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

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

Individual Tax Reform

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.