By Morgan Lewis, CPA, Tax Senior Associate and Foster Woodburn, CPA, Tax Senior Associate | Real Estate & Construction Industry Team
The Tax Cuts and Jobs Act (TCJA) has provided many substantial changes throughout the tax code. Much has been covered on the corporate and individual tax rate cuts, but the TCJA contains many other provisions that have a wide-ranging impact across all industries. Below are some of the tax law changes that could significantly affect many businesses in the real estate and construction industry.
Fixed Assets and Depreciation
A major change of the TCJA that will affect the real estate industry is depreciation of qualified improvement property (QIP). Subject to technical corrections, QIP now must be depreciated over a 39 year life. As the law currently stands, there is no longer a 15 year option for QIP, which would dramatically change the depreciation expense taken each year for these assets. However, it is expected that the IRS will issue technical corrections to change this. The good news is that taxpayers may take 100% bonus depreciation on QIP assets placed in service between September, 28, 2017, and December 31, 2017. However, there is currently no bonus depreciation allowed for QIP assets placed in service in 2018, but Section 179 expensing is allowed.
The maximum Section 179 expense increased with the TCJA to 1 million dollars from 510,000 dollars in 2017. The phase-out amount also increased to 2.5 million dollars. The cap and phase-out amounts will be indexed for inflation each year.
Bonus depreciation has also increased because of the TCJA. Taxpayers may now deduct 100 percent bonus on new or used assets placed into service after September 27, 2017, and before January 1, 2023. After that it will decrease by 20 percent each year.
- For example:
Assets placed in service after December 31, 2022, and before January 1, 2024, will be eligible for 80 percent bonus depreciation deduction.
Another important change from the TCJA for the real estate and construction industries is the definition of qualified real property under Section 179. It is now expanded to include nonresidential property improvements such as roofs, HVAC, security systems, alarm systems, and interior improvements.
Business Interest – 30% Limitation Exception
As part of the TCJA, net business interest expense (interest income less interest expense) will generally be limited to 30 percent of a taxpayer’s adjusted taxable income. This provision applies to all businesses, regardless of entity structure, with an exemption for any business that has average annual gross receipts less than 25 million dollars for the three.
However, the law also specifically provides that a “real property trade or business” can irrevocably elect out of this limitation with the caveat that alternative depreciation system (ADS) be used to depreciate applicable real property, which is further defined as nonresidential real property, residential rental property, and qualified improvement property. Thus, other tangible property is not subject to ADS if this election is made. ADS depreciates assets over longer lives than the generally-preferred Modified Accelerated Cost Recovery System (MACRS) depreciation, which essentially translates to less depreciation deduction in any given year. Also, assuming that QIP assets will in fact be eligible for 100 percent bonus depreciation, the election will exclude it from bonus depreciation eligibility.
The above election is applicable to real estate development, construction, rental, and management businesses, among others. It is important to point out that the election is irrevocable, so all facts and circumstances must be considered before making the election. It is also not 100 percent clear whether an electing business will be expected to change to ADS for applicable real property previously placed in service.
20% Qualified Business Income Deduction
One of the provisions of the TCJA that has been widely discussed is the IRC Section 199A 20 percent pass-through business income deduction. Despite this seemingly straightforward moniker, the deduction itself is more convoluted than a simple 20 percent deduction. The basic premise is that any non-corporate taxpayer can deduct the lesser of 20 percent of qualifying business income (QBI) or the greater of: 50% of W-2 wages or 25% of W-2 wages + 2.5 % unadjusted basis of qualified property from their taxable income.
There are several aspects of this deduction that have implications for real estate businesses. There is some lack of clarity as to the meaning of QBI and whether all rental real estate enterprises fall under its definition – commercial and apartment rental businesses should qualify for the deduction, but rentals of vacation homes or commercial buildings with a triple net lease, may not.
The calculation itself also provides an important nod to the real estate industry. Many real estate entities do not necessarily pay W-2 wages, which means that the deduction would often be lost without the “2.5 percent unadjusted basis of qualified property” addendum. Qualified property is defined as depreciable property whose depreciable life has not expired. In this case, depreciable life means the greater of ten years or the property’s MACRS life. Again, the deduction provides for the unadjusted basis in property, meaning it does not need to be reduced by depreciation taken. In summary, while a real estate business may not pay W-2 wages, it can still foreseeably claim a deduction as long as it has depreciable property that has not expired.
Like–Kind Exchanges & DPAD Section 199
The TCJA also eliminated the nine percent deduction for domestic production activities (DPAD) that many construction businesses utilized in the past. However, the new 20 percent QBI deduction referenced previously may be able to provide a more favorable deduction anyway depending on the relevant facts and circumstances.
Like-Kind Exchanges (LKEs) under IRC Section 1031 will now be limited to real property only. Taxpayers will only be allowed a deferral of the gain on exchanges of real property that is not held primarily for sale. However, the Pre-Act rules apply to taxpayers with exchanges of personal property where the relinquished property was disposed of or the replacement property was acquired on or before December 31, 2017. For exchanges involving both real and personal property, the personal property will need to be carved out of the gain deferral.
Construction companies disposing of equipment such as trucks, tractor trailers, and heavy equipment may want to consider the timing of such dispositions with acquisitions of replacement equipment. If the disposition/acquisition of equipment occurs near year-end and straddles two tax years, there may be negative tax consequences. An advantage to timing these transactions within the same tax year is to ensure that beneficial first-year depreciation (Section 179 or 100 percent bonus) on the newly acquired assets will offset the potential ordinary income recapture that is likely triggered on disposition. In this type of scenario, the loss of favorable LKE treatment for personal property becomes mostly a non-issue since the tax effect will likely be a wash.
For those in the real estate industry, the preservation of deferral of gain on real property LKEs is a major relief, as the industry involves many deals structured over these exchanges. There was initially some concern that the favorable treatment would be removed altogether.
The TCJA has a wide variety of implications for the real estate and construction industries. While the above summaries are certainly not exhaustive, they may help point to certain areas that will definitely be impactful to businesses and individuals in the industry.
Additional Real Estate and Construction Industry Tax and Business Resources
- Tax Reform: An Overview of Pass-Through Entity Impacts
- Understanding the New Section 199A Pass-through Deduction
- Real Estate Investors and Developers: Are You Aware of the Historic Rehabilitation Tax Credit?
- Central Virginia Real Estate Market Outlook and Trends
- Checkpoint 2018 Thomson Reuters/Tax & Accounting. All Rights Reserved.
- The New 20% Pass-Through Deduction: Can Real Estate Owners Claim It? | Erik P. Doerring, McNair Attorneys
- The Precarious Fate of Qualified Improvement Property (article) | Copyright © 2018, CBIZ, Inc. All rights reserved.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.