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Tax Reform’s Sprawling Impact on Real Estate Companies

February 8, 2018
Whether owners, developers, or contractors, real estate companies of all varieties are asking the same question: What does the Tax Cuts and Jobs Act (TCJA) mean for us? Despite tax advisors’ best efforts, it is impossible to come up with a concise response, but this is for good reason. The TCJA has introduced many new issues to consider, as well as many gray areas. The following summary highlights the most relevant issues for real estate companies.

1. 20 Percent Qualified Business Income (QBI) Deduction

One of the hottest topics related to the new tax law is a new “20 percent QBI deduction” under Internal Revenue Code Section 199A. So as not to be outdone by the reductions in tax rates for C corporations, Congress handed owners of non-corporate entities the QBI deduction. Unfortunately, there is a lot of uncertainty for some taxpayers about (a) whether the underlying activity is eligible for the deduction, and (b) whether limitations related to wages and depreciable basis will ultimately prevent the deduction.

QBI Deduction Eligibility

  • The theory of the deduction is that an owner of a sole proprietorship, partnership, limited liability company, or S corporation will benefit from a 20 percent haircut on the taxability of each of their businesses’ QBI, and will thus retain the approximate 10 percent tax rate advantage from before the TCJA, compared to a C corporation that pays dividends to its shareholders (generally triggering a second level of taxation).
  • Initial eligibility for the deduction requires that the activity rise to the level of a “trade or business.” For most taxpayers, this determination should be fairly straightforward. For rental real estate, however, this determination may be more challenging. Trade or business generally implies a certain level of day-to-day activity. For example, would operating a single, triple-net lease property rise to the level of a trade or business?
  • Real estate services companies will need to pass a second, more restrictive standard to determine deduction eligibility. Owners of a “specified service trade or business”* are phased out of the deduction on these business’s income when the taxpayer’s overall taxable income exceeds the following “threshold amounts” or are within the following “phase-out ranges”:
    • $157,500, partially phased-out up to $207,500
    • $315,000, partially phased-out up to $415,000 (joint return)

*The definition of a “specified service trade or business” is as follows: “Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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.”

QBI Deduction Limitations

  • This is significant: Whether a taxpayer’s taxable income exceeds the above threshold amounts also impacts whether or not the wage and unadjusted depreciable basis limitations apply. This is true whether or not a business is a specified service trade or business (therefore impacting rental real estate). The limitations work as follows:
    • A taxpayer’s QBI deduction attributable to each business is limited to the lesser of 20 percent of QBI or the greater of:
      • 50 percent of the taxpayer’s share of W-2 wages with respect to the qualified trade or business (i.e., W-2 wages paid by the entity), or
      • The sum of 25 percent of the taxpayer’s share of W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted depreciable basis of all qualified property.
  • If the application of these limitations is intended to be “entity-by-entity,” the placement of wages and unadjusted depreciable basis on a per-entity basis has critical implications on the practical availability of the QBI deduction. Taxpayers who are subject to the limitations will be motivated to consider restructuring alternatives.
  • Additional guidance is needed to reduce uncertainty about (1) the manner in which Section 199A should be applied in tiered situations, (2) whether QBI factors from multiple entities can be aggregated, and (3) whether the activity of one entity with a mix of both qualified and unqualified businesses can/should be bifurcated.
  • Also worth noting is that the TCJA repealed the Domestic Production Activity Deduction (DPAD). This prior law deduction was essentially equal to nine percent of the taxable income of qualifying businesses (such as manufacturing and construction). The loss of DPAD should be more than offset by the introduction of the 20 percent QBI deduction.

2. Choice of Entity

  • For real estate companies of all varieties, C corporations have generally always been the entity choice of last resort. With the TCJA slashing entity-level tax rates of C corporations from 35 percent to 21 percent, many taxpayers are newly questioning whether a C corporation could be a more tax-efficient vehicle (especially when there are concerns regarding availability of the QBI deduction in alternate entity types).
  • For a real estate and construction business to seriously consider using a C corporation without being tax inefficient, the owners would first need to be willing and able to forego taking cash out of the business (to avoid subjecting dividends to double taxation). This is one of many issues that must be considered. Clients and practitioners will need to tread carefully.

3. Business Interest Expense Limitation

  • Another new consideration for taxpayers effective Jan. 1, 2018, is a limitation on the deductibility of business interest expense. Deductible business interest expense will be limited to 30 percent of a taxpayer’s “adjusted taxable income” (ATI). For real estate held by pass-through entities, ATI will generally be similar to net operating income (NOI). However, beginning in 2022, ATI will be reduced by depreciation and amortization. Disallowed or “excess” business interest expense is not permanently lost, but instead is carried forward indefinitely.
  • Exempt from the new limitation are businesses with average annual gross receipts of $25 million or less, subject to related entity aggregation rules.
  • An “electing real property trade or business” or an “electing farming business” can make an irrevocable election out of the default limitation, but must utilize longer depreciable lives for certain asset classes. Generally speaking, this should only be a material trade-off for owners of commercial property who incur internal building improvements with some regularity.

4. Bonus Depreciation and Section 179 Expense

  • Very favorable for taxpayers, the TCJA changed bonus depreciation rules to enable businesses to expense 100 percent of qualified property placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Beginning Jan. 1, 2023, the amount of qualified property a business will be able to expense via bonus depreciation will decrease 20 percent each year.
  • Also very favorable for taxpayers is the fact that used property will now also qualify for 100 percent bonus depreciation.
  • Significant for owners of commercial property is that certain internal building improvements are likely now eligible for 100 percent bonus depreciation.
  • For purposes of Section 179 expense (not available for rental real estate) businesses can now deduct up to $1 million of qualified property placed in service each year (up from $500,000). Additionally, lodging activities are newly eligible for Section 179 expense.

5. Section 1031 Like-Kind Exchanges

  • Tax-deferred exchanges of personal property assets are no longer available for exchanges in which one leg of the exchange did not close prior to Dec. 31, 2017. Real property, however, is still available to be exchanged in a tax-deferred transaction under Section 1031.

6. Governmental Incentives as Contributions to Capital

  • Previously, corporations could receive nonshareholder contributions to capital tax free. Under the TCJA, effective Dec. 22, 2017, any such government incentives become taxable, effectively devaluing the incentive on an after-tax basis. This up-front taxation of incentives means they are less helpful in closing the developer’s “gap” to make projects viable. With local governments likely unwilling or unable to “gross-up” incentives to counteract this new treatment, developers will want to discuss planning alternatives with their advisors.

7. Changes to Net Operating Loss (NOL) Deduction and New Excess Business Loss Limitation

  • Under the TCJA, NOLs created after the 2017 tax year can only offset 80 percent of subsequent years’ taxable income, can only be carried forward, and do not expire. Pre-2018 NOLs offset 100 percent of subsequent years’ taxable income and can be carried back two years and/or forward up to 20 years.
  • Also new for the 2018 tax year is an annual limit on business losses of $500,000 for joint taxpayers or $250,000 for single taxpayers. Coupled with the inefficiency of an “80 percent NOL,” it may be advisable to selectively elect out of bonus depreciation or engage in other planning to manage the amount of taxable losses in individual tax years.
  • Despite the many favorable changes for taxpayers (lower tax rates, QBI deduction, enhanced bonus depreciation and expensing, and the opportunity for some to elect out of business interest limitations), the new $500,000 annual limit on taxpayers’ ability to deduct business losses could significantly increase the amount by which certain taxpayers will have to cover their federal income taxes.

8. Miscellaneous Provisions

  • Methods of Accounting
    • Effective Jan. 1, 2018, the gross receipts threshold for businesses permitted to use the completed contract method for long-term contracts or the overall cash method of accounting was raised from $10 million to $25 million. (The completed contract method enables taxpayers to defer the recognition of profit until the contract is substantially complete.) Application of these provisions will not result in an adjustment under Section 481.
    • Note, however, that for purposes of the Alternative Minimum Tax (AMT), income from long-term contracts must still be reported using the percentage-of-completion method. While the TCJA softened the impact of AMT, it was not eliminated completely. Therefore, one must also consider the potential impact of AMT before electing to account for long-term contracts under the completed contract method.
  • Meals and Entertainment Expenses
    • Effective Jan. 1, 2018, deductions for entertainment-related expenses that were previously 50 percent deductible are generally entirely nondeductible. Certain meals and beverages, however, can be treated as 50 percent deductible. If not already tracked separately, clients with both meals and entertainment expenses should consider setting up separate general ledger accounts for these expenses.
  • Research Tax Credit (also called the R&D Credit)
    • ​Good news for contractors, the TCJA retained the research tax credit which had been permanently extended under prior legislative action.
With all the complexity created by the TCJA, we encourage you to reach out to your KSM advisor to discuss how these changes will affect you and your businesses.

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