Prepared by FGMK Tax Partners Randy Markowitz and Perry Weinstein and Senior Tax Associate Jeffrey Golds
The Tax Cuts and Jobs Act of 2017 (the “Act”) has been passed by both the House and Senate and contains provisions that will have a profound, long-term impact on the tax treatment of real estate. Below is a list of some of the changes impacting real estate included in the Act;
- Mortgage Interest. For mortgages entered into after December 15, 2017, the Act lowers the limit for mortgage interest deduction to interest on a $750,000 home loan, down from $1,000,000. However, the interest deduction for second homes is preserved. In addition, the interest limitation will revert back to $1,000,000 in 2026, and will include interest on all loans, regardless of when they are entered into. This means that, while interest on a new $1,000,000 home loan will be limited to $750,000 for the next 8 years, the interest on the entire $1,000,000 loan will be deductible again beginning in 2026.
- Home Equity Loans. The Act eliminates the interest deduction for home equity loans, including existing home equity loans.
- Gain on Sale of Primary Residence. The Act does not modify the existing rule that a home which has been used as a principal residence for 2 of the last 5 years is eligible for long-term capital gains.
- State and Local Tax Deduction. Under the Act and effective 2018, the state and local tax deduction for individuals will be capped at $10,000 annually. This cap is for income, property and sales taxes combined, so individuals and trusts can only deduct up to $10,000 in state and local taxes total, including real estate and property taxes.
- Corporate Rate. The Act lowers the corporate rate from a variable rate up to 35% to a flat 21% rate. All C-Corporations will now be subject to a 21% tax rate, regardless of income.
- Pass Through Rate. Business owners of pass-through entities (e.g. sole proprietorships, partnerships, LLCs, S-Corporations, trusts, and estates) will be allowed to deduct 20% of their domestic Qualified Business Income (i.e. the net of a taxpayers items of income, gain, deduction, and loss related to such taxpayer’s business). Ordinary dividends from an REIT or publicly traded partnership are eligible for a straight 20% deduction. For taxpayer’s earning income from an S-Corporation or Partnership, the deduction will be limited to the greater of either A) 50% of the business’s W-2 wages, or B) 25% of the business’s W-2 wages plus 2.5% of the unadjusted basis of all qualified property used in the trade or business (i.e. tangible property subject to depreciation). The deduction is not available to Specified Service Businesses (e.g. health, law, accounting, etc.), except for taxpayers with taxable income not exceeding $315,000 for married filing jointly, $157,500 for other individuals and will be phased in for income over $315,000 over the next $100,000 of taxable income for married filing jointly and $50,000 for other individuals. Notably, Specified Service Businesses do not include engineering or architectural firms. Additionally, the Act suggests that many real estate management companies would not be considered Specified Service Businesses either.
- Business Interest Deduction. The Act limits the deduction for net interest expenses to the sum of business interest income, 30% of the businesses Adjusted Taxable Income, and floor plan financing interest. Adjusted Taxable Income is defined as a taxpayer’s taxable income, computed without regard to a) any item of income, gain, deduction, or loss not allocable to a trade or business, b) any business interest income, c) any NOLs, d) any pass-through business deduction under 199A, and, in years before 2022, any depreciation, amortization, or depletion) This rule will only apply for businesses with greater than $25,000,000, and is tested at the entity level. For qualifying businesses, this will significantly limit the interest expenses they are able to deduct. However, real estate businesses (including REITs, corporations, and hotel management companies) are permitted to elect out of this regime and deduct all of their business interest expenses. To do so, a real estate business must elect to use the Alternative Depreciation System, which requires straight line depreciation of all assets, and the use of a 30 year class life for residential real property and a 40 year class life for nonresidential real property.
- Domestic Production Activities Deduction. The Act repeals the Domestic Production Activities Deduction for all taxpayers beginning in 2018.
- Section 179 Expenses. Beginning in 2018, the Act raises the yearly limit on Section 179 expenses to $1 million and raises the phase out threshold to $2.5 million. The Act also expands the definition of Section 179 property to include Qualified Real Property, which is defined to include a roof, HVAC system, fire alarm and suppression system, and security system. Under current regulations, in many circumstances the installation of these systems would be considered as having taken place after the building is placed in service, even if installed just one day later.
- Cost Recovery. The current recovery periods for real estate assets are not changed by the Act. However, as mentioned above, real estate businesses with greater than $25 million in gross receipts a year looking to elect out of the business interest deduction limit will have to elect to use the Alternative Depreciation System, which applies a 30 year class life for residential real property, a 40 year class life for nonresidential real property, and a 20 year class life to qualified improvement property. However, the Act makes available immediate expensing of all assets with a recovery period of 20 years or less. Therefore, site work, personal property used in the real estate business, and any qualified improvement property may be 100% deducted if placed in service between the effective date of September 27, 2017 and January 1, 2023. Beginning in 2023, the amount which may be immediately expensed is reduced 20% each year through 2027, after which immediate expensing will no longer be available. Furthermore, the Act now permits a taxpayers to take a 100% deduction on used property which otherwise qualifies as long as the property is new in the hands of the taxpayer.
- Active Loss Limitation. The Act prohibits excess business losses of taxpayers other than a C corporation for taxpayers earning above a threshold amount. Excess business losses are the excess of business deductions over the income of such trade or business, plus the threshold amount ($500,000 for joint filers, $250,000 for all others, adjusted for inflation). In other words, business losses greater than $500,000 for married jointly filing individuals and $250,000 for all others will be disallowed. Disallowed losses may be carried forward by the taxpayers as part of their net operating loss. This provision is applied after the application of the passive loss rules.
- Carried Interest. Partnership interests received in connection with the performance of services in managing assets, including real estate, will be subject to a 3 year holding period in order to be treated as long-term capital gains rather than the current one year holding period.
- State and Local Taxes. While the Act limits individual deductions of state and local taxes to $10,000, this limit does not apply to state and local taxes paid or accrued in the carrying on of a trade or business. Any property or other taxes accrued in the construction, rehabilitation, or rental of real estate will remain fully deductible.
- Like-Kind Exchanges. Like-kind exchanges of real estate will be able to continue without any changes. However, the Act repeals the use of a like-kind exchange for any type of property other than real estate. In addition, partnerships that properly elect under Section 761(a) to not be treated as a partnership will be treated as though each partner owns a pro rata share of each asset owned by the partnership or LLC.
- Contributions to Capital. Contributions of property in aid of construction, as well as contributions made by a governmental entity, are no longer to be treated as tax free capital contributions. This means the donation of land to a construction project by a governmental entity will no longer be a tax free event. This may result in more long term ground leases between government entities and developers. However, land that will be donated under an existing governmental master plan development will still be tax free.
- Rehabilitation Credit. The Act eliminates the 10% credit for rehabilitation of buildings placed in service before 1936, and now will require that the 20% credit for rehabilitation of a Qualified Historic Building be taken ratably over a five year period rather than immediately. However, both the 10% and existing 20% credit will be available for taxpayers who currently own buildings and begin rehabilitation work within the first 180 days of 2018.
- Low Income Housing Tax Credit. The Low Income Housing Tax Credit is not being eliminated or modified by the Act.
- New Markets Tax Credit. The New Markets Tax Credit is not being eliminated or modified by the Act.
- Advanced Refinancing Bonds. The tax free nature of interest for Advanced Refinancing Bonds is eliminated by the Act.
- Private Activity Bonds. The tax free nature of interest for Private Activity Bonds is not being eliminated or modified by the Act.
If you have any questions related to the above or the Act in general, please do not hesitate to contact your FGMK tax advisor.
The summary information in this document is based on pending legislative proposals and is being provided for educational purposes only. These proposals are subject to change, and it is believed likely will change from the contents noted herein. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.