The Tax Cuts and Jobs Act (TCJA) has created a lot of uncertainty as well as a lot of opportunity in the tax world. This is especially true in the real estate industry. Let’s take a look at the major provisions that will affect tax liabilities for real estate agents, property managers and real estate investors.
Real Estate Agents And The Qualified Business Income Deduction (QBID)
Section 199A coined the term “Specified Service Trade or Business” (SSTB) and provides that individuals, estates and trusts that have income derived from an SSTB will not qualify for the deduction if the individual, estate or trust has taxable income exceeding $207,500 (or $415,000 with respect to a married couple filing jointly), and there is a ratable phase-out of the deduction where the income is from an SSTB and the taxpayer has income between $157,500 and $207,500 if filing single, or $315,000 and $415,000 if married filing jointly.
Fortunately for real estate professionals such as brokers, agents, developers and property managers, they are not included in the SSTB definition. However, there are still some pitfalls that could reduce the deduction. For one, if property is leased by an SSTB and is 50% or more owned by the same SSTB owners and the landlord, then the rental activity and the SSTB are aggregated and both are ineligible for the deduction subject to the limitation. This eliminates the opportunity to increase the QBID for SSTBs by shifting income to a related party not subject to the limitation. On the other hand, if a real estate professional has significant consulting or financial income subject to the SSTB limits, shifting those SSTB operations to a separate entity could potentially reduce their overall tax liability by reducing income subject to the QBID limitations.
QBID Property Factor
For those taxpayers subject to the QBID limitation, there is a key provision that helps real estate investors keep more of their deduction. When subject to the limitation, the QBID is the larger of 50% of the W-2 wages paid by the business or 25% of W-2 wages plus 2.5% of the qualified business property. Section 199A references section 167 for the definition of qualified business property, which saves compliance time with any special calculations.
Accelerated Depreciation And Class Changes
Businesses may take 100% bonus depreciation on qualified property both acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Under the new law, qualified property is defined as tangible personal property with a recovery period of 20 years or less. The new law eliminates the requirement that the original use of the qualified property begin with the taxpayer, as long as the taxpayer had not previously used the acquired property and the property was not acquired from a related party. The inclusion of used property is a significant and favorable change from previous bonus depreciation rules.
Keeping with the bonus depreciation theme, TCJA increases the maximum amount a taxpayer can expense under section 179 to $1 million and increases the investment limit, or phase-out threshold amount, to $2.5 million. The $1 million limitation is reduced by the cost of qualifying property placed in service during the taxable year that exceeds $2.5 million.
TCJA also expands the definition of section 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. The definition of qualified real property for section 179 purposes was also expanded to include any of the following improvements made to nonresidential real property: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems and security systems as long as the improvements are placed in service after the date the building was first placed in service.
Qualified Improvement Property (QIP)
Another major change to depreciation for the real estate industry involves Qualified Improvement Property (QIP). QIP is now defined as any improvement to an interior portion of a building that is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. QIP does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. Additionally, the separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property were consolidated into QIP with supposedly a 15-year recovery period.
Unfortunately, QIP was not included in the list of 15-year depreciation period property and is not currently eligible for bonus depreciation. The government released proposed bonus depreciation in August and QIP still only qualifies for bonus depreciation if acquired and placed in service between September 27, 2017 and December 31, 2017. This first set of proposed regs leaves 2018 forward QIP ineligible for bonus depreciation — a significant issue for companies with real estate holdings since nonresidential interior renovations generally qualify as QIP. In the meantime, the industry is hopeful for a technical correction to relieve this error.
Like-kind exchanges, which allow taxpayers to swap an asset for a similar one without triggering a tax obligation, have existed in the tax code for many years. Most commonly used on assets such as real estate, machinery and equipment, like-kind exchanges allow taxpayers to continue to reinvest in similar types of property and not have to pay taxes until cashing in on the property.
Under the old law, no gain or loss is recognized to the extent the property held for the productive use in a taxpayer’s trade or business (or held for investment purposes) is exchanged for property of a like kind that is also held for productive use in a trade or business (or for investment).
The new law, effective for exchanges completed after Dec.31, 2017, limits like-kind exchanges to only real property held for the productive use in a trade or business (or for investment).
Where Do We Go From Here?
While tax reform has created many advantages for the real estate industry, the haste in passing such broad legislation has brought about just as much confusion. QBID offers great incentives to small rental operations and service providers, and the changes to bonus depreciation and class life will ultimately provide more avenues to accelerate expenses once further clarifications are released.