Tax Reform Changes Related to Real Estate
The Tax Cuts and Jobs Act of 2017 includes many new changes that are relevant to taxpayers who own real estate or are involved in real estate related activities. The changes as outlined below relate to Individuals and Real Estate, Accelerated Depreciation, Recovery Periods for Real Estate, Section 199A Deduction for Qualified Business Income, §1031 Tax-Deferred Exchanges, New Limitations on Interest Deductions and Recharacterization of Certain Capital Gains.
Individuals and Real Estate
• State and Local Taxes – Taxpayers are permitted a maximum $10,000 non-business deduction on state and local income, real property and personal property taxes.
• Mortgage Interest – Taxpayers are permitted to deduct the interest paid on acquisition indebtedness of up to $750,000. (Debt incurred on or before December 15, 2017, is grandfathered under the previous law of deducting interest paid on acquisition indebtedness of up to $1,000,000.)
• Home Equity Interest (HELOC) – The deduction for interest paid on home equity indebtedness is suspended.
• Bonus depreciation increased to 100%, from 50%, for qualifying property (excluding buildings or land) acquired after September 27, 2017, and before 2023. These provisions now apply to both new and used personal property. Bonus depreciation expense percentage steps down by 20% per year beginning in 2023.
• Businesses may immediately expense up to $1,000,000 (up from $500,000) of the cost of any §179 property placed in service each tax year to the extent of their taxable income. The phase-out threshold has also increased to $2,500,000.
Recovery Periods for Real Estate
• Residential real property depreciation recovery periods remain at 27.5 years and non-residential real property recovery periods remain at 39 years
• For property placed in service after December 31, 2017 to nonresidential real property, “qualified improvement property” will be eligible for a general 15year recovery period (utilizing a straight line method). Qualified improvement property is eligible for the bonus depreciation deduction. The definition of qualified real property has been expanded to include all qualified improvement property and certain improvements (roofs, HVAC property, fire protection and alarm systems, and security systems) made to nonresidential real property.
Section 199A Deduction for Qualified Business Income
• There is now a deduction of 20% allowed by non-corporate taxpayers’ pass-through entities against “qualified business income”.
• Real estate owned by a partnership or limited liability company (a so called “pass-through” entity) passes its net income through to its partners and members (“Partners”) to be taxed at those Partners’ individual tax rates. These activities may be eligible for the 199A deduction. This deduction also applies to sole proprietorships owning income producing real estate. The result of this new 20% deduction is to reduce the maximum effective federal income tax rate on real estate income to 29.6% (37% – (37% X 20%).
• This new deduction, unless extended by future legislation, will expire on December 31, 2025.
• The deduction attributable to 20% of the taxpayer’s QBI cannot exceed the greater of (A) 50% of W-2 wages paid with respect to the QBI or (B) The sum of 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property (tangible property)
• Qualified trade or business includes any trades or businesses other than specified service trades or businesses in the fields of:
o Health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or
o Which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
• Exception for limitations: Where a taxpayer’s taxable income does not exceed $315,000 (joint filer) or $157,500 (other filers), subject to full phase-in at $415,000 and $207,500, respectively, they are not subject to the limitations for wages and/or qualified property, nor qualified trade or business exclusions.
§1031 Tax-Deferred Exchanges
•Limits the non-recognition of gain for like-kind exchanges to real property that is not held primarily for sale.
o §1031 no longer applies to personal property.
o This means that any §1031 exchange of real estate, which might otherwise also include small amounts of personal property, should allocate in a purchase and sale agreement the entire purchase price to the qualifying real estate.
o Personal property could arise where cost segregation studies have been previously performed on the relinquished property real estate, or will be performed upon the replacement property real estate.
o Personal property can also arise on a real estate sale where there is personal property included as part of the real estate sale, such as refrigerators or stoves in an apartment building, movable modular units in office buildings, or where there is separate equipment and machinery as part of the real estate sale.
New Limitations on Interest Deductions
• A business’net interest expense deduction is limited to 30% of the taxpayer’s “adjusted taxable income”. However, businesses with average annual gross receipts of $25 million or less are exempt from the limit.
• There is a “Real Estate Interest Exception” to this new interest deduction limitation. If a taxpayer (who owns real property) elects to use this Real Estate Interest Exception for its interest tax deductions, then that taxpayer will be limited in its use of the new more favorable cost recovery rules and will have to depreciate and/or amortize their real estate over longer recovery periods.
Recharacterization of Certain Capital Gains
• Gain on sale of capital assets held more than 1-year are generally subject to long-term capital gain rates.
• Gain attributable to “applicable partnership interests” is subject to recharacterization as short-term capital gain unless the underlying asset has been held for at least 3 years.
• Applicable partnership interests include partnership interests that are transferred to (or held by) the taxpayer in connection with the performance of substantial services in any “applicable trade or business.”
o Applicable trade or business includes an activity (1) conducted on a regular, continuous and substantial basis, (2) consists of raising or returning capital, and (3) either investing in (or disposing of) specified assets or developing specified assets
o Specified assets include securities and commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts on any of the above, or proportionate partnership interests in any of the above
o Applicable partnership interests do not include interests that are held directly or indirectly by a corporation or capital interests that provide a right to share in capital commensurate with (a) amount of capital contributed or (b) value of such interest subject to tax under section 83 upon the receipt of vesting of such interest
If you have any questions relating to the Tax Cuts and Jobs Act of 2017 as it applies to real estate, please contact your WNDE tax professional.