The recently-enacted §199A Qualified Business Income (QBI) deduction has created an opportunity for substantial deductions for taxpayers who meet the requirements. In order to qualify for this deduction several criteria must be met and there are limitations based upon wages and property in a business. With respect to the real estate industry, one of the most important provisions is the limitation based on 25% of wages and 2.5% of unadjusted basis immediately after acquisition of qualified property or UBIA.
Qualified property means:
The most recent proposed regulations define the depreciable period as beginning on the date the property is first placed in service by the taxpayer and ending on the later of the date 10 years after that date, or the last day of the last full year in the depreciable period. For example, company X purchases a piece of machinery on November 18, 2014. The machinery is used in the business and is depreciated over five years. Even though the depreciable life of the asset is only five years, the owners of X will be able to take the unadjusted basis into consideration for purposes of the QBI limitation for ten full years, from 2014 through 2023, because the qualifying period runs for the longer of the useful life (five years) or 10 years. Consider the same facts, only the asset is a non‐residential rental building that is depreciated over 39 years. The owners of X will be able to take their share of the building’s basis into consideration from 2014 through 2052. These periods intentionally ignore any adjustments for accelerated depreciation or expense elections under §179.
The UBIA provision becomes complex when compounded with different types of property transactions. For instance, qualified UBIA property can be exchanged tax-deferred in accordance with §1031, contributed gain-free to a partnership under §721, or distributed gain-free to a partner with sufficient basis under §731.
A tax-advantageous transaction in the real estate industry consists of exchanging real property tax-deferred under §1031. In a §1031 exchange, the basis of the replacement property received by the seller is equal to the basis of the relinquished property (carryover basis). For UBIA, the depreciable period of any carryover basis begins with the placed-in-service date for the relinquished property. Any excess basis received caused by a trade-up in value is placed in service on the same date of the replacement property.
For example, in 2014, company X acquires a building for $1,000,000. In 2018, when the adjusted basis of the building is $600,000, X exchanges the building plus $250,000 in cash for another building in a §1031 exchange. X takes a split basis in the property. For $600,000 of UBIA in the replacement property, the depreciable period begins in 2014. For $250,000 of UBIA in the replacement property, the depreciable period begins in 2018.
Less common transactions are contributions and distributions of property to and from a partnership, so-called §168(i)(7) transactions. Like §1031 exchanges, a key issue with UBIA and these transactions are placed-in-service-dates and depreciable periods. Depreciation deductions begin when business property is placed in service. The “immediately after acquisition” portion of UBIA is defined as of the date the property is placed in service. When one of the non-recognition transactions occurs with qualifying UBIA property, two placed-in-service dates will exist.
The taxpayer receiving the qualifying property in a step-in-the-shoes transaction determines the placed-in-service date for the property using a two-step approach as defined by the regulations; Step 1: the portion of the transferee’s unadjusted basis in the qualified property that does not exceed the transferor’s unadjusted basis in such property is treated as placed in service on the date the transferor first placed the property in service. Step 2: any portion of the transferee’s unadjusted basis in the qualified property that exceeds the transferor’s unadjusted basis in such property is treated as separate qualified property that is placed in service on the date of the transfer.
To clarify, the proposed regulations provide a comprehensive example (truncated and modified for purposes of this article):
(i) C operates a business as a sole proprietorship. On January 5, 2011, C purchases Building Y for $100,000 and places it in service in C’s business. C’s basis in Building Y is $100,000. Building Y is qualified property. Assume that Building Y’s recovery period is 10 years. As of December 31, 2018, C’s basis in Building Y, as adjusted for depreciation deductions, is $25,000. On January 1, 2019, C incorporates the sole proprietorship and elects to treat the newly-formed entity as an S corporation for Federal income tax purposes. C contributes Building Y and all other assets of the trade or business to the S corporation in a non-recognition transaction under §351. The S corporation immediately places all the assets in service.
(ii) For purposes of the QBI UBIA limitation, C’s UBIA of Building Y from 2011 through 2018 is its $100,000 cost basis. S corporation’s UBIA of Building Y is determined under the applicable rules of subchapter C as of date the S corporation places it in service. Therefore, the S corporation’s UBIA of Building Y is $25,000, the basis of the property at the time the S corporation places the property in service. For purposes of determining the depreciable period of Building Y, the S corporation’s placed-in-service date will be the date C originally placed the property in service in 2011. Therefore, Building Y may be qualified property of the S corporation (assuming it continues to be used in the business) for 2019 and 2020 and will not be qualified property of the S corporation after 2020, because its depreciable period will have expired.
In summary, the proposed regulations for §199A provide a gambit of rules for determining the UBIA of qualified property. Taxpayers will once again have to increase their levels of record-keeping to properly track the separate service dates. If you have any questions related to how these rules apply to your tax situation, please reach out to a member of Withum’s Real Estate industry group.