6 Tax Bill Revisions Impacting the Real Estate Industry
The 2018 Tax Cuts & Jobs Act contains several major changes to the tax landscape for both businesses and individuals. Below are six key areas where the new policies will impact the real estate industry.
1. Taxation of pass-through entities
A deduction is 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. The final bill added the provision limiting the deduction to the greater of 50% of wages paid or the sum of 25% of W-2 wages paid, plus 2.5% of the cost of tangible depreciable property.
The deduction should be widely available to real estate firms. The deduction is also available to REIT investors on REIT dividends subject to ordinary tax rates.
2. Bonus depreciation
The previous bonus depreciation requirement for property to be “original use” has been eliminated. Bonus depreciation is now available to both new and used property acquired after Sept. 27. Fixed assets acquired between Sept. 27, 2017, and Dec. 31, 2022, can be expensed in their entireties. The bonus depreciation phases out between 2023 and 2026.
Cost segregation studies will continue to provide meaningful tax benefits for the real estate industry. Benefits include identification of immediately deductible repairs, significantly shorter depreciable lives and the availability of bonus depreciation on assets that would not have otherwise qualified.
3. Qualified improvement property
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 space is leased. Qualified Improvement Property has a 15-year life, making it eligible for 100% bonus depreciation.
Building enlargements, elevators, escalators and internal structural framework are excluded from the definition.
“With proper planning, the after-tax returns of owning real estate can be significantly improved as a result of the potential for accelerated depreciation deductions on Qualified Improvement Property and the 20% deduction on pass-through income,” Moore Colson CPAs and Advisors Partner and Real Estate Practice Leader Steve LaMontagne said. “These changes will benefit small investors, as well as major institutions.”
4. Net interest expense limit
The interest expense limitation could have a material impact on real estate investors. It is not uncommon for real estate projects to generate annual tax losses. 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. A taxpayer’s net interest expense deduction is limited to 30% of income before interest, taxes, depreciation and amortization. After four years, the 30% limit is applied to income before interest and taxes.
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 the Alternative Depreciation System.
ADS is a system the IRS requires to be used in special circumstances to calculate depreciation on certain business assets. ADS generally increases the number of years over which property is depreciated, decreasing the annual depreciation deduction. Listed property used 50% or less for business purposes, tangible assets used primarily outside of the U.S. and farming equipment require ADS.
5. Historic tax credits
Owners of historic properties have access to a tax credit for Qualified Rehabilitation Expenditures. Owners can still take a 20% credit for QREs in the same year of the expenditures for historic structures listed in the National Register.
The previous bill allowed 10% credit on QREs with respect to a qualified rehabilitated building other than a historic structure, provided the building was placed in service before 1936. That provision has been repealed in the new tax bill.
6. Tax-exempt investors
The new tax law produced mixed results for tax-exempt investors in real estate. Under previous policies, 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. Under the new tax provisions, losses from one activity cannot offset profits from another, subjecting some tax-exempt entities to unrelated business income tax.
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