Potential Impact of Tax Reform on the Construction and Real Estate Industries
Since the very beginning of Donald Trump’s campaign to become President of the United States, he has emphasized the need for individual and business tax reform. The last time major tax reform occurred in the United States was more than 30 years ago, in the more collegial Reagan-era atmosphere that brought us the Tax Reform Act of 1986.
Despite the various tax proposals introduced by the Trump administration and Congressional leaders, the timing and certainty surrounding passage of tax legislation in 2017 remains unclear.
Tax reform proposals at a glance
The following table compares selected aspects of current tax law to the tax reform proposals advanced by both President Trump and House Republicans. Regardless of the current political theater in Washington, DC, many proposals warrant serious consideration as they represent a drastic change to current federal income tax law.
|Current Law||President Trump’s Proposals||House Republican Tax Reform Blueprint|
|Personal tax rates||Seven tax brackets: 10%, 15%, 25%, 28%, 33%, 35%, 39.6%||Three tax brackets: 10%, 25%, 35%||Three tax brackets: 12%, 25%, 33%|
|Personal long-term capital gains tax rates||Up to 23.8%||Up to 20%||Ordinary rates with a 50% exclusion (i.e., 6%, 12.5%, 16.5%)|
|Maximum pass-through tax rate||39.6%||15%||25% for “active business income”; 33% for other ordinary income|
|Maximum corporate tax rate||35%||15%||20%|
|Personal standard deduction||Married filing jointly: $12,700 Head of household: $9,350 Single: $6,350||Married filing jointly: $25,400 Single: $12,700||Married filing jointly: $24,000 Single with a child: $18,000 Single: $12,000|
|Depreciation||Fixed assets are generally capitalized and depreciated with Section 179 immediate expensing available in some cases||U.S. manufacturers (possibly including construction contractors) can elect to expense cost of fixed assets in year of purchase||Cost of tangible and intangible property, including buildings (but not land), is immediately expensed|
|Interest expense deductibility||Generally deductible||U.S. manufacturers lose deductibility of interest expense when full expensing of fixed assets is elected||Deductible only to the extent of interest income|
|Carried interest (capital gains allocated to the holder of a partnership profits interest)||Taxed at capital gains rates||Taxed at ordinary income rates||Taxed at capital gains rates|
|Domestic production activities deduction||Construction contractors eligible for a deduction equal to 9% of their construction income||Not specifically addressed but plan generally involves limiting tax deductions||Repealed|
|Section 179D energy-efficient commercial buildings tax deduction||Certain building owners and construction contractors eligible for a deduction of up to $1.80 per sq. ft. for energy-efficient commercial building property placed in service through 2016||Not specifically addressed but plan generally involves limiting tax deductions||Not specifically addressed but plan generally involves limiting tax deductions|
|Alternative minimum tax (AMT)||Potentially imposed on both corporations and individuals||Repeal||Repeal|
|Gift and estate tax||Tax of up to 40% imposed on gifts and estates, subject to a $5.45 million lifetime exemption per spouse||Repeal estate tax (replaced by income tax in campaign proposal); proposal is unclear regarding gift tax||Repeal estate tax; proposal is unclear regarding gift tax|
Tax planning considerations before tax reform passes
We recommend that construction and real estate clients begin positioning themselves to address the opportunities and challenges that any tax reform will present by considering the potential impact of tax reform on your financial projections, tax accounting methods, timing of asset acquisitions, like-kind exchanges, capital structure, and organizational structure. Each of these considerations is discussed, in turn, below.
Tax reform proposals generally lower tax rates and broaden the tax base by reducing or eliminating several tax breaks. Don’t assume that the reduction in tax rates will result in lower taxes, since the benefit of reduced tax rates may not fully compensate for the loss of deductions repealed as part of base broadening. You may want to model the impact of tax reform on your tax liability and consider the impact of reform on your financial projections. In addition, you may want to consider the potential impact of tax reform on your state tax liabilities (e.g., will states where you operate conform to federal base-broadening measures without reducing state tax rates, thus increasing state tax bills?).
Tax accounting methods
If you are subject to today’s top tax rates, you might benefit from accelerating deductions and deferring income this year if tax reform results in lower tax rates next year. Now would be an ideal time to develop a strategy to take advantage of a change in tax rates, since many tax reduction strategies need to be implemented well in advance of year-end.
Timing of asset acquisitions
If you plan to acquire fixed assets in the near future, consider whether you would be better off acquiring the assets before or after reform legislation is enacted, and then time your asset acquisitions accordingly. In some cases you may be better off acquiring fixed assets in 2017, particularly where you are able to use the available depreciation deductions (including bonus depreciation and section 179 expensing) to offset income otherwise subject to marginal federal tax rates of up to 43.4 percent and where the asset is subject to a three-, five- or seven-year useful life.
In other cases you may be better off delaying the acquisition until 2018 if legislation is enacted that allows you to expense the cost of fixed assets in the year of purchase, even if the deductions offset income otherwise subject to reduced tax rates. If you are evaluating whether to lease or purchase an asset, consider how a change in tax rates would affect your cash flow projections.
The most recent tax proposals advanced by President Trump and House Republicans do not address like-kind exchanges. Legislation introduced in 2014 would have repealed section 1031, and some believe that proposals to repeal section 1031 will resurface as the tax reform process unfolds. Note that the proposals permitting the immediate expensing of buildings would not fully replace section 1031, if repealed, since the proposals would not permit land to be expensed.
Further, federal accelerated expensing may not be adopted by some states. If you are considering a real estate transaction, stay abreast of developments with Section 1031 since some exchanges may yield more favorable tax results under current law than after reform occurs.
If limitations are imposed on the deductibility of interest, then the after-tax cost of debt financing would increase relative to the cost of equity financing, potentially influencing the amount of leverage that businesses use in their capital structures. While the proposals do not specify how interest on existing debt would be treated, clients obtaining financing may want to opt for longer-term debt (preferably without prepayment penalty) since a grandfather provision may permit interest on existing debt to be deducted.
The tax structure that makes most sense for a construction or real estate business under current law will not necessarily make the most sense after tax legislation is enacted. Newer businesses may want to select an organizational structure that provides flexibility to adapt to whatever changes tax reform may bring.
The income tax status of a limited liability company can be changed by merely filing an IRS election and without making any changes to the entity from a legal perspective. This makes LLCs a versatile business entity and one well suited for a changing tax environment. If you are contemplating a change to your organizational structure, consider the impact that reform might have on your proposed structure or wait until there is greater certainty before moving forward with significant changes.
Even the most casual observer of Washington politics can appreciate the animosity harbored by the various political factions and the resulting challenges to tax reform. Whether the issue is health care, the environment, or tax law reform, while one side of the aisle is committed to dismantling the Obama administration’s legacy, the other appears intent on defending.
These practical challenges justify skepticism that monumental, once-in-a-generation tax law changes will occur in 2017. Instead, the odds seem to favor passage of a scaled-back tax reform package.
Current timelines call for tax reform to proceed in the fall, but the window of opportunity is narrowing. If reform does not occur before early 2018, we expect to see declining enthusiasm in Congress for tax law changes, which is a common occurrence in the face of midterm elections. CLA’s tax reform committee will continue to monitor the issue and communicate as the process unfolds.