $600,001+

These rates are lower than the previous rates; however, not significantly lower. The big savings for individuals is to come through the near doubling of the standard deduction.

Personal exemptions and the standard deduction

The TCJA eliminates personal exemptions but compensates by increasing the standard deduction to $12,000 single and $24,000 married filing jointly (MFJ), indexed for inflation for tax years beginning after 2018. According to the Tax Foundation, nearly 70% of all filers take the standard deduction, meaning only 30% of filers itemize deductions. Therefore, even after the elimination of the personal exemption, when the lower rates are coupled with the increase in the standard deduction, the result should be a tax decrease for many taxpayers.

So what about the 30% that itemize deductions?

Every deduction on Schedule A has been modified to some extent. Accordingly, the 30% of taxpayers that have historically itemize deductions will be impacted.

Some of the more significant changes are described below. 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 the TCJA, the 7.5% floor is extended through 2018.

Changes to state and local tax deduction

Under pre-TCJA law, taxpayers were entitled to a deduction, without limitation, equal to the state and local taxes (SALT) paid during the year. The deduction primarily consisted of state, local, and/or foreign real property and income taxes paid.

Under the new tax law, SALT deductions are capped at $10,000. Since this has traditionally been one of the largest itemized deductions, it is anticipated that it will have one of the greatest impacts on 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. The limitation was $1 million under prior tax law. Taxpayers with debt acquired on or before December 15, 2017 remain subject to the $1 million limitation, as the new law is not applied retroactively.

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 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.

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. Common miscellaneous itemized deductions included unreimbursed employee expenses, investment expenses (i.e. brokerage fees), and tax preparation fees.

Is there more?

Yes, there is much more, but just three additional changes are discussed here.

Expanded use of Section 529 account funds: For distributions after December 31, 2017, “qualified higher education expenses” include tuition at an elementary or secondary public, private, or religious school, and various expenses associated with home schooling, up to a $100,000 limit per tax year.

Individual alternative minimum tax (AMT): The TCJA doesn’t repeal the AMT for individuals as was hoped for, but it does increase its exemption amounts. Before the TCJA, the individual AMT exemption for MFJ was $86,200 and that amount was reduced by 25% of the amount by which the couple’s alternative taxable income exceeded $164,100. The TCJA increases the AMT exemption amount to $109,400 MFJ and that amount is reduced by alternative taxable income above $1 million.

Child tax credit: Under pre-TCJA tax law, individuals could claim a maximum child tax credit (CTC) of $1,000 for each qualifying child under the age of 17. The CTC was phased out for taxpayers with AGI above certain threshold amounts.

The TCJA modifies the CTC by increasing the credit amount to $2,000 per qualifying child and increasing the threshold amounts for the phase-out to $400,000 MFJ and $200,000 for all other returns. Additionally, $1,400 of the CTC is refundable.

The talk has just begunMuch is yet to be determined about the changes enacted by the TCJA. There will be many more articles and discussions as issues and unintended consequences appear and regulations are issues. Be sure and stay tuned.

As originally published in Kentucky CPA Journal

Article Dean Dorton

Stock market analysts and commentators have credited the Tax Cuts and Jobs Act with boosting market prices during late 2017 and early 2018. As we have discussed in previous articles, the tax code reform has many nuances with unique consequences for each business. We would like to isolate one significant change in the tax code and discuss its impact on business value — the Federal corporate income tax rate cut from 35% to 21%.

As detailed in a previous valuation article, three methods are commonly used to value a business. We focus here on the income approach, which reflects the fact that the value of a business is equal to the sum of its future cash flows discounted to present value. Clearly, a lower corporate income tax rate directly increases the future cash flows of a business, as shown in the example below.

Corporate Tax Rate 35% 21% % Increase
Pre-tax income $1,000,000 $1,000,000
Taxes (350,000) (210,000)
Free cash flow $650,000 $790,000 21.5%

Regardless of the amount of pre-tax income selected, the 21.5% increase to free cash flows stays constant. As such, the Federal corporate tax rate decrease from 35% to 21% increases the free cash flows of a corporation by 21.5%, assuming all other factors are held constant.

The next step of the income approach is to discount the free cash flows to present value. Assuming the discount rate (i.e. rate of return) an investor would accept/demand for an investment in the business remains the same, the 21.5% increase in cash flows results in a 21.5% increase in company value. Accordingly, we conclude that, all other things being equal, the decline in the corporate tax rate from 35% to 21% increases value by 21.5%.

Though this article focuses on the direct impact on value of the corporate tax rate change in isolation, it should be noted that the decline in the rate could have indirect impacts on value, as well. For example, after-tax borrowing costs will increase as a result of the federal tax rate decline, which may impact the weighted average cost of all capital, which in turn impacts a company’s value. In addition, other provisions of the new tax law may also impact value. For example, the more favorable depreciation rules associated with the new law could lower the effective tax rate of a company, resulting in increased cash flows, and thus increased value. In general, and all other factors being equal, we believe that the value of most companies will increase as a result of the new tax law, but just how much is a function of several (perhaps many) factors, several of which are difficult to evaluate.

For more information or questions about business valuation, please contact David Angelucci at 859.425.7695 or dangelucci@deandorton.com or Shelby Clements at 502.566.1052 or sclements@deandorton.com.

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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

The Tax Cuts and Jobs Act includes a new deduction for individual business owners who conduct their activities through a sole proprietorship, partnership, or S corporation. Trusts and estates are also eligible to claim the deduction. The deduction is effective for taxable years beginning after December 31, 2017, but continues only through taxable years beginning prior to December 31, 2025. In a series of three articles, we will discuss the new deduction, its complexities, and its uncertainties. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)

The qualified business income (QBI) deduction is a 20% deduction from the net taxable business income of each separate qualified trade or business of the taxpayer, regardless of whether the business is conducted as a sole proprietorship or through a pass-through entity, such as a partnership or S corporation. The deduction is applicable regardless of whether the taxpayer has an active or passive role (for example, as a limited partner) in the operation of the business. Additionally, the new law provides for a 20% deduction with respect to certain qualified income from real estate investment trusts (REITs) and publicly-traded partnerships (PTPs).

The 20% deduction for each separate trade or business is subject to certain limitations related to wages paid and depreciable property owned and used by the business. There is an additional limitation for the combined business income deduction for each separate trade or business and the deductions related to REIT and PTP income based on the taxable income of the individual taxpayer. After this limitation is applied, the deduction is increased if the taxpayer has qualified cooperative dividends.

Although the next article will cover in more detail the definition of a qualified trade or business and type of business income that qualifies for the deduction, it should be noted that based on the statutory language, most retail, manufacturing, and real estate businesses, and many service businesses, should qualify. However, certain service businesses will not qualify for the deduction if the owner’s taxable income exceeds a certain amount.

As noted above, the qualified business income deduction is calculated separately for each qualified trade or business and then the combined amount is subject to the taxable income limitation. In determining the deduction for each separate business, the calculation begins with 20% of the net taxable business income of the business. This is the maximum deduction applicable to that business. There are special rules applicable to businesses with losses, which we will address later.

The next step is to determine the limitation based on the wages paid by the business and the depreciable property owned and used by the business. This limitation is only applicable if the owner’s taxable income for the year exceeds a certain “threshold amount” for the taxable year. The threshold amount for 2018 is $315,000 for taxpayers filing joint returns and $157,500 for all other taxpayers. These amounts will be adjusted for inflation. The limitation is “phased-in” after taxable income exceeds these amounts and is fully applicable when taxable income exceeds $415,000 and $207,500, respectively.

Generally, the deduction for each separate business is limited to the greater of two amounts.

The first amount is 50% of the “W-2 wages” of the business. W-2 wages include wages paid by the business that are subject to withholding plus certain deferred wages, such as Section 401(k) contributions. So, for example, if a business had $200,000 of wages paid including deferrals, this limitation amount would be $100,000.

The second limitation amount is the sum of 25% of W-2 wages plus 2.5% of qualifying depreciable property owned and used by the business. The property generally must be real property or personal property that was acquired within the last 10 years. The 2.5% is applied to the original cost or basis of the property, rather than the remaining undepreciated cost. Assuming the business in the above example had $1 million of qualifying property at the end of the tax year, this second limitation would be the sum of 25% of $200,000 for the wage component plus 2.5% of $1 million for the property component, or $50,000 + $25,000 = $75,000.

Accordingly, the higher of the two limitation amounts is $100,000, so the qualified business income deduction for this separate business would be limited to $100,000, regardless of the whether the 20% of business income was a higher amount. However, if the 20% amount is less than the limitation, say $50,000 in this example, then the deduction is limited to the 20%, or $50,000 in this example.

As noted above, the sum of the deductions for each separate trade or business, plus 20% of qualified REIT and PTP income, is limited by the taxable income of the owner (or owner and spouse if filing jointly). The combined deduction is limited to 20% of the taxable income in excess of capital gains and certain cooperative dividends. Although guidance has not been published, capital gains as defined in the legislation include capital gains from the sale of assets used in a business. The lower of these two amounts, plus 20% of certain cooperative income, is the final deductible amount on the tax return. The deduction cannot exceed taxable income for the year.

As noted above, there are special rules regarding losses at businesses that qualify for the new deduction. Generally, if a taxpayer has multiple businesses, a loss at one business will reduce the combined deduction for all other separate businesses with positive income for the tax year. Additionally, an overall loss for all businesses for the tax year will be carried over to the next tax year and reduce the deduction in the succeeding tax year.

In the next article, we will discuss the types of trades or businesses and the income that qualifies for the new deduction.

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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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