“Am I better off under the new law”? My clients’ favorite question this year does not have an easy answer. Indeed, I do not really have a great way to answer that question without making my client’s head spin. So here I will do my best to spin away…
At a high level, there were a few main changes under the 2017 Tax Act that need to be reviewed in the context of any real estate business (and dozens of other changes that could apply in some cases). Below are a few areas that require immediate attention.
20% Deduction for Qualified Business Income.
The new 20% deduction for qualified business income will apply to real estate rental and development businesses. This deduction may also be limited based on a combination of W-2 wages paid by the business or by the unadjusted cost of depreciable property of that business.
Taxpayers need to identify companies that cannot take the full 20% deduction due to insufficient wages or real property base. We are in the process of restructuring dozens of companies to ensure that our clients are getting this deduction.
A “specified service trade or business” cannot take this deduction. We are reviewing management agreements and other economic arrangements to mitigate this risk.
Interest Expense Limitation.
Interest expense will be limited to 30% of EBITDA for any taxable year (until 2022) and 30% of EBIT (from 2022 onwards). A real estate business may avoid this limitation by making an irrevocable election to be treated as an “electing real property trade or business”.
The interest expense limitation will not apply to businesses with under $25 million in gross receipts. How the $25 million cut off is applied among related entities would require a 30 page memorandum rather than a short article to explain (suffice to say that it is complicated).
Every real estate entity that is subject to the rule will need to make an election (under rules that are not yet issued) or they will be subject to the limitation.
Although the exception for a “real property trade or business” was intended to capture leveraged real estate rental and development businesses, it may be much broader than that, since the way that the new law defines the term (taken from the real estate professional rules) includes real property construction, management , leasing and brokerage businesses.
Larger Depreciation Deductions.
Bonus depreciation is now equal to 100% of the cost of “qualified improvements” and most tangible personal property and is now available for new and used property (that is a big deal). However, bonus depreciation for real property is not allowed for an “electing real property trade or business”. Section 179 expensing was increased from $500,000 to $1,000,000 and is only limited if total expenditures exceed $2.5 million.
Most leveraged real estate businesses will likely elect to be treated as an “electing real property trade or business”. The trade off is that these entities will need to depreciate their assets on the ADS system rather than MACRS, and not be eligible for bonus depreciation. Figuring out how these rules work together is not for the faint of heart.
Not only was the limit on Section 179 deductions increased, but it is also now available for major real property components (such as roofs and HVAC systems). This could be a great year to make major improvements.
So what did I not get to that affects real estate clients? To name a few items: elimination of the state tax deduction, the potential use of C corporations in certain situations, the application of the 2014 tangible personal property regulations in the context of the new tax bill, the applicability of the new carried interest legislation, major changes to the net operating loss rules, elimination of the deduction for entertainment expenses and increase in the estate, gift and GST tax exemption amounts. The effect of the tax bill on every business is very significant and planning is paramount. Waiting until year end to plan for these changes will prove costly for most businesses.
To view this article in the Baltimore Business Journal please click here.