New Tax Issues and Strategies for Real Estate Firms
The highly anticipated tax reform has completed its epic journey through Congress. The Tax Cuts and Jobs Act (TCJA) offers several rate cuts and improved expensing treatment for pass-through and corporate businesses, including some special changes aimed exclusively at real estate developers and investors.
As this legislation evolved, CLA worked closely with industry liaisons in Washington to advocate for the unique needs of the real estate marketplace, including issues such as real property cost recovery, 199A benefits for real property businesses, and enhanced accounting method flexibility.
Most provisions are effective beginning in 2018 (though many are effective only for 7 to 10 years before reverting to existing law, absent further legislation). The temporary nature of these law changes is an unfortunate reality for business planners. Further, because it is solely a Republican initiative, these changes may be vulnerable if the balance of control in Congress shifts.
Tax strategies for your business
This article is focused on the impacts to, and opportunities for, developers, investors, and managers of real estate businesses, including those operating as pass-through entities and C corporations. The discussion that follows generally references federal tax implications only. State income tax implications for many taxpayers will significantly influence planning, particularly with regard to multi-state businesses and the double-tax regime of C corporations. Many states are expected to undertake legislative changes in the first half of 2018 to adapt to the implications of federal tax reform.
The AMT is repealed for C corporations, but AMT credits carry forward and become refundable over the 2018 – 2021 tax years. The credits may be used to offset current tax, with 50 percent of any excess amounts becoming refundable in 2018 – 2020, and any residual AMT credits being refundable in 2021.
The AMT continues for individuals. The exemption rises to $109,400 for married-filing-jointly (MFJ) taxpayers ($70,300 for singles), with the full exemption allowed until phase-outs begin at $1 million for MFJ ($500,000 for singles). While the higher exemption amounts will be helpful, many real estate investors may find they continue to be subject to AMT when capital gains are present or where long-term accounting methods other than a home construction method or percent complete method are used. Depreciable lives of most real property remains consistent between regular tax and AMT in the new law, including Section 179 and asset expensing rules, so depreciation differences are not expected to be a common source of large AMT adjustments.
As in previous years, low-rate dividends and capital gains may trigger AMT. Further, at lower income levels the spread between regular tax and AMT may make it more challenging to use some tax credits.
For a dozen years, certain taxpayers benefitted from the Domestic Production Activities Deduction (Section 199 or DPAD), which provided a 9 percent deduction for qualifying income. It represented an almost 3 percent rate reduction for qualified real property improvement work in the United States, including its construction, design, and engineering. This industry-specific provision helped construction contractors but did little for property owners and managers. It is now repealed and replaced by Section 199A, which offers a 20 percent income reduction for a much broader category of qualified income, though C corporations no longer qualify. Unlike DPAD, the 199A deduction is limited by 20 percent of adjusted taxable income, rather than DPAD’s somewhat larger adjusted AGI base.
Similar to the old DPAD, the new 199A deduction is contingent on the payment of wages. The 20 percent 199A deduction may not exceed the greater of:
- 50 percent of wages paid, or
- 20 percent of modified taxable income.
Businesses that are limited by the 50 percent of W-2 income rule can use a substitute limit based on 25 percent of wages plus 2.5 percent of a modified depreciable asset cost amount. For example, this allows a real estate rental business which has $40,000 of W-2 wages, and a rental building depreciable basis at purchase of $1,000,000, the option to qualify for the deduction based on a wage component of $10,000 (wages of $40,000 times 25 percent) plus 2.5 percent of the unadjusted depreciable basis of the building rented ($1,000,000 times 2.5percent = $25,000). The taxpayer would prefer the alternate rule yielding $35,000 (the $10,000 wage component plus the $25,000 building component) to the 50 percent of wages rule yielding $20,000 ($40,000 times 50 percent = $20,000).
This alternate rule is based on unadjusted tangible depreciable property basis immediately after acquisition if:
- The property is held and available and used during the year in the production of qualified income, and
- Its depreciable life has not ended before the close of the tax year.
The depreciable life, for this purpose, is deemed to not end in less than 10 years from an asset’s placed in service date, unless actually disposed. For property with a depreciable life longer than 10 years, the period ends with the last full year of the asset’s depreciable life.
The qualifying cost is not adjusted downward by depreciation claimed, though it might be adjusted downward in the case of a partial disposition event.
As a result of Section 199A, the reasonable compensation standards have taken on added importance. Business income may qualify for the 199A deduction, but W-2 wage income does not, resulting in a higher effective tax rate (plus associated payroll taxes) on wage amounts compared to qualified business income. Nonetheless, the rules require an S corporation to pay reasonable compensation in all cases. Generally, both wage and K-1 amounts from an S corporation are reported simultaneously on the owner’s return, so minimizing compensation offers a favorable tax rate arbitrage, but failure to pay reasonable compensation spells trouble when it comes to IRS examinations and the calculation of accuracy-related penalties, particularly after TCJA changes in penalty thresholds. Service partners in partnerships also face a reasonable compensation standard when guaranteed payments are in use.
Under 199A, businesses qualify at any size or income level, other than those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, certain financial or brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more employees. These specified service activities qualify only if the owner’s taxable income does not exceed $315,000 for MFJ ($157,500 for single), when phase-outs begin to apply.
Importantly, while the deduction is available to taxpayers in these specified fields up to $315,000, the W-2 wage limit is also phased in for individuals as taxable income rises over $315,000 for MFJ ($157,500 for singles). Effectively, there is no wage limitation below these thresholds.
The final legislation also allows the deduction to trusts. C corporations do not qualify for 199A benefits, presumably because they already benefit from a preferential 21 percent income tax rate, but all other taxpayers are permitted the deduction.
Contractual relationships might be reconsidered in light of this new benefit to manage the three relevant components of this deduction: 1) the business income, 2) W-2 wages plus the unadjusted basis of depreciable property, where applicable, and 3) the owner’s adjusted taxable income. Some taxpayers may want to consider adjusting wage agreements and transactional arrangements to increase qualification, where appropriate.
With a top individual tax rate at 37 percent, and a 20 percent business income deduction potential, this provision has an approximate equivalence to a 7 percent rate reduction, bringing the effective rate potentially as low as 29.6 percent (37 percent top rate, less a 20 percent exclusion = 29.6 percent).
Because W-2 wages alone may not support a maximized deduction, many real estate companies will rely in part on the 2.5 percent of unadjusted depreciable basis test to maximize this deduction. Further, given the propensity for real estate operating and holding entities to be taxed as partnerships, it may be prudent to review partner incentives because “guaranteed payments” reduce 199A qualifying income (and do not contribute to W-2 wages). Though guaranteed payments are unlikely to be eliminated, alternatives based on profit sharing, waterfall allocations, and the use of management companies may contribute to increased qualified business deductions.
Many real estate owners have grown accustomed to the basis and at-risk rules applicable to entity interests owned, and the passive activity rules applicable to activities within those entities (and often grouped using various strategies to minimize loss limitations each year). Real estate investors often use single-purpose entities, and the number of reported entities and activities can become sizable. Now, these investors face a new chessboard of calculations required to qualify for Section 199A benefits. These new calculations will occur after all passive limitation calculations have been completed, and excess loss limitations (discussed below) considered.
We do not yet know if the 199A evaluation will be made with reference to entity or activity treatment already in use for basis or passive reporting, or if the IRS will formulate a new approach. In any case, the qualified business income will be taken times 20 percent and compared to the business income, W-2 wages, unadjusted basis of depreciable property, and the owner’s adjusted taxable income.
Many real estate activities produce tax losses. It is important to note that 199A-qualified losses may more quickly offset qualified income than might be expected. By way of an oversimplified example:
A MFJ taxpayer with a rental property earning $400,000 might expect to qualify for a 199A deduction of $80,000. If there are no wages and the qualified asset base is $2 million, the 199A deduction is limited to $50,000 (2.5 percent of qualified assets). If there is a second rental property with a $250,000 loss, the 199A deduction is apparently reduced to zero, regardless of the wages or asset base in the second property. Taxpayers expecting any portion of the $400,000 to yield a deduction will be disappointed.
If, in the following year, the loss property is sold at a $300,000, long-term gain taxed at 20 percent, 199A might not be relevant, and the loss of the 199A deduction potential of the profitable property in year one may become essentially permanent.
In a year where there are many real estate (or other) businesses with a mix of both income and losses (potentially of varying character), the need for further IRS guidance becomes evident.
The unique features of a REIT and the impacts of tax reform alter the traditional real estate entity choice framework. Real estate has the option to use the unique REIT structure in lieu of more common partnership or corporate alternatives. REITs maintain qualification by holding requisite amounts of real property interests and distributing 90 percent of earnings annually to investors pooled in groups of 100 or more.
REITs qualify for the new 21 percent corporate tax rate, but REIT dividends are deductible, and 90 percent of earnings must be distributed annually. Those REITs that retain some earnings will benefit from the 21 percent rate on those earnings, a significant improvement over the 35 percent rate of the prior law. Recipients of REIT dividends benefit from capital gains rates (generally 20 percent) on dividends funded by gain transactions (plus a possible 3.8 percent net investment income tax, or NIIT), while other qualified REIT dividends benefit from the 199A deduction (a deduction of up to 20 percent of qualified REIT dividend income). This 20 percent 199A deduction is allowed on ordinary REIT dividends regardless of wage or net invested capital tests. A 0.9 percent Medicare tax, however, may apply.
REIT dividends received by a C corporation are taxed at 21 percent plus, eventually, a second tier of taxation when it pays dividends to its shareholders (potentially, about 19 percent more, including NIIT*). In contrast to a C corporation, ordinary REIT dividends paid to non-corporate shareholders qualify for the 20 percent Section 199A deduction, and if those dividends are received by an individual in the top 37 percent bracket, they will bear a 29.6 percent (37 percent reduced by 20 percent = 29.6 percent) net tax cost (plus potential unearned income Medicare tax). Certain REIT dividends may qualify as capital gain dividends, and these would qualify for a 20 percent rate to non-corporate recipients plus, potentially, a 3.8 percent NIIT. This offers a single flow-through rate on, potentially, 90 percent or more of ordinary REIT earnings.
This compares favorably to real estate trade or business activities in a traditional partnership structures where a similar 20 percent rate would be applied to capital and Section 1231 gains on real property, while ordinary income flowing through to individuals will qualify for a similar 29.6 percent effective rate.
These partners, however, will have to meet the wage and invested capital tests to secure their 199A deduction.
While in many instances the single-level of tax imposed in a REIT structure will be preferable, REITs should also consider the tax impact of becoming a C corporation, particularly where earnings will be reinvested for a significant period of time. REITs may want to consider converting to a C corporation both for the attractive initial tax rates and the operating flexibility. Real estate operating companies in C corporation form will be taxed at a 21 percent corporate rate, plus a second level of tax to the shareholders as dividends are paid, but C corporations avoid many limitations that constrain REIT actions (the 90 percent distribution requirement, limitations on service offerings, and qualifying asset requirements). While the second tier of tax may raise the effective rate to near 39 percent*, if a substantial portion of the distribution is deferred, the present value of the tax burden on the dividend payment is lessened.
As with other taxpayer types, REITS are now subject to the interest expense limitations and related real property depreciation elections, the net operating loss utilization limitations, and the carried interest rules.
*After corporate level taxes of 21 percent have been paid by a C corporation, 79 percent remains undistributed. If the distribution is of ordinary qualified character and occurs at current rates, the C corporation shareholder pays an additional 20 percent dividend tax rate plus 3.8 percent Medicare tax on the distribution, adding tax of 23.8 percent to the 79 percent distribution. This effectively adds 18.8 percent to the federal tax revenues at the time of distribution, plus the 21 percent paid initially by the C corporation for a total tax of about 39 percent. Top federal rates are used here. Actual federal rates may be lower for some non-corporate taxpayers. State income taxes, if applicable, may raise the total effective tax rate.
A carried interest is a share of the profits of a real estate or other venture that is provided as an incentive to the venture creator or investment manager. Going forward, a three-year holding period is required to receive long-term capital gain treatment for carried interests received in connection with the performance of services. Because interests in real property activities generally create a long-term performance incentive maturing after other investor performance thresholds have been met, the three-year requirement is unlikely to alter real estate business practices but will add challenges to deal formation.
This provision is complex. It applies to any non-corporate partner’s substantial service interests in a partnership having a business of raising capital or investing in, developing, or disposing of “specified assets.” This sweeps in real estate held for rental or investment, or related options or derivatives (among other things). There is a limited exception provided for interests taxed under Section 83, upon receipt or vesting. The IRS is provided authority to carve out additional exceptions and clarifications.
The three-year holding period applies to sales of assets held by the partnership directly or indirectly, or to the sale of the partnership interest itself. Further, the law provides that if an applicable partnership interest is transferred (other than by sale) to a related person, the transferor recognizes short-term capital gain. The rule may require short-term treatment of gain on disposition of the partnership interest or to capital assets held by the partnership for less than three years. In an unusual turn, “related” for this purpose includes certain family members as well as certain business associates within the past four years.
There appears to be no “grandfather” rule for partnership carried interests already existing at the time of passage of the legislation.
Taxpayers using umbrella partnership real estate investment trusts (UPREITs) should note that a conversion of UPREIT interests into REIT shares is generally a capital gain event. Conversions involving carried interests will now give rise to short-term capital gain to the carried interest holder where the holding period is less than three years. (The application of the carried interest rules to transactions involving S corporations remains unsettled.)
For the first time, deducting business losses exceeding certain limits will not be allowed in the current year, even if other taxable income is present. A non-corporate taxpayer’s aggregate deductions over the aggregate income in excess of $500,000 MFJ ($250,000 single) attributable to trades and businesses are not deductible and will carry forward as a net operating loss (NOL).
This rule increases the risks to real estate investors given that losses are common in the early years of a real estate project due to prolonged lease-up periods, accelerated depreciation, and interest expense. These losses may already be limited for passive investors, but for non-passive owners, including real property professionals, overall losses in excess of $500,000 are now limited.
The presence of an excess business loss is determined by aggregating all reportable net income or loss of all trades or businesses in the year (after application of basis and passive loss limitations). The single aggregated loss, to the extent it exceeds $500,000, becomes a net operating loss carryforward.
While the unused loss has an unlimited carryforward period, it can only be used to offset 80 percent of taxable income in carryforward years under the new NOL rules discussed below. Further, since individuals remain subject to AMT, loss utilization may be even more difficult when AMT applies.
Beginning with losses generated during the 2018 tax year, net operating loss utilization will be limited to 80 percent of (pre-NOL) taxable income. While NOLs will be eligible for unlimited carryforward, most carrybacks will no longer be permitted.
Real estate investing has historically been a cyclical industry. Under prior law, an NOL was eligible for a two-year carryback. A $1 million NOL might produce a $400,000 refund based on taxes paid in earlier, profitable years. This important source of funds in stressed financial times will no longer be available. In addition, using the NOL in future years remains complicated by the 80 percent limitation, as well as AMT.
Assume Betty, a real estate developer, has a $400,000 business loss in 2018, of which $300,000 is unused and becomes a NOL carryforward. In 2019, Betty has $400,000 of business income included in her $200,000 of taxable income. Betty can use $160,000 of her loss carryforward (limited to $200,000 taxable income times 80 percent) and carries forward $140,000. She has $40,000 of taxable income in 2019. Though this limitation has caused Betty to have a tax liability for 2019, the resulting taxable income allows for her use of low rate brackets, and possibly certain tax credits which might otherwise expire without benefit. So this limitation can have both benefits and detriments, depending on the circumstance.
Section 179 provides one of the elective provisions allowing the deduction of capital asset costs. In 2017, up to $510,000 of property additions can qualify for deduction. For tax years beginning in 2018, the new law raises the maximum amount deductible to $1 million for taxpayers with total qualifying additions below $2.5 million, after which qualification phases out.
The new law expanded the definition of real property eligible for 179 expensing. The qualifying expenditures include the cost of roofs, HVAC property, fire protection and alarm systems, and security systems used in nonresidential structures after the building is placed in service.
The law also expands qualifying 179 property to include depreciable tangible personal property used predominantly in connection with furnishing lodging. This will provide added deductions to landlords, who have not traditionally qualified to use this provision. Previously, qualified property included items used to furnish transient lodging (hotels and motels). Qualification is now extended to include furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment, dormitory, or other facility where sleeping facilities are rented on a non-transient basis (rental periods of more than 30 days).
The new law allows a 100 percent first-year deduction for tangible personal trade or business property (whether new or used) acquired and placed in service after September 27, 2017, and before 2023. This provision offers immediate deductibility to property with an applicable recovery period of 20 years or less, including most business equipment and some real property as well. However, property does not qualify if it has been used by the taxpayer at any time prior to its acquisition.
Although they may be real property as a general matter of law, many finishes and features in buildings may qualify for 100 percent write-off as property with a recovery period of 20 years or less. Certain floor covering, cabinetry, and decorative features are eligible and qualified improvement property may become eligible, as described below.
After 2017, the law consolidates existing depreciation rules applicable to qualified leasehold improvements, restaurant property, and retail property into a single category of qualified improvement property (QIP). As newly defined, it no longer matters if the property is subject to a lease, placed in service in a building more than three years old, or is a restaurant building.
Due to a drafting error in the TCJA, the depreciable life of QIP property is unspecified. This suggests a 39-year life for MACRS, and a 40 year life using the alternative depreciation system (ADS). This classification leaves QIP ineligible for bonus depreciation. Congressional conferees clearly intended QIP to be depreciated on a 15-year straight line method with a half-year convention (or ADS life of 20 years for electing taxpayers). A technical correction to remedy this is anticipated in 2018. QIP qualifies for Section 179 under existing language.
The general depreciable lives of real property remain at 27.5 years for residential and 39 years for nonresidential assets, but ADS lives are shortened for residential property from 40 to 30 years.
Taxpayers subject to the interest expense limitation discussed below may escape that limit at a cost of using ADS in depreciation calculations. The election, if made, applies a straight line depreciation life of 40 years to nonresidential property, 30 years to residential property and, ostensibly, 40 years to QIP. Bonus depreciation is generally not applicable to ADS property.
If the election is not made, taxpayers would apply the straight line method to lives of 39, 27.5 and, apparently, 39 years to such property, with Section 179 expensing allowed where applicable. In the event of a technical corrections bill, a 15-year life and bonus depreciation could potentially be available on the QIP assets. The costs of deferred depreciation under ADS will need to be compared to the cost of deferred interest expense deductions on a case-by-case basis. Depreciation (including Section 179 and asset expensing) of five- and seven-year assets is generally not affected by this election.
Cost Segregation Studies
A cost segregation study identifies property costs which can be depreciated at an accelerated rate using a shorter depreciable life than the 27.5 or 39 year terms commonly assumed. These studies consistently accelerate deductions and offer attractive tax deferrals to clients. Now, with tax reform, those deferrals have transformed to partially permanent savings as rates have fallen. A tax rate drop of ten points means when the tax liability comes due, it comes at a much lower rate than ever before, a windfall for clients who were primarily attracted to cost segregation for the opportunity to defer the day of reckoning by 10, 20, or more years by effectively managing the stream of cost recovery deductions.
Cost segregation remains an effective tax tool. With more deduction opportunities than ever, the cost segregation service is compelling and can still be done now for investments in 2017 and prior years, with those deductions still claimed against the high-rate 2017 tax. This is a great year to consider a cost segregation evaluation.
Interest expense continues to be fully deductible for taxpayers (except for tax shelters) with three-year trailing average annual gross receipts of less than $25 million. Above this level, limits begin to apply. The disallowance for tax years through 2021 is for net interest expense (interest expense less interest income) in excess of 30 percent of the business’s adjusted taxable income. This adjusted taxable income is calculated by adding back any deductions for depreciation, amortization, depletion, interest, the section 199 deduction, non-business income, and NOL carryovers.
Pass-through entities must make a determination at the entity level. If 30 percent of the adjusted taxable income of the pass-through entity exceeds the interest incurred by the entity, the excess passes through to the owner as “excess taxable income” and can be taken into account in computing the amount of business interest that can be deducted by the owner.
If an S corporation has interest expense in excess of the limitation, the excess carries over at the entity level until the corporation generates enough income to absorb the interest. If a partnership has interest in excess of the limitation, the excess interest is allocated to the partners with the excess interest carried over at the partner level until the partner is allocated excess taxable income from that entity. The result is that an S corporation shareholder does not reduce its basis in the S corporation stock until the interest is deducted, but a partner reduces its basis in the partnership when the interest is incurred, even if not yet deductible. Importantly, there is a specific election available to real property trades or businesses. These businesses, which generally include real property development, construction, acquisition, rental, management, or brokerage, may elect out of interest limitations altogether, although they must then apply ADS to depreciate applicable real property used in the business.
Although the final legislation was silent on how to apply this to the hospitality industry, some guidance can be found in the House-Senate Conference Report. The report states that the real property trade or business definition includes operation or management of a “lodging facility,” and, generally, a lodging facility includes an apartment, hotel, motel, dormitory, or any other facility where sleeping accommodations are let. The IRS has the authority to narrow this definition in implementing the rules, so we suggest taxpayers in the hospitality industry proceed cautiously and look to further IRS guidance.
The IRS has not yet determined the mechanics of making the real property trade or business election. The election is irrevocable and does not appear to be annual, so considerable long-term planning may be needed to evaluate the costs and benefits of such a decision.
Since the benefit of this choice (in the form of faster interest expense deductions) is reduced by the cost of deferred depreciation, it may be advantageous to hold interest-producing debt in the same entity as non-depreciable land, while depreciable assets are held separately in an equity-financed venture.
Historically, like-kind (Section 1031) exchanges have been commonly used to defer gains on both real and personal property when business or investment assets are exchanged for qualifying replacement assets to be held for use in a business or for investment. The new legislation retains the provision for real property but repeals its application to other assets. Exchanges which are in-process at year-end will be allowed to complete under the old law. Generally, a 180-day period is allowed to complete an exchange transaction.
Exchanges sometimes include mixed elements of real and personal property, and, though the personal property is generally minor, these will now be taxable components of an otherwise qualifying transaction. Note that where a cost segregation has been done, many assets eligible for short tax lives may be identified. Most of these short-lived assets are real property and continue to qualify for deferral when properly replaced (e.g., carpeting, cabinetry, or signage), but personal property assets become taxable (e.g., vehicles, desks, trade name, and tenant list).
Frequently, real property exchanges involve combinations of several elements, such as:
- Land improvements
- Built-out improvements (including assets classified as short-lived, Section 1245 assets like carpeting, millwork, and decorative features)
- Depreciable personal property (such as furniture, appliances, and tools)
Previously, Section 1031 applied to all these asset groups. After tax reform, however, the depreciable personal property and intangibles no longer qualify for exchange. The exchanges of all real property assets continue to qualify as elements of a real property exchange, regardless of tax life or character under Sections 1245, 1250, or other sections. Where real property Section 1245 assets are disposed, however, replacement real property of Section 1245 property of similar value is required to avoid recapture.
This may cause technical issues for some S corporations holding real estate that are subject to the Section 1374 built-in gains tax, because the gain from the sale of personal property cannot be offset by immediate expensing of the replacement property. For ventures in partnership form, the disposition of Section 704(c) personal property assets (appreciated personal property contributed to a partnership by a partner) may result in gain solely to the contributor partner, while replacement asset depreciation is allocable based on the entity’s profit-loss ratio. Those electing out of the interest expense limitation may need to apply ADS lives to some replacement property, further increasing the impact of this partial 1031 repeal.
Beginning in 2018, an accrual basis taxpayer must include items in income no later than the tax year in which such income is taken into account as income on an applicable financial statement. An exception exists for long-term contracts, which follow existing rules in Section 460. Likewise, Section 467 provides special tax accounting rules differing from GAAP for real property leases where rent payment streams are uneven throughout the lease term. We expect the provisions of Section 467 will continue to apply, even if the reported taxable income represents a deferral compared to the financial reporting presentation.
The new law codifies the one-year-only deferral of the advance payment rule the IRS has used administratively since 2004. This allows income to be deferred for one taxable year after receipt if it conforms to reporting in the taxpayer’s applicable financial statement (or under special rules for taxpayers without an applicable financial statement). The method is useful for deferrals for rental income involving substantial services integral to the rental (e.g., hotel, motel, or trade show rentals), but is not generally applicable to other real estate rentals.
The new rule applies only to accrual method filers, so taxpayers using the cash method with average revenues below $25 million would be among those exempted from this revenue deferral restriction.
This provision applies only to revenue recognition and does not alter existing expense recognition treatments.
Since 2002, the IRS has allowed safe-harbor use of the cash method for many small taxpayers. Beginning in 2018, the cash method is allowed for taxpayers (other than tax shelters) with three-year trailing average revenue of $25 million or less. Importantly, this exception is also extended to C corporations, and partnerships with C corporation partners, in place of a historic requirement permitting the cash method for C corporations only when revenues were below $5 million.
Many partnerships are required to use the accrual method because they include a corporate partner. This no longer prohibits the use of the cash method if the revenue threshold can be met. Keep in mind that the $25 million revenue test requires the inclusion of relevant related party revenues.
The cash method has also been available to service and other businesses without inventories, regardless of revenues (for example, law firms or brokers). These rules have not changed. Some real estate businesses may also qualify under these historic rules and may therefore be eligible for the cash method even above $25 million, though procedures for obtaining IRS approval for the cash method are more challenging at higher revenue levels.
The cash method can be a highly effective method for tax planning, but it is unavailable for “tax shelters.” This term encompasses several types of ventures but, importantly, in loss years, it sweeps in many limited liability entities under the umbrella term “syndicates.”
A syndicate includes a partnership, joint venture, or S corporation that allocates more than 35 percent of its losses to limited partner or entrepreneur owners who do not actively participate in the management of the venture. Many real estate ventures with significant numbers of partners may fall under this definition and, in these cases, the entity would be required to use the accrual method regardless of revenue levels.
Many small businesses (in particular, those with average annual gross receipts less than $10 million) may still qualify to change to the cash method on their 2017 tax returns. While the accrual method is convenient for many taxpayers, a cash method election may be more effective in deferring income and can be particularly attractive when tax rates decline, as they have between 2017 and 2018. Such a change requires the filing of a Form 3115, Application for Change in Accounting Method, and often results in a sizable taxable income reduction in the year of change. While a change to the cash method can offer excellent tax deferral to some taxpayers, other taxpayers benefit from the opposite change, from the cash to the accrual method. All taxpayers should review their method options in light of the new law.
After 2017, any producer or reseller with average revenues less than $25 million is exempted from tax accounting requirements under the uniform capitalization rules of Section 263A (UNICAP). The UNICAP exemption applies to manufacturers, distributors, or retailers, but the rule also applies to developers and producers of real property. For real estate-related enterprises using the completed contract method, 263A capitalization adjustments will no longer be required if the $25 million test is met. The exemption also applies to self-constructed property of qualifying taxpayers (e.g., spec homes or self-developed projects) and construction period interest of Reg. Sec. 1.263A-8. Other exemptions from UNICAP remain unchanged.
In addition to the cost capitalization rules of Section 263A, two other provisions are important to the capitalization of costs of property held for sale to customers. While not repealed, the traditional Section 471 rules for inventory accounting have become more flexible for taxpayers below the $25 million-or-less threshold. Real estate held for sale (for example, residential lots, condominium units, and other dealer properties) is not technically inventory (a term generally limited to “merchandise”), so the new Section 471 exemption is generally limited to dealer property held for sale, other than real property. Generally, few assets of real estate dealers are inventories under Section 471, so the enhanced exemption is of narrow application in real estate firms.
Though not Section 471 inventory, for real property held for sale by dealers with revenues below the $25 million threshold, real property project costs still face capitalization under Section 263(a)* for new buildings, permanent improvements, or betterments. Generally, capitalization of costs of acquisition and construction is still required, though the capitalized amounts may now exclude indirect costs. Capitalization of costs to development projects, and within projects, becomes more flexible with the $25 million average revenue exemption. Taxpayers that can meet the revenue test should consider different treatment of real property “inventory” costing for projects beginning after 2017.
*Section 263(a) addresses a range of transactional costs of capital expenditures but is separate and independent of Section 263A, which deals more narrowly with inventory and production costing. The two should not be confused, and the TCJA does not provide any revenue-based exemption from 263(a).
Many real estate developers who contract to deliver improved real estate may fall under special rules for long-term construction. For tax purposes, contractors may include nearly any business that commits to the delivery of improvements to real property, and such contracts not completed in the year they begin are classified as long-term. These long-term contracts must generally report using the percentage-of-completion method, unless they are exempted under Section 460.
For contracts entered into after December 31, 2017, the definition of an exempt contract has expanded, allowing taxpayers several alternatives to the percentage-of-completion method. Since 1986, contractors with three-year trailing average gross receipts of less than $10 million have been exempt. The threshold is now raised to $25 million.
This provision opens the door to the use of the cash, completed contract, and other methods for many more developers. These alternative methods can yield substantial income deferrals for regular tax, but AMT will continue to require a long-term contract (LTC) adjustment to the percentage-of-completion method for taxpayers other than C corporations. With a narrowing of the rate between regular tax brackets and AMT, the value of the deferral will be smaller, in percentage terms, for those subject to AMT.
C corporations may exclude from taxable income certain non-shareholder contributions to capital under Section 118. The new law generally provides that such contributions 1) do not include any contribution in aid of construction or any other contribution from a customer, and 2) any non-shareholder contribution by a governmental entity or civic group.
While this will not apply to a contribution made after enactment by a governmental entity pursuant to a master development plan approved prior to December 22, 2017, future projects may need alternative structures. Tax increment financing and similar government development assistance will need to take account of the new rule.
The new law provides for the designation of certain low-income community population census tracts as qualified opportunity zones. The designation is made by application of the states to the U.S Treasury and, once approved, lasts for 10 years.
Gains on any property realized by a taxpayer may be reinvested on a tax-deferred basis in a qualified opportunity fund and may qualify for permanent exclusion from income upon the qualified sale or exchange of an investment in the qualified opportunity fund. The fund is an investment vehicle holding at least 90 percent of its assets in qualified zone property. The maximum deferred gain equals the qualifying amount invested in the fund during the 180-day period, beginning on the date of sale of the gain asset.
At the election of the taxpayer, after an investment is held for designated periods, the basis of the investment is adjusted higher. Adjustments are made after five and seven years and, in the event a holding period of 10 years is reached, basis is adjusted to the fair market value of the investment at the date of the sale or exchange of the investment. Taxpayers continue to be allowed losses associated with investments in qualified zone funds.
S corporations must have only qualifying owners such as individuals and qualified estates and trusts. Nonresident alien taxpayers have not been permitted as shareholders historically. The new law permits a nonresident alien individual to be a potential beneficiary of an electing small business trust (ESBT) beginning January 1, 2018. This narrow expansion of qualification may permit certain trusts to meet or continue to meet ESBT qualification.
Most business meals are only 50 percent deductible. The new law expands this rule to include meals provided through an in-house cafeteria or otherwise on the premises of the employer. Entertainment expense are fully disallowed, eliminating the need to determine when such expenditures are business-related. Documentation of the qualifying nature of entertainment expenses for tax purposes will no longer be necessary. In spite of these limits, the cost of recreational and social activities primarily for the benefit of employees (e.g., a company-wide barbeque or holiday party) continues to be fully deductible.
For court orders on or after the date of enactment, no deduction is allowed for any otherwise deductible amount paid to a government or specified nongovernmental entity relating to any violation of law, or the investigation or inquiry into a potential violation. An exception applies to payments for restitution (including remediation of property) or amounts required to come into compliance, provided they are identified as such in the court order or settlement agreement. An exception also applies to taxes due, if they would have been deductible if paid in a timely manner.
Government agencies are required to begin reporting of settlements greater than $600 at the time of the settlement.
Any settlement, payout, or attorney’s fees related to sexual harassment or sexual abuse will be nondeductible if the settlement or payment is subject to a nondisclosure agreement.
Lobbying expense deductions with respect to legislation before local governments (including Indian tribal governments) are eliminated.
The 20 percent certified historic structure rehabilitation credit has been retained and can be claimed over a five-year period beginning with the rehabilitated structure’s placed-in-service date. The less generous 10 percent credit for qualified rehabilitation expenditures for pre-1936 buildings was repealed. A transitional rule allows taxpayers owning any such building on and after January 1, 2018, 180 days, beginning on the date of enactment, to begin certain qualifying rehabilitation project measurement periods of 24 or 60 months.
WOTC remains unchanged from the current tax law and available to employers with W-2 employees. Many employers have found significant savings related to hiring employees from targeted groups. The groups qualifying an employer for credit include qualified veterans, ex-felons, food stamp recipients, people who were previously unemployed for a period of six months prior to starting their new job, residents of rural renewal counties, and others. Any taxpayer who has payroll and tax liability will be able to take advantage of this opportunity, but appropriate procedures must be in place at the time of hire.
The TCJA preserves the New Markets Tax Credit program through the 2019 allocation round. The New Markets Tax Credit is designed to subsidize deals that might not otherwise obtain financing. If you have a building project proposal or are embarking upon a major renovation, the New Markets Tax Credit program can provide extensive cash benefits.
Although not included in the TCJA, on February 9, 2018, the Bipartisan Budget Act of 2018 extended numerous previously expired tax provisions through the 2017 year. Most important to the real estate industry are the Energy Efficient Commercial Buildings Deduction (Section 179D) and the Credit for Energy-Efficient New Homes (Section 45L), which expired December 31, 2016. Section 179D provides an accelerated depreciation deduction to the owner of energy-efficient property meeting certain standards or, in the case of a property owned by a governmental entity, it provides a deduction to the person primarily responsible for the design of the energy efficient property systems.
The Section 45L credit allows homebuilders whose projects meet certain energy efficiency standards to claim a tax credit for up to $2,000 per qualifying dwelling unit. Other real estate-related items in the extender legislation included certain depreciation rules for motor sports complexes, empowerment zone incentives, energy credit property incentives, and biofuel plant property. The qualified periods of these incentives are extended, but the baseline requirements are the same.
For wages in tax years beginning after December 31, 2017, and before January 1, 2020, there is a new credit equal to 12.5 percent of wages paid to qualifying employees during periods in which they are on family and medical leave (FMLA) if the rate of payment of the wage is at least 50 percent of normal. The credit is increased by 0.25 percent (but not above 25 percent) for each percentage point by which the payment exceeds 50 percent. All qualifying full-time employees must be given at least two weeks of annual paid family and medical leave (and all less-than-full-time eligible employees must receive a commensurate amount of leave, pro rata). Note that leave mandated or paid for by a state or local government does not count for purposes of this credit. Also, the credit does not apply to highly-compensated employees ($72,000 of annual compensation in the prior year).
Estate and gift tax
The estate tax is a tax on estate values in excess of certain exclusion thresholds at the time of death, while the gift tax is imposed on certain cumulative transfers during life. Current exclusion thresholds are roughly doubled in 2018, from $10.98 million for married couples ($5.49 million single) to $22.36 million ($11.18 million single). The step-up in basis at death is also preserved. Because of the equity frequently accumulated in real estate assets as well as appreciation patterns, and long-term hold characteristics of real property, these improved estate tax exemptions offer important benefits for real estate owners. The rising exemptions are a staircase to a new level of estate and succession planning. When effectively used, they help ensure that heirs are not forced to sell property just to cover their estate tax bill, and that family-owned property developers and managers can pass their businesses on to the next generation.
Since the generation-skipping transfer tax exemption amount is based on the estate exclusion amount, the generation-skipping transfers will also see an exclusion increase.
In light of the substantial increase in exemptions, along with the many changes in the income tax systems, most taxpayers who would have had taxable estates prior to reform will want to have their estate plans reviewed to take advantage of the improved flexibility for their estates, as well as in planning for lifetime giving.
International real estate investment
Investors may find the United States to be increasingly attractive both due to the strong economy and the new and lower tax rates. Whether a foreign investor is an individual or a corporation, many of the law changes are favorable.
Persons who have traditionally invested through foreign corporations or U.S. C corporation blocker structures will now benefit from the reduced 21 percent corporate tax rate on operating and exit income. Leveraged blocker structures will have to navigate the new interest expense limitation provisions discussed above. Any interest deduction at the fund level may not be limited, as there is a special election for real property trades or businesses to elect out of the interest expense limitation regime if they utilize the ADS depreciation system. Issues may arise related to the interest expense on debt at the blocker level. The new law raises the question of whether the blocker is engaged in a trade or business and whether the interest at the blocker level qualifies as business interest. In addition, it appears the fund level income allocated to the blocker is generally not included in the blocker’s income for purposes of the 30 percent limitation. This could mean the interest would not be deductible at the blocker level unless there were other sources of taxable income. Careful analysis is needed to evaluate the future benefit of leveraged blocker structures.
Those investing directly or through trust structures remain eligible for favorable long-term capital gains rates on an exit of an interest in a fund or any allocated gain from the sale of the underlying asset. In addition, the new condensed individual rates and lower top tier bracket will be favorable for any operating income generated, which is subject to the ordinary tax rates. Non-resident individuals are also eligible for the benefits provided by the new section 199A if all of the other qualifications are met.
Support the real property industries
At CLA, we encourage all of our clients to maintain relationships with their elected representatives in Congress and in state offices. Talk to your representatives about how this legislation affects you. We also suggest connecting with NAIOP, the Commercial Real Estate Development Association, Urban Land Institute, and other industry associations who continuously monitor legislative activities and provide advocacy.
By participating in the legislative process in 2017, the cooperation of grassroots industry professionals and association advocates preserved private activity bonds, low-income housing incentives, work opportunity tax credit, new markets credit, certified historic structure rehabilitation credit, and like-kind exchanges of real property, just to name a few of the successes. These efforts greatly improved the TCJA legislation and the enduring health of our industry.
Several provisions of the new law apply a $25 million revenue threshold. This revenue test is consistently based on a three-year trailing average of gross receipts, computed on an aggregated basis of all related entities. Related party testing is complex but generally uses a 50 percent common ownership test.
Using the cash method and other exemptions that rely on this test offers simplicity and may create significant tax benefits; however, caution is warranted given the complex related party rules involved. Each exemption is independently elected and can be used in any combination the taxpayer chooses.
What happens when my revenues climb above $25 million?
- A change to the accrual method may be required.
- Long-term contracts must begin to apply the percentage-of-completion method.
- Sections 471 and 263A inventory rules must be applied.
- Interest expense limitation rules must be followed.
- Revenue deferrals may become limited to financial statement practices.
- Accounting method change applications are required for each of the above. In the event revenues fall below $25 million, the opposite method changes should be available.
How we can help
This article is an overview of the TCJA legislation and is intended as an educational tool, not as a substitute for competent professional advice. Plans for your business should be made in consultation with your professional advisors. Some elements of this article may change during the coming year, but CLA’s real estate professionals will continue to follow the legislation as it is clarified and implemented. Our resources and our professionals can help you plan for changes in your organization as we adapt to this new business environment.