Guest blogger and CPA Anca Stradley of McLean, Koehler, Sparks and Hammond breaks down the recently passed tax reform bill and its implications for the real estate industry.
On December 22, 2017, President Donald Trump signed the "Tax Cuts and Jobs Act" (H.R. 1), a sweeping $1.5 trillion tax reform of the Internal Revenue Code of 1986 that is now the law of the land.
This bill has been characterized as the most significant overhaul of the U.S. tax code in more than 30 years. The administration’s stated goals are to grow the economy, raise wages and promote economic competitiveness. While the corporate rate reduction and international reforms are proposed to be permanent, the tax bill sunsets nearly all individual tax provisions (including the new pass-through income deduction) at the end of 2025.
There are a large number of provisions that affect the corporate and business category of taxpayers. All industries are affected by this, including the real estate industry. Most of the provisions are effective January 1, 2018. Here is a breakdown of some important aspects of the tax reform bill:
One of the outlines that circulated before the passage of this package included some references to limits on interest deductibility.
Given the importance of debt financing to real estate, limits on the interest deduction could have a significant impact on the real estate market. While H.R. 1 does provide some limits on the deductibility of interest for both corporations and partnerships, there is a specific exception for real estate.
Specifically, the limits on interest deductibility do not apply to a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. While the scope of real estate businesses exempted from limits on interest deductibility might seem broad, in practice it might be more difficult to determine when certain businesses are in the real estate business.
There are also open questions regarding the extent to which an entity would be subject to interest limitations when it engages in both real estate and other businesses. Business owners that engage in real estate activities need to pay special consideration to these provisions and also consider whether restructuring would be needed so that the borrowing is undertaken by the entity engaged in the real estate activities.
Another theme that circulated was increased expensing in the year of acquisition of certain purchases. H.R. 1 retains the current recovery periods for nonresidential real property (39 years), residential rental property (27.5 years) and qualified improvements (15 years). The bill also replaces separate definitions for qualified Restaurant, Leasehold, and Retail Improvement with one definition of "Qualified Improvement Property".
There had also been a lot of speculation regarding what provisions of the Code would be eliminated to help pay for the tax cuts. One provision that was noted as a potential revenue raiser was the elimination of the like-kind exchange provision. While H.R. 1 generally eliminates like-kind exchanges, it preserves like-kind exchanges for real property. It repeals the use of like-kind exchanges for personal property, such as art work, auto fleets, heavy equipment, etc.
25% Max Rate on Qualified Individual Business Income
H.R. 1 includes a provision that establishes a maximum 25% rate on the qualified business income of individuals. Qualified business income from a passive partnership or S Corporation will generally qualify for this rate. A rental activity is usually treated as passive under the passive activity rules unless the activity belongs to an individual who qualifies as a real estate professional (spends at least 750 hours per year on the activity), in which case, the activity may "escape" the passive activity rules.
Under the old law, individuals in the real estate industry may have preferred to be treated as real estate professionals in order to have the activity treated as an active business. However, with the new provision in place the calculus could change if being treated as a real estate professional means that an individual might not be fully eligible for the new 25% business rate. So individuals who were spending at least 750 hours per year on real estate activity, may no longer wish to do so.
Other Tax Bill Items of Note
There are a lot of other provisions that have a direct or indirect impact on the real estate industry including the maximum 25% rate on ordinary REIT dividends or the 3-year holding period required in the case of certain net long-term capital gain on the sale of a partnership interest held by the taxpayer. The law imposes a three year (rather than a one year) holding period to get long term gain treatment on the sale of a partnership interest if that interest was acquired in connection with the performance of services.
The bill also provides for a 20% qualified business income deduction at the individual level intended to give a tax break to small business owners. There are certain conditions that have to be met and limitations. The bill specifically limits the deduction to non-personal service businesses. However, there is an exception for business owners with taxable income of less than $157,500 (for single taxpayers) or $315,000 (for couples filing jointly) which will make it possible for many real estate professionals to take advantage of the deduction.
With the lower individual tax brackets came some limits on itemized deductions. H.R 1 allows an itemized deduction of up to $10,000 for the total of state and local property taxes and income or sales taxes. This $10,000 limit applies for both single and married filers and is not indexed for inflation.
In addition, the final bill reduces the limit on deductible mortgage debt to $750,000 for new loans taken out after 12/14/17. Current loans of up to $1 million are grandfathered and are not subject to the new $750,000 cap. Neither limit is indexed for inflation. The bill also repeals the deduction for interest paid on home equity debt through 12/31/25. Interest is still deductible on home equity loans (or second mortgages) if the proceeds are used to substantially improve the residence. Interest remains deductible on second homes, but subject to the $1 million / $750,000 limits. These changes are most likely to have some impact on home prices, especially in high cost, higher tax areas.
With the passing of the bill, more clarity in regard to what the future will bring could empower real estate investors who were cautiously waiting to make their business moves.
What's more, the preservation of the 1031 tax-deferred exchanges for real property will provide a measure of relief to the real estate industry. Moreover, the favorable treatment of pass-through income may encourage additional capital to enter the commercial real estate market.
As the bill was just signed into law, real estate investors should consult with their advisors and take the time to better understand how the new legislation will impact their situation and whether any changes should be made to their business structures.
Article provided by Anca Stradley, CPA, MBA - MKS&H.
About: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Frederick and Hunt Valley, Maryland. For more than 70 years, MKS&H has been helping owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of our clients, their culture and business goals. This approach enables our clients to achieve their greatest potential. Please visit www.MKSH.com for more information.Thoughts? Comments? We’d love to hear from you.