For the most up-to-date information on Qualified Improvement Property, see our latest post.
On December 15, the conference report for the Tax Cuts and Jobs Act was released and reconciles several key differences for real estate owners between the proposed House and Senate bills (discussed in KBKG’s previous Tax Insight dated November 10, 2017). The agreement to these issues are as follows:
Recovery Periods for Real Estate and Improvements
In general, residential rental property will continue to be depreciated over 27.5 years while non-residential real property structures are depreciated over 39 years. The previous Senate proposal reduced the life of all building structures to 25 years.
Under the new law, however, a real property trade or business must use the Alternative Depreciation System (ADS) if they choose to elect out of the limitation on interest deductions. Doing so would require a 40-year, 30-year, and 20 year ADS tax life for non-residential real property structures, residential real property, and qualified improvement property, respectively.
KBKG Insight: Bonus depreciation is not allowed for mandatory ADS property. However, it is allowed for property that a taxpayer elects to depreciate using ADS. It is unclear whether the election made for interest deductibility is deemed an election that would effectively disallow bonus depreciation for ADS property.
Beginning in 2018, there will be no separate definitions of qualified leasehold improvements, qualified retail improvements, and qualified restaurant property. This is all replaced with a general 15-year recovery period for Qualified Improvement Property (QIP).
KBKG Insight: Elimination of qualified restaurant property is a blow to the food service industry as restaurant building structures will now be depreciated over 39 years (versus the previous 15-year life). Instead, only costs to the interior of restaurant buildings that meet all other requirements of Qualified Improvement Property will be depreciated over 15 years and be eligible for bonus depreciation.
Temporary 100% Bonus Depreciation
The previous bonus depreciation requirement for property to be “original use” has been eliminated which means bonus depreciation now applies to both newly constructed buildings and used property acquired after September 27, 2017.
Bonus rates will vary depending on when the property was acquired and placed in service. For property acquired before September 28, 2017 the current bonus rules apply. For property acquired after September 27, 2017, bonus rates will be as follows:
Note: Long Production Period Property would get an additional year to be placed in service at each rate.
KBKG Insight: Cost segregation studies become extremely valuable under this new provision. Property components identified as land improvements or tangible personal property are eligible for immediate expensing for both newly constructed buildings and acquired property. While previous proposals excluded many real estate investors and developers from receiving this benefit, the final language allows for bonus depreciation on assets used in real property trades.
Expansion of Section 179 Expensing
Section 179 expense limitations for 2018 will double from $500,000 to $1 million while the phase-out limitation will be increased from $2 million to $2.5 million.
Qualifying property eligible for 179 expensing will include roofs, HVAC, fire protection & alarm systems, and security systems, as long as these improvements are made to non-residential real property and placed in service after the building was first placed in service.
Section 179 expensing is also expanded to include tangible personal property used in connection with furnishing lodging, such as furniture and appliances in hotels, apartment buildings, and student housing.
KBKG Insight: Taxpayers incurring significant costs to renovate existing buildings should carefully examine invoices for these items to maximize the Section 179 expense.
Modified Tax Rates
The conference agreement provides a reduction of the corporate tax rate to 21% for the tax years beginning on or after December 31, 2017.
There are slightly modified tax rates for individuals with the top bracket reducing from 39.6% to 37.0%. The conference agreement further adopts a 20% deduction for pass-through income of real estate investors, along with certain other businesses, limited to the greater of
a) 50% of wage income or
b) 25% of wage income plus 2.5% of the cost of tangible depreciable property for qualifying businesses, including publicly traded partnerships but not including certain service providers.
KBKG Insight: 2017 is a critical tax year for both corporate and pass-through businesses to accelerate tax deductions on real estate holdings as it can lead to permanent tax savings via the tax rate arbitrage. Consider scrubbing fixed asset schedules to identify missed repair deductions, missed retirement loss deductions, and cost segregation opportunities. Tax professionals should notify clients that extending 2017 tax returns may be necessary to ensure enough time to deploy this time-sensitive strategy.
For most businesses, there will be limits to interest deductions except for businesses with average annual gross receipts of less than $25 million over past three years.
For real property trades or businesses, however, taxpayers have the option to elect out of the limitation on interest deductions.
KBKG Insight: Taxpayers must evaluate the benefit of full interest deductibility verses the use of ADS depreciation recovery periods they are required to use if that election is made.
1031 Exchanges and Cost Segregation
1031 exchanges continue to be allowed for real property but are no longer allowed for tangible personal property for property acquired after December 31, 2017. Transition rules allow for old rules to apply to exchanges in which the taxpayer disposed of relinquished property, or received replacement property, on or before December 31, 2017.
KBKG Insight: Cost segregation can still be beneficial on both sides of a real estate exchange but will require careful tax planning. Under the new rules, taxpayers cannot defer 1245 recapture tax on the personal property from a cost segregation study. However, any recapture tax realized on the relinquished property can be offset with accelerated first-year deductions from a cost segregation study on the newly purchased property.
The corporate alternative minimum tax (AMT) is being fully repealed while the individual AMT is still applicable, albeit with higher exemption amounts and significantly higher phaseout thresholds through 2025. As a result, less individual taxpayers are expected to be subject to AMT.
KBKG Insight: Taxpayers who previously passed on claiming any general business tax credits because they were limited by AMT should reassess their situation. For instance, multifamily investors that were in AMT in 2017 may find themselves no longer paying AMT in 2018, allowing them to make full use of tax saving strategies like securing the Residential 45L Tax Credits on prior projects.
Low-Income Housing Tax Credit / Historic Rehabilitation / New Markets Tax Credits
The Low-Income Housing Tax Credit and Private Activity Bonds are preserved as under current law. The 20% historic credit is retained but claimed ratably over five years while the 10% historic credit for pre-1936 buildings is repealed. The New Markets Tax Credit is retained through 2019 as under current law.
The entire committee report can be found here: H.R. 1 Tax Cuts and Jobs Act
Authors: Gian Pazzia, CCSP, Lester Cook, CCSP, and Geoffrey Gan, CCSP, MBA