The Tax Cuts and Jobs act made multiple changes to tax regulations impacting the real estate industry. Highlights of some of the changes are summarized below.
Section 1031 exchanges are now limited to only exchanges of real property not held primarily for sale. It only includes property held for use in a trade or business or for investment. As a result, exchanges of machinery, equipment, vehicles, patents and other intellectual property, artwork, collectibles, and other intangible business assets no longer qualify for nonrecognition of gain or loss as like-kind exchanges. Real property located in the U.S. cannot be exchanged for real property located outside the U.S.
Shorter recovery periods – for property placed in service after December 31, 2017, one category of qualified improvement property is created subject to a depreciation life which is expected to be 15 years. The statutory life is not yet defined in the legislation. The new qualified improvement property combines the previous separate qualified leasehold, qualified restaurant and qualified retail improvements categories and expands the definition to include all improvements made to the interior portion of a building that are not attributable to the enlargement of the building, elevator or internal structure framework.
Increased bonus depreciation – the bonus depreciation deduction has been increased to 100% for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. Bonus depreciation will then be phased out and sunset after 2026. Additionally, the requirement that the original use of the property begin with the taxpayer has been eliminated. Used property acquired and place in service after September 27, 2017 will qualify for bonus depreciation.
Increased section 179 expensing – for years beginning after December 31,2017, the maximum section 179 expense is increases to $1,000,000 and the phase-out threshold increases to $2,500,000. Section 179 expensing is expanded to include tangible personal property used in connection with furnishing lodging and to include certain improvements to nonresidential real property.
Business Interest limitation
Businesses with average gross receipts of $25 million or more over the prior three years will be subject to an interest deduction limitation. Under this limitation, the deduction allowed for business interest for any tax year cannot exceed the sum of;
- the taxpayer’s business interest income for the tax year; plus
- 30% of the taxpayer’s adjusted taxable income for the tax year (computed without regard to depreciation, amortization or depletion).
The business interest limitation generally applies at the taxpayer level; however, pass-through entities are required to determine the limitation at the entity level For an affiliated group of corporations that file a consolidated return, it applies at the consolidated tax return filing level.
Business interest that isn’t deductible under the new rules may be carried forward indefinitely. Pass-through entities separately state and allocate the excess business interest to each partner/shareholder in the same manner as nonseparately stated taxable income or loss. The excess business interest from pass-through entities is available as a deduction in future years.
Real property trades or businesses can elect out of the business interest limitation if they use the alternative depreciation system (ADS) to depreciate real property used in a trade or business. ADS depreciation requires the business to depreciate the property over a longer life of 30 and 40 years for residential and nonresidential property, respectively. Taxpayers making this election cannot use bonus depreciation.
Cash Basis Accounting
The new law permits more entities to choose the cash basis method of accounting. Previously, most corporations and partnerships could not use the cash basis method of accounting unless average annual revenues for the past three years were below $5 million. The new law increases the average revenue limit to $25 million.
Taxpayers electing to change to the cash basis method of accounting, file Form 3115 and recognize any positive Code Sec. 481(a) adjustments resulting from the change over a four-year period and any negative adjustments over a one-year period.
Excess Business Loss
For taxable years beginning after December 31, 2017, excess business losses of a taxpayer, other than a corporation, are disallowed for the taxable year. The excess business loss is calculated by reducing the aggregate business deductions by the sum of the taxpayer’s aggregate business gross income plus $250,000 (single) or $500,000 (married filing joint). Such losses are carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent taxable years. Under the bill, NOL carryovers generally are allowed for a taxable year up to the lesser of the carryover amount or 80 percent of taxable income determined without regard to the NOL deductions or dividends paid deduction for REITs.
In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S-corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are considered in applying the limitation under the provision for the taxable year. The provision applies after the application of the passive loss rules.
For years beginning after December 31, 2017, noncorporate taxpayers will be allowed a deduction of up to 20% of qualified business income from pass thru entities. The 20% deduction is calculated at the taxpayer level and is subject additional limitations for taxpayers with taxable income of $157,500 or more (single) and $315,000 or more (married filing joint). For taxpayers above the threshold amounts, the deduction on qualified business income is limited to the lessor of:
- 20% of qualified business income; or
- the greater of (1) 50% of wages from the trade or business or (2) the sum of 25% of W-2 wages from the trade or business plus 2.5% of the unadjusted basis of qualified property.
Qualified property for the above calculation is property held by the business at the end of the tax year, used during the year in the production of income and not fully depreciated by the end of the tax year.
For many real estate entities, wages are not a significant expense of the business and these entities will rely on the 2.5% of unadjusted basis of qualified property for use in the calculation of the deduction at the taxpayer level.