In December 2017, Congress approved and President Donald Trump signed into law the Tax Cuts and Jobs Act of 2017 (TCJA), the most sweeping tax reform package passed in the last 30 years. This legislation affected both individuals and businesses as a whole. However, there seems to be much debate on the intended purpose. In the context of real estate, it changed the landscape entirely, with the biggest winners seeming to be investors and developers. This article discusses significant tax reform changes in real estate and whom they affected most in the last five years.
Federal Implications on the Real Estate Market
Corporate tax rate. The most significant and noticeable change made by the TCJA was the corporate income tax rate. Under the TCJA, Congress permanently lowered the corporate tax rate from the top 35 percent to a flat 21 percent for tax years beginning after December 31, 2017. This reduction made the corporate taxation much more palatable to real estate entities because the corporate rate is combined with the qualified dividends, bringing the corporate tax rate for distributions to its shareholders to 36.8 percent, almost equal to the new reduced individual tax rate of 37 percent.
Nonetheless, for the real estate industry, pass-through taxation will likely continue to dominate because the effective rate, considering distribution/dividends, is lower, and disposing of property is simpler from a tax-planning perspective through a partnership; this gives structuring firms options on how they utilize real estate. However, one beneficiary of the reduced corporate rate is the real estate investment trust (REIT). REITs are vehicles that investors use in the real estate industry. The new rate will benefit REITs that distribute 90 percent of their taxable income annually or have taxable REIT subsidiaries. REITs should consider distributing only 90 percent of taxable income to retain more cash for operations and development. Then the remaining 10 percent of taxable income will be taxable to the REIT but at a lower rate.
Section 199A: Qualified business income deduction (pass-through deduction). Under section 199, Congress sought to provide balance to the TCJA because of the reduction to the corporate tax rate. The TCJA offers a 20 percent deduction on qualified income for certain non-corporate taxpayers and captive REIT dividend income, which sunsets in 2026. This deduction, however, is a little more complicated than advertised, as it only applies to domestic, non-investment, qualified business income. This means many sole proprietors, self-employed individuals, partners in partnerships, beneficial owners of trust, and shareholders in S-corporations can use this new deduction under the TCJA. Yet, this deduction is not available to corporations that are owners of qualified pass-through entities.
Ultimately, if a taxpayer is in the highest tax bracket and can claim the full deduction, it will lower the effective rate on federal income to 29.6 percent. Nevertheless, there are two significant hurdles taxpayers must meet to qualify: (1) meeting the definition of a qualified trade or business and (2) fitting under the individual income requirement.
Generally, qualified business income includes domestic income from a trade or business. Conversely, it does not include employee wages, capital gains, interest, dividend income, and specified service businesses. The individual income of $157,000 ($315,000 if filing jointly) begins the phase-in and is fully phased in at $217,500 ($415,000 if filings jointly). Once phased in, the deduction is limited to the greater of two amounts: (1) 50 percent of the taxpayer’s allocable share of wages or (2) 25 percent of the taxpayer’s allocable share of wages.
Section 1031: Like-kind exchanges. While the stripping of like-kind exchanges is a significant blow to industries specializing in personal and intangible property (e.g., rental cars and sports contracts), the real estate investor was the big winner. Nonetheless, real estate has become a significant industry for non-recognition gain with a pen stroke. Currently, taxpayers who exchange real estate that is the same type or “like kind” do not have to recognize gain so long as the property was used for business or held as an investment. Taxpayers must exchange that property solely for other business or investment property of like kind.
Moreover, the properties are like kind if they are of the same nature or character, even if they differ in grade or quality. For example, an apartment building would generally be “like kind” with other apartment buildings; however, real property in the United States is not like kind with property outside the United States. Yet, an exchange of real property held primarily for sale still does not qualify as a like-kind exchange.
These changes help investors and developers while hurting individual homeowners who wants to use their property as a non-recognition investment.
Depreciation. Under the TCJA, the real estate industry received an additional benefit under depreciation. Businesses may temporarily take 100 percent bonus depreciation on qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. After 2023, full depreciation will phase down 20 percent each year for real property placed into service after December 31, 2022, and before January 1, 2027.
In addition, the TCJA eliminated the requirement that the original use began with the taxpayer and issued a “new to you” rule that included used property. The new definition included used qualified property to be eligible for 100 percent bonus depreciation; however, the used property must fit under specific factors, and taxpayers should consult a tax professional to make sure their used property qualifies. This was a significant and favorable change to the bonus depreciation rule in favor of real estate investors and developers.
The Internal Revenue Service (IRS) issued guidance that allows taxpayers to make a late bonus depreciation election or revoke an election for a particular property acquired after September 27, 2017. Under the TCJA, a taxpayer can elect out of 100 percent bonus depreciation or elect to take 50 percent bonus depreciation.
The TCJA increased the maximum amount of assets a taxpayer may expense to $1 million under section 179. It also increased the amount at which the deduction begins to phase out from $2 million to $2.5 million. The $1 million limitation is reduced (but not below zero) by the amount by which the cost of a qualified property placed in service during the taxable year exceeds $2.5 million. For taxable years after 2018, there is an inflation adjustment for the $1 million and $2.5 million limitation. Moreover, the definition of section 179 property expanded to include improvements made to nonresidential real property placed in service, including roofs, heating, ventilation, air-conditioning property, fire protection, alarm systems, and security systems. These additions and increases only served to help investors and developers to establish increased financing in the real estate industry. Moreover, the new depreciation rules allow immediate tax benefits that investors and developers would have to take two or more years to receive.
Business interest expense. Some have argued that section 163(j) interest expense may have the most effect on the real estate industry. With the TCJA focusing on limiting the interest expense deduction, some see the leverage of real estate companies as under attack because leasing of real estate is simply off-balance-sheet financing for many companies.
The TCJA specifies all business interest expense deductions be limited to 30 percent of adjusted taxable income. The limitation applies to a taxpayer with $25 million or more gross receipts for the prior three tax years. The three-year lookback ensures that real estate entities will not have the ability to plan out of their gross receipts to come under the $25 million threshold. At first glance, most people would not think real estate entities would reach the $25 million threshold and would have the opportunity to deduct all their interest expenses. The TCJA specified two hurdles real estate companies must overcome to plan out of section 163(j) and deduct their entire interest. First, complex aggregation rules require real estate entities with various ownership interests to aggregate their receipts. Second, the entity can’t be considered a “tax shelter.” A tax shelter is any partnership or entity whose plan or arrangement is the avoidance or evasion of federal income tax.
However, TCJA provided an exception to allow a “real property trade or business” to elect out of the limitation as a trade-off for applying a longer depreciation life span to specific property. If the definition is applied, deductions have unlimited carry forward at the entity level. There is some clarity needed concerning whether an upper-tier entity (equity fund) that indirectly invests in real estate assets through a lower-tier entity will be considered a real property trade or business such that it also has the benefit of electing out of the limitation.
Net operating losses and excessive business losses. The TCJA modified the net operating loss (NOL) rules. NOLs are no longer allowed to be carried back to prior tax years and are only deductible on a carryforward basis. Now, businesses may carry forward NOLs indefinitely without any expiration. Furthermore, the TCJA limits the NOL deduction to 80 percent of taxable income for the year instead of its usual 100 percent. This new rule allows REITs and other real estate entities to offset income using NOLs and apply to losses in taxable years beginning after December 31, 2017. Businesses need careful tracking of all NOL carryforwards.
The TCJA added a hurdle when dealing with excessive business losses. Starting with tax years ending after December 31, 2017, and before January 1, 2026, the TCJA limits a business loss for the non-corporate taxpayer. A non-corporate taxpayer is allowed a deduction for business losses equal to the amount of business, plus $250,000 ($500,000 if filing jointly) for a taxable year. These limits will adjust for inflation.
If the taxpayer exceeds the loss limit, the taxpayer will have an excess business loss, which the taxpayer can deduct as an NOL carried forward in subsequent years. Moreover, the losses may not offset non-business income such as interest income or portfolio income or gain. Partnerships and S corporations apply these rules at the partner or shareholder level.
