On Friday, December 22, 2017 just in time for Christmas, the Tax Cuts and Jobs Act legislation landed on the President’s desk where he happily signed it. A historic event by anyone’s standards.
The following is a targeted discussion of the provisions in the law that will most impact businesses in the construction and/or real estate industry. Unless otherwise noted, the changes are effective on January 1, 2018. We can expect additional complications at the state and local level because many states automatically adopt federal changes and others may adopt them in part or in whole at some future date.
Owners of pass-through entities and sole proprietors will be able to claim a below-the-line deduction for 20% of their net qualified business income. Qualified business income does not include S-corporation wages, guaranteed payments for services, or investment income from a pass-through entity.
For taxpayers with income above $315,000 joint ($157,500 single), the 20% deduction is subject to the phase-in of two limitations:
Under prior law, non-corporate taxpayers’ ability to deduct losses from a business activity is limited by their tax basis, their amount at risk, and the passive loss rules. Taxpayers who overcome these hurdles will now be confronted with a fourth limitation. For tax years through 2025, excess business losses will no longer be deductible in the current tax year. Instead, those losses must be carried forward and treated as part of the taxpayer’s net operating loss in the subsequent tax year. An excess business loss is the excess of the taxpayer’s total trade or business deductions and losses over the sum of (a) their total income and gains and (b) $250,000 (single) or $500,000 (joint). With operating losses generated after 2017 only offsetting 80% of taxable income, rather than 100% under old law, this new provision is particularly harsh.
The depreciable lives for nonresidential real property and residential rental property remain at 39 and 27.5 years, respectively, under the new law. The favorable depreciation rules under old law for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property have been eliminated, and these previously separate categories are now consolidated under a singular “qualified improvement property” definition.
Qualified improvement property is any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the building was first placed in service. Qualified improvement property does not include any improvement that relates to the enlargement of the building, an elevator or escalator, or the building’s internal structural framework. The intent of the new tax law was to provide for a 15-year depreciable life for qualified improvement property, however, due to a drafting error in the statute, there’s nothing in the new law that actually provides qualified improvement property with a 15-year life. This glitch is expected to be corrected in a future “technical corrections” bill.
Bonus depreciation allows a taxpayer to immediately deduct a percentage of the cost of qualifying property in the year the property is acquired, rather than depreciating it over a period of years. For qualified property acquired and placed in service between September 28, 2017, and December 31, 2022, the bonus is 100%. Beginning in 2023, that bonus will decrease by 20% each year. In addition to increasing the bonus depreciation percentage, the definition of qualifying property was expanded to include used property.
Section 179 allows a taxpayer to immediately deduct a certain amount of the cost of qualifying property in the year the property is acquired rather than capitalizing that cost and depreciating it over a period of years. The maximum amount that can be expensed is increased to $1 million. This $1 million amount is reduced by the amount that the taxpayer’s total qualifying assets placed in service in the taxable year exceed $2.5 million. The definition of qualifying property is also expanded to include roofs, HVAC property, fire protection and alarm systems, and security systems in nonresidential buildings that are placed in service after the building is placed in service.
The deduction of business interest expense is limited to 30% of the taxpayer’s adjusted taxable income (“ATI”) . ATI is business income computed without the deduction of depreciation and amortization for tax years 2017-2021. After 2021, business income is reduced by depreciation and amortization. Taxpayers with average annual gross receipts that do not exceed $25 million (determined after applying the “aggregation rules” that capture controlled groups of corporations) are exempt from this limitation. Also exempt from the limitation is interest incurred on “floor plan” debt that’s used to finance the acquisition of motor vehicles, boats and “farm machinery and equipment” that are held for sale or lease and is secured by the “inventory.” Motor vehicles for this purpose means any “self-propelled” vehicle designed for transporting persons or property on a public street, highway, or road. Our construction equipment dealer friends, other than dealers in farm machinery and equipment, almost made it to the finish line to be included with the “floor plan” debt exemption, but unfortunately didn’t make it into the final tax bill. Complexities arise in determining the interest expense limitation in the case of partnerships (not S corporations). Any disallowed interest is carried forward indefinitely.
Taxpayers may elect to not have this limitation apply to any business involving real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. However, for property placed in service after December 31, 2017, these taxpayers are required to depreciate their nonresidential property using a 40-year life and residential rental real property using a 30-year life under the ADS system. Qualified improvements were intended to have a 20-year life under ADS system, however, until a technical corrections bill is crafted, as mentioned above, it is not clear.
Prior to 2018, a taxpayer could deduct 50 percent of business meals and entertainment and 100 percent of meals provided through an in-house cafeteria or meals provided for the convenience of the employer (i.e., de minimis fringe benefit). Under the new tax law, entertainment is no longer deductible and meals provided through an in-house cafeteria or for the convenience of the employer are subject to the 50 percent limitation. For tax years after 2025, meals provided through in-house cafeteria or for the convenience of the employer will not be deductible at all.
The rule allowing a 50 percent deduction for business meals and a 100 percent deduction for expenses incurred for recreational, social, or similar activities (including facilities, but not club dues) primarily for the benefit of employees (other than employees who are highly compensated employees) was retained.
Under the new law, the adjusted gross income limit for gifts of cash to public charities and certain other organizations is increased from 50 percent to 60 percent through 2025. However, a charitable deduction is now denied for payments made in exchange for college athletic event seating rights.
Under old law, a C or S corporation (but not a partnership or an LLC) could receive amounts from a governmental entity or civic group on a tax-free basis. Common examples of such tax-free amounts were tax increment financing (TIF) funds, a bargain purchase of land, and incentive grants. However, beginning with the date that the new law was enacted, such amounts will now be taxable unless they are made pursuant to a master development plan that was approved by the governmental entity prior to the law’s enactment date.
The provision under prior law allowing the nonrecognition of gain in the case of a like-kind exchange of property held for productive use in a trade or business or for investment is modified to limit its application to only real property that is not held primarily for sale.
Thus, personal property such as construction equipment is no longer eligible for a tax-free exchange. This new limitation applies to exchanges completed after December 31, 2017, unless the disposition of the old property or receipt of the new property has already occurred by December 31, 2017.
To qualify for long-term capital gain on the sale of a partnership interest received in exchange for services, the taxpayer must now hold that partnership interest for a three year period. The fact that an individual may have included an amount in taxable income upon their acquisition of the partnership interest or made a Section 83(b) election with respect to the partnership interest is irrelevant. Developers that build and sell in the short term will need to grant carried interests as soon as possible in the development process and consider this new holding period when evaluating the after-tax economics of a sale.
For rehabilitation expenditures paid or incurred after December 31, 2017, the 10% credit for pre-1936 buildings is repealed, but the 20% credit for certified historic structures remains. In addition, the credit must now be claimed ratably over a five-year period rather than being claimed in the year the rehabilitated building is placed in service. A transition rule applies to rehabilitation expenditures for either a pre-1936 building or a certified historic structure that are paid or incurred after December 31, 2017, as long as the building is owned by the “taxpayer” at all times on and after January 1, 2018 and the 24-month (or 60-month) period begins no later than 180 days after the date of the law’s enactment. This transition rule gives taxpayers a very limited opportunity to get the necessary property ownership in place by December 31, 2017.
Under the new law, there is no longer a deduction available for income attributable to domestic production activities.
Other retained tax credits of interest to the construction and real estate industry are: Research and Development Tax Credit, Work Opportunity Credit, Low Income Housing Credit, and New Markets Tax Credit.
The 2017 Tax Cuts and Jobs Act made the most significant changes to the Internal Revenue Code in the last 30 years, and as outlined above, these changes have significant impact on the construction and real estate industry. It will be important to monitor future guidance from federal and state and local taxing authorities as this historic tax bill is digested. If you have questions about how these tax changes may affect your business, please contact your Withum advisor.
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