December 2017’s tax reform bill changed the taxation landscape dramatically, impacting the entire spectrum of taxpayers, from individual rates to corporate structures. Income taxes generally comprise a significant cost, negotiation point and hot topic for real estate operators, so understanding these changes and how they can impact the after-tax return on investment is crucial.
A few of the significant updates to the tax code that will influence tax planning strategies related to real estate investment and development are discussed below.
Pass-Through Tax Rate
Tax code revisions resulted in not only a reduced corporate rate of 21% (down from 35%), but a new 20% pass-through deduction has been established for non-corporate taxpayers (partnerships, LLCs, S-Corps, and sole proprietorships) on qualified business income. Numerous limitations exist, yet opportunities remain that expand the limitation threshold.
Carried Interest Legislation
The relationship between carried interest (promote, kicker, sweat equity) and capital gain treatment has long been a point of contention between the real estate industry, Wall Street and Congress. As of January 1, 2018, a partnership interest held for less than three years will have its allocation of promote gain re-characterized as short-term capital gains which are taxed at ordinary rates. Regulations are forthcoming. Therefore a large gray area exists related to planning opportunities prior to the effective date of any regulations.
Real Property Like-Kind Exchanges Continue
Congress voted to maintain 1031 exchanges for real property, the section of the tax code that allows tax-free property sales generally as long as proceeds are invested into new property purchases. This provision applies to real property only, and no longer will apply to personal property. Additional due diligence is needed to assess the impact of cost segregations and the potential allocation of purchase price to personal property.
Interest Deduction Limitation
Deduction of net business interest expense may be limited to 30% of adjusted taxable income (new term to be assessed) for companies or combined groups with gross receipts of greater than $25 million. Does this mean that parking the old and cold partnership asset with a highly leveraged and structured deferred lease is no longer as strong of a tax deferral option? How will this impact leverage ratios? Exceptions exist but at the cost of slower depreciation.
Expensing and Depreciation on Capitalized Fixed Assets
Bonus depreciation and section 179 has been expanded. This treatment may not always be beneficial so make sure to conduct the analysis.
Tips for navigating new legislation
- Don’t believe the hysteria. There are lots of moving pieces to this legislation, many of which are as yet undefined and benefits extend to most taxpayers, even Californians. Conduct your own due diligence.
- Extend the scope of future forecasting. Don’t stop short by examining only the current or upcoming year. Take the time in your tax planning strategies to evaluate how these regulations will impact your business 3, 4, and 5 years out.
- Look closely before restructuring. With these new regulations in place, will you take an aggressive or conservative approach? Determine if your returns will be worth it before making any significant structural changes to your operation.
New amendments to the tax code can deliver significant benefits to real estate investors, but it’s important to take a close look at the details of how these changes will impact your specific operation before making any major decisions.