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The Top 6 New Tax Bill Provisions Impacting the Real Estate Industry

January 5, 2018

The 2018 Tax Bill contains many major changes to the tax landscape for both businesses and individuals. Below are some key highlights that impact the real estate industry, and a comparison between the current and new tax laws.

 

Provisions Impacting the Real Estate Industry

Topic

2017 Tax Law

2018 Tax Law
Taxation of pass-through entities Pass-through income is generally subject to individual income tax rates and brackets.
  • Enacts a 20% deduction of qualified business income for certain pass-through businesses limited to the greater of:
    • 50% of wages paid or
    • 25% of wages paid plus 2.5% of the cost of tangible depreciable property
  • The 20% deduction is available to REIT investors receiving REIT dividends taxed at ordinary rates.
  • The deduction expires in 2025.
Bonus depreciation 50% bonus depreciation on short-lived capital investments (e.g., machinery and automobiles) through 2020. 100% expensing of short-lived capital investments (e.g., machinery and automobiles) as well as “Qualified Improvement Property” through 2022, then phased out between 2023 and 2026.
Qualified improvement property

Four types of improvements to Non-Residential Real Property:

  • 15-year lives, eligible for bonus depreciation:
    • Qualified Retail Improvements
    • Qualified Leasehold Improvements
    • Qualified Restaurant Property
  • 39-year lives, eligible for bonus depreciation:
    • Qualified Improvement Property
  • Eliminates Qualified Retail Improvement Property, Qualified Leasehold Improvement Property, and Qualified Restaurant Property designations.
  • 15-year life assigned to Qualified Improvement Property remains eligible for bonus depreciation. See Note 1.
  • Qualified Improvement Property definition expanded to include:
    • Any improvement to an interior portion of a building, regardless of whether or not the space is leased.
    • Excludes building enlargements, elevators, escalators, internal structural framework.
Net interest expense limit
  • Taxpayers can take a full deduction of interest paid.
  • No limit.
  • Net interest deduction is limited to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA) for four years.
  • Net interest deduction is limited to 30% of earnings before interest and taxes (EBIT) after initial four-year period.
  • Optional annual election out of the interest deduction limit. Requires use of ADS depreciation (generally requires straight-line depreciation, with no accelerated depreciation).
    • 40 Years – Non-Residential
    • 30 Years – Residential
    • 20 Years – Qualified Improvement Property
Historic tax credits

Two-tier tax credit for qualified rehabilitation expenditures (QREs):

  • 20% of QREs with respect to a historic structure listed in the National Register, all taken in year generated.
  • 10% of QREs with respect to a qualified rehabilitated building other than a historic structure, provided the building was in placed in service before 1936.
  • Retains the 20% credit on historic structures, but requires the credit to be taken ratably over five years.
  • The 10% credit on pre-1936 structures has been repealed.
Tax-exempt investors
  • Subject to Unrelated Business Income Tax (UBIT) at corporate tax rates on trade or business income not substantially related to an exempt organization’s exempt purpose.
  • Exempt entities with more than one unrelated trade or business can use losses from one activity to offset income of another activity.
  • Tax-exempt organizations can no longer aggregate profits and losses from its various unrelated trades or businesses. Instead, unrelated business income is calculated separately for each business.
  • If UBIT is triggered, it will be taxed at the lower corporate rate of 21%.

Note 1: The 15-year life for Qualified Improvement Property was included in the Committee Report, but was inadvertently omitted from the statute. It is our understanding that this will be addressed and corrected in a technical correction.

 

Practical Impact of the Legislation – Real Estate

Taxation of Pass-Through Entities

A deduction is now 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, which would have had a negative impact on real estate firms that typically pay little in wages. Fortunately, the final bill added the provision limiting the deduction to the greater of 50% of wages paid or 25% of W-2 wages paid plus 2.5% of cost of tangible depreciable property. This limitation should make the deduction widely available to profitable real estate firms. In addition, the deduction is available to REIT investors on REIT dividends subject to ordinary tax rates.

 

Depreciation

The previous bonus depreciation requirement for property to be “original use” has been eliminated. This means bonus depreciation is now available to both new and used property acquired after September 27, 2017. Furthermore, fixed assets acquired between September 27, 2017, and December 31, 2022, can be expensed in their entirety. The bonus depreciation rates are phased out between 2023 and 2026.

There have been substantial changes to the depreciation provisions for real property improvements. 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 the space is leased. Building enlargements, elevators, escalators, internal structural framework are excluded from the definition. In addition, Qualified Improvement Property is now recovered over 15 years rather than 39 years, and is eligible for bonus depreciation.

 

Interest Deductions

The interest expense limitation could have a material impact on real estate investors. Operating results, interest expense, and depreciation may result in annual tax losses on real estate investments. 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.

Furthermore, 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 ADS depreciation. ADS typically requires the use of straight-line depreciation, and requires slightly longer lives for non-residential real property (40 years versus 39 years) and qualified improvement property (20 years versus 15 years). Note that bonus depreciation is not allowed on assets required to be depreciated under ADS. There is some uncertainly as to the availability of bonus depreciation where the election out of the interest deduction limitation is made. We are closely monitoring the situation and are on the alert for clarifying guidance from the IRS or Treasury.

At least annually, real estate managers will need to determine whether their interest may be limited, and if the ADS election will produce the desired results.

 

Cost Segregation Studies

We expect that cost segregation studies will continue to provide meaningful tax benefits for our real estate clients. Historically, the benefits have included identification of immediately deductible repairs, significantly shorter depreciable lives, and the availability of bonus depreciation on assets that would not have otherwise qualified. To preserve interest deductions, we anticipate that many of our real estate clients will make the annual election to use ADS depreciation. Even if bonus depreciation is not permitted where ADS is elected, meaningful benefits will come from the identification of fully deductible repairs and qualified improvement property eligible for much shorter depreciable lives under ADS.

If bonus depreciation is permitted with the election to use ADS, the benefits of the cost segregation studies will likely be more meaningful than in prior years. Because the depreciable life of Qualified Improvement Property has been reduced to 15 years, improvements will now be eligible for 100% bonus depreciation. If bonus depreciation is not permitted, an analysis will need to be performed annually to determine if the benefits of bonus depreciation outweigh the limitations imposed on deductible interest.

 

Tax-Exempt Investors

The new tax law produced mixed results for tax-exempt investors in real estate. Until now, a tax-exempt organization could aggregate all profits and losses from its various unrelated business activities and pay unrelated business income tax only on any resulting net income. Going forward, losses from one activity cannot offset profits from another, likely subjecting some tax exempt entities to unrelated business income tax. On a positive note, unrelated business tax is now assessed at the lower corporate rate of 21%.

Other Provisions of the Tax Reform that May Impact Real Estate Investors

 

Corporate Tax Reform

Topic

2017 Tax Law

2018 Tax Law
Tax rate C-Corporation multi-bracket income tax structure ranging from 15% to 35%. C-Corporation single rate at 21% of corporate income.
Corporate Alternative Minimum Tax (AMT) 20% corporate tax rate on alternative minimum taxable income. Corporate AMT is eliminated.  Individual AMT thresholds are significantly increased.
Net operating loss carrybacks (NOLs)
  • NOLs can be carried back two years.
  • NOLs can be carried forward 20 years.
  • No usage limits in regards to taxable income.
  • Eliminates two-year carryback.
  • Indefinite carryforward.
  • Usage limited to 80% of taxable income.

Individual Tax Reform

Topic

 2017 Tax Law

2018 Tax Law
Expiration date N/A Many provisions begin to phase-out at the conclusion of the 2025 tax year.
Tax brackets

Rate

Single

Head of Household

Joint
10%> $0 $0 $0
15%> $9,525 $13,600 $19,050
25%> $38,700 $51,800 $77,400
28%> $93,700 $133,850 $156,150
33%> $195,450 $216,700 $237,950
35% > $424,950 $424,950 $424,950
39.6%> $426,700 $453,350 $480,050
Rate Single Head of Household Joint
10%> $0 $0 $0
12%> $9,525 $13,600 $19,050
22%> $38,700 $51,800 $77,400
24%> $82,500 $82,500 $165,000
32%> $157,500 $157,500 $315,000
35%> $200,000 $200,000 $400,000
37%> $500,000 $500,000 $600,000
Standard deduction and personal exemptions

Standard Deduction:

  • $6,350 for single filers
  • $9,350 for head of household
  • $12,700 for joint filers

Personal exemption:

  • $4,050 per person

Standard Deduction:

  • $12,000 for single filers
  • $18,000 for head of household
  • $24,000 for joint filers

Personal exemption:

  • All exemptions are eliminated.
Alternative minimum tax (AMT)
  • $54,300 exemption for single filers with $120,700 phaseout threshold.
  • $54,300 exemption for head of household with $120,700 phaseout threshold.
  • $84,500 exemption for joint filers with $160,900 phaseout threshold.
  • $70,300 exemption for single filers with $500,000 phaseout threshold.
  • $70,300 exemption for head of household with $500,000 phaseout threshold.
  • $109,400 exemption for joint filers with $1,000,000 phaseout threshold.
Mortgage interest deduction

Tax payers may deduct interest paid on mortgages and equity debt.

  • Limited to $1,000,000 in mortgage debt.
  • Limited to $100,000 in home equity debt.

Proposed law states that tax payers may deduct interest paid on mortgages:

  • No home equity debt.
  • Limited to $750,000 in total mortgage debt.
State and local income/sales/property tax deduction Can currently deduct all state and local taxes. $10,000 limit comprised of property tax plus your choice of state income tax or sales tax.
Health insurance Current tax law imposes a penalty for those who opt out of health insurance. Reduces the individual mandate penalty of not carrying health insurance to $0 in 2019.
Gross income adjustments Current law provides many favorable adjustments that can be claimed regardless if the taxpayer itemizes.
  • Repeals the moving expense deduction, exempting active duty military personnel.
  • Eliminates the alimony deduction in 2019 as well as eliminates the requirement for alimony payments to be included in income.
  • Keeps student loan interest deduction, graduate student tuition waivers, and educator expense deduction.
Miscellaneous itemized deductions Currently there are many favorable deductions available to taxpayers to itemize. Suspends miscellaneous itemized deductions that are required to be greater than 2% of adjusted gross income (2% floor).
Medical expense deduction Medical expense deduction currently has a 10% threshold. Medical expense deduction is not suspended, but the threshold is reduced to 7.5% for 2018 and reverts to 10% afterwards.
Child and family tax credits
  • Current law provides for a partially refundable $1,000 child tax credit for the first two children.
  • Reduced additional child credit for third and subsequent children.
  • Child tax credit increased to $2,000 with $1,400 being refundable.
  • Dependents ineligible for the child tax credit would be able to utilize a new $500 per-person family tax credit.
  • Phaseout thresholds are set at $400,000 for joint filers and $200,000 for single filers.
  • No limit to number of children.

We will be reaching out to our real estate clients to evaluate current tax structures, project future tax liabilities, and review other changes for you and your business resulting from the new law. Please contact your Moore Colson advisor with any questions.

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