Construction Site Sunrise

As the major new tax legislation takes effect, you can prepare to take advantage of rate cuts and policy shifts with well-crafted strategies.

Tax strategies

Reconstructing Taxation: Strategies for Construction

  • Perry McGowan
  • Nick Graff
  • 1/22/2018

The highly anticipated tax legislation has completed its epic journey through Congress. The Tax Cuts and Jobs Act offers several rate cuts and improved expensing treatment for pass-through and corporate businesses, including some special changes aimed exclusively at the construction and real estate industries.

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.

This article is focused on the impacts on, and opportunities for, construction and real estate businesses, including those operating as pass-through entities and C corporations.

As this legislation has evolved, CLA has been working closely with Associated General Contractors of America (AGC) and their congressional liaisons to advocate for the unique needs of the real estate marketplace. AGC serves as an important voice to those who craft legislation but who may be unfamiliar with practical realities of real property business. AGC and similar industry trade associations have worked to promote a healthy real property economy. The AGC has summarized some of the key aspects of the legislation, the features of which are discussed more fully below.

Tax strategies for your business

This legislation offers immediate opportunities. We suggest that contractors, developers, investors, and real estate operators carefully consider their tax strategies and discuss their options with industry-focused tax professionals.

Alternative minimum tax (AMT)

The AMT is repealed for C corporations, but AMT credits carry forward and become refundable over the 2018 – 2021 tax years.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. Any residual AMT credits are 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 small construction contractors and certain developers have AMT adjustments related to long-term contracts (LTCs). These adjustments will arise when LTCs use special methods of accounting, such as completed contract or the cash method, which often yield more significant income deferrals than the percent complete method (PCM). In addition, the new definition of “small contractor” will increase the number of taxpayers eligible for these favorable deferral methods. We anticipate that AMT, when it arises on LTCs, will generally give rise to usable AMT credits, though careful planning is recommended.

Like in previous years, low-rate dividends and capital gains may trigger the AMT. Further, at lower income levels the spread between regular tax and AMT may make it more challenging to use some tax credits.

The new Section 199A

For a dozen years, contractors, architects, and engineers have benefitted from the Domestic Production Activities Deduction (Section 199 or DPAD), which provided a 9 percent deduction for qualifying income. It represented a roughly 3 percent rate reduction for qualified real property improvement work in the U.S., including its construction, design, and engineering. This industry-specific provision is replaced by Section 199A, which offers a 20 percent income reduction for a much broader category of qualified income.

Similar to the old DPAD, the deduction of 20 percent of income may not exceed 50 percent of wages paid or 20 percent of modified taxable income. Pass-though entities that are limited by the 50 percent of W-2 income rule can use a substitute limit. This allows, for example, a real estate rental business which does not have W-2 wages to qualify for the deduction based on the unadjusted depreciable basis of the building rented.

In general, reasonable compensation must be paid to owners (via W-2 to S corporation owners or via guaranteed payments to partners), and only the net business income after subtracting the owner compensation is eligible for the 199A deduction. Unlike DPAD, the 199A deduction is limited by 20 percent of adjusted taxable income, rather than DPAD’s somewhat larger adjusted AGI.

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: the business income, the W-2 amount, and the owner’s adjusted taxable income. Some taxpayers may want to consider wage amounts 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, about twice the previous DPAD value.

Overall, most construction jobs require wages far in excess of that required to meet the 50 percent limit, but contractors with insufficient wages should consider planning.

Going forward, entities taxed as partnerships (including LLCs) might want to consider alternatives to guaranteed payments, where appropriate, since they reduce 199A qualifying income (and do not contribute to W-2 wages). Though guaranteed payments are unlikely to be eliminated, alternatives based on profit share or waterfall allocations will yield more tax benefit in the new qualifying business income deduction.

Carried interests

A carried interest is a share of the profits of a real estate or other venture that are 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 these interests in real property activities are generally a long-term performance incentive maturing after other investor performance thresholds are met, the three-year requirement is unlikely to alter real estate business practices.

Excess business losses

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 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 construction contractors. For example, a single owner S corporation that loses $2 million during the year may need a capital infusion from the owner. The owner withdraws $2 million from a retirement plan, creating taxable income. Because the business loss is limited to $500,000, the owner has taxable amounts totaling $1.5 million, and an associated tax bill, likely consuming scarce dollars with tax payments at a time of stretched financial resources.

Net operating loss limitations

Beginning with losses generated during the 2018 tax year, net operating loss 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.

Construction is a highly cyclical industry. Under former 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.

Increased Section 179 expensing

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 under Section 179. 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. Section 179 is expanded to include certain depreciable tangible personal property used predominantly to furnish lodging. This will provide added deductions to landlords, who have not traditionally used this provision.

Certain real property is eligible for 179 expensing. The qualifying expenditures include the cost of roofs, heating, ventilation, air-conditioning, fire protection, alarm systems, and security systems.

Temporary 100 percent cost recovery

For property acquired and placed in service after September 27, 2017, and before 2023, the new law allows a 100 percent first-year deduction for both new and used property. However, property does not qualify if it has been used by the taxpayer at any time prior to its acquisition.

This provides construction contractors an opportunity to reduce taxable income for new and used property additions placed in service by the end of the tax year. Real estate owners may have building additions qualifying for 100 percent expensing. 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, decorative features, and qualified improvement property are eligible for 100 percent bonus depreciation.

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). Due to a drafting error in the legislation, the depreciable life of QIP property under Modified Accelerated Cost Recovery System (MACRS) and ADS is not specified.* Recovery is expected to be on a 15-year straight line method with a half-year convention (or alternative depreciation system (ADS) life of 20 years for electing taxpayers).* 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. The general depreciable lives of real property remains 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 is expected to apply straight line depreciation to lives of 40, 30, and 20* years for nonresidential, residential, and QIP, respectively. 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 15* years to such property, with Section 179 expensing and bonus depreciation potentially available on the 15* year 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 short-lived assets is generally not affected by this election.

$25 million revenue testing

Several provisions of the Act 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.

Interest expense limits for your business

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, interest expense 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). 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, where the excess interest limitation or excess taxable income is determined, before passing to the individual level where it may be adjusted by passive limitations or other items. Interest expense which is limited for an entity continues to be limited until the pass-through owner is allocated excess taxable income from that entity.

Importantly, there is a specific election available to real property trades or businesses. These businesses, which generally include 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. The IRS has not yet determined the mechanics of making the 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 in individual cases.

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.

Like-kind exchange transactions limited

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).

Construction contractors frequently exchange construction equipment and vehicles. These assets will no longer qualify for exchange deferral. However, replacement assets may qualify for expensing under the Section 179 or 100-percent cost recovery discussed above, yielding the same net result. However, it will be important to place the replacement property into service in the same year as the disposal.

This may cause technical issues for some S corporations that are subject to the built-in gains tax because the gain from the sale of equipment 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 interest expense limitation may need to apply ADS lives to some replacement property, further increasing the impact of this partial 1031 repeal.

Limited revenue deferral

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 continue to follow existing rules in Section 460, discussed further below. The new law codifies the one-year-only deferral of the advance payment rule the IRS has used administratively since 2004. This provision applies only to revenue recognition and does not alter existing expense recognition treatments. The rule applies only to accrual method filers, so taxpayers with average revenues below $25 million using the cash method are exempt from this revenue deferral restriction.

Cash method

Since 2002, the IRS has allowed safe-harbor use of the cash method for many taxpayers. Beginning in 2018, the cash method is allowed for taxpayers (other than tax shelters) with revenues below a three-year trailing average revenue threshold of $25 million. 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.

Inventories

After 2017, any producer or reseller with average revenues less than $25 million is exempted from tax accounting rules applicable to inventory under Section 471. Qualifying taxpayers may either treat inventories as non-incidental materials and supplies, or conform to the taxpayer’s financial accounting treatment. This optional reliance on financial accounting treatment is somewhat a return to the practices in years before 1986.

The same $25 million test exempts these taxpayers from uniform capitalization rules of Section 263A (UNICAP). The UNICAP exemption applies to all producers or resellers (commonly manufacturers, distributors, or retailers). For real estate-related enterprises using the completed contract method, 263A capitalization adjustments will no longer be required if they meet the $25 million test. The exemption also applies to self-constructed property of qualifying taxpayers (e.g., spec homes or construction period interest and tax expenses of developers). Other exemptions from UNICAP remain unchanged.

Long-term contracts

For contracts entered into after December 31, 2017, the definition of an exempt contract has expanded, allowing for a variety of choices for long-term contract accounting methods (other than the percentage of completion method). Since 1986, exemption has been available for contractors with three-year trailing average gross receipts below $10 million. The threshold is now $25 million.

This provision opens the door to the use of the cash, completed contract, and other methods for many more contractors. These alternative methods can yield substantial income deferrals for regular tax, but AMT will continue to require an LTC adjustment to the percent 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.

Non-shareholder contributions to capital

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.

Investment in qualified opportunity zones

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.

Expansion of S corporation qualifying ownership

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.

Entertainment and meal expense restrictions

Most 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.

Legal settlement and lobbying changes

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.

Research expenditures and tax credit

The new law continues the research credit, though the deductibility of research costs is adjusted for tax years beginning after December 31, 2021. Research expenditures, including the cost of software development and depreciation and depletion allowances for property used in connection with the research, must be capitalized and amortized over a five-year period (15 years for certain foreign research), beginning with the midpoint of the year the expenses were incurred.

Where research property is retired, abandoned, or disposed of, remaining basis is not deductible except through the amortization procedure. Similar to current law, research deductions are reduced by research credits claimed.

Historic rehabilitation credit

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.

Employer-aid family and medical leave credit

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).

$25 Million Revenue Testing

Several provisions of the Act 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.

What happens when my revenues climb above $25 million?

  1. A change to the accrual method may be required.
  2. LTCs must begin to apply PCM.
  3. Sections 471 and 263A inventory rules must be applied.
  4. Interest expense limitation rules must be followed.
  5. Revenue deferrals may become limited to financial statement practices.
  6. 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.

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 AGC 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 have greatly improved the legislation and the enduring health of our industry.

How we can help

This article is an overview of the legislation. Plans for your business should be made in consultation with your professional advisors. CLA’s construction and real estate professionals will continue to follow the legislation as it is clarified and implemented in the coming year. Our resources and our professionals can help you plan for changes in your organization as we adapt to this new business environment.