Selected Real Estate and Pass-Through Provisions of the Tax Bill
Gibbons Corporate & Finance News - Legislative Tax Alert
December 21, 2017
The U.S. Senate and House of Representatives have now voted for the Joint Conference Committee tax bill and the President is expected to sign it into law shortly. This article highlights some of the key provisions relevant to commercial and rental real property holders and developers. These provisions are effective January 1, 2018, unless otherwise noted.
Real Property Depreciation Deductions
The Conference bill would eliminate the separate provisions for, and definitions of, qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and would provide a 15-year straight line recovery period for all qualified improvement property per the Conference Statement. The Conference bill would also expand the definition of qualified improvement property to mean “any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service.” Under the alternative depreciation system (“ADS”), all qualified improvement property now has a recovery period of 20 years per the Conference Statement.
The Conference bill would also reduce the ADS recovery period for residential real property from 40 years to 30 years.
Note that the Conference bill would not shorten the recovery period for nonresidential real property and residential rental property from 39 and 27.5 years, respectively, to 25 years, as had been proposed. This is an important late change in the proposed tax bill.
Section 1031 Like-Kind Exchanges
The Conference bill would restrict deferral of gain on like-kind exchanges after December 31, 2017 solely to real property that is not held primarily for sale. This provision would prevent taxpayers from using Section 1031 to defer gain on exchanges of art or other personal property, and will adversely affect the tax treatment of trade-ins of tangible personal business property. The final bill would provide for a favorable transition rule to the extent that either the property being disposed of is disposed, or the property being received is received, on or before December 31, 2017, as part of an exchange.
Section 179 Expensing
The Conference bill would increase the amount businesses can expense under IRC Section 179 from the current cost limit of $500,000 to $1,000,000 of Section 179 property (generally limited to most depreciable tangible personal property purchased for use in the active conduct of a trade or business). The bill also increases the phase-out amount from $2,000,000 to $2,500,000, an amount which reduces the deduction dollar-for-dollar when the total Section 179 property placed in service in the current year by a taxpayer exceeds that amount. In addition, the bill would index these amounts for inflation.
The Conference bill follows the Senate bill in expanding the definition of qualified real property for purposes of Section 179 to include all qualified improvement property and certain improvements (roofs, heating, ventilation, air-conditioning property, fire protection and alarm systems, and security systems) made to nonresidential real property.
Interest Deduction Limitations
The Conference bill would amend current IRC Section 163(j) to limit net interest deductions for all businesses to 30% of their adjusted taxable income. The Conference bill would calculate adjusted taxable income as earnings before interest, income taxes, depreciation, and amortization (“EBITDA”) for taxable years beginning before January 1, 2022. For subsequent years, adjusted taxable income would be reduced by allowable deductions for depreciation, amortization, or depletion. Also, adjusted taxable income would be calculated before any deductions under the new pass-through rules are taken into account. Disallowed amounts of interest expense would carry over indefinitely under the Conference bill.
The Conference bill exempts small businesses – those with average annual gross receipts under $25 million (taken from the House version) from this interest deduction limitation. The Conference Bill would also exempt floor plan financing – i.e., interest expense on debt used to finance the acquisition of motor vehicles held for sale or lease.
The Conference bill would allow real property trades or businesses (defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business”) to elect out of the Section 163(j) limitation. Electing out would require the use of the Alternative Depreciation System (“ADS”) to depreciate nonresidential real property (40 years), residential rental property (30 years reduced from 40), and qualified improvement property (20 years per the Conference Statement).
Partnership Technical Termination
Under current law, if more than 50% of the total capital and profits interests of a partnership is sold or exchanged, there is a technical termination of the partnership, which has consequences that include the option to make certain new tax elections. The Conference bill would repeal this rule (IRC Section 708(b)(1)(B)).
Currently, the tax rates that apply to pass-through income, i.e., income allocated by partnerships or S corporations to their partners or shareholders, respectively, are the marginal rates that apply to such partners or shareholders as individuals.
The Conference bill would generally follow the proposed Senate bill and, in lieu of a separate tax rate decrease, would allow individual partners, S corporation shareholders, and sole proprietors to deduct 20% (decreased from 23% in the Senate bill) of qualified business income (all domestic business income other than investment income). The 20% deduction would not be fully available for specified service trade or businesses (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, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and 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) unless the taxpayer’s taxable income does not exceed threshold amounts: $315,000 for married individuals filing jointly, or $157,500 for individuals). Joint return filers with taxable income in excess of the threshold amount by no more than $100,000 ($415,000 total), or single returns with total taxable income of no more than $207,500, would see the 20% deduction phase d out with respect to specified service trade or businesses as their taxable income exceeds the threshold amounts.
In addition, for taxpayers whose taxable income exceeds the threshold amounts, the 20% deduction would generally be limited to the greater of (a) the taxpayer’s allocable share of 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 percent of the taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. Generally, qualified property is tangible depreciable property used in the qualified trade or business for which the depreciable period has not ended.
The ability to include 2.5 percent of the unadjusted basis of qualified property in calculating the foregoing limitation should allow more real estate trades or businesses to take advantage of the 20% pass-through deduction.
This article addresses some of the more substantial tax items of interest to real estate investors and developers, along with an outline of the treatment of pass-through entities under the Conference bill. Investments in real estate, which for U.S. investors are typically structured utilizing pass-through vehicles, would generally stand to benefit from these reforms. These changes, in concert with the lowering of corporate income tax rates to 21%, may make investing in U.S. real estate significantly more attractive to foreign investors.
If you have questions or concerns with how any of these provisions will impact you or your business, please do not hesitate to contact us.