Selected Real Estate and Pass-Through Provisions of the Tax Cuts and Jobs Act Bills of the House and Senate
Article
Gibbons Corporate & Finance News - Legislative Tax Alert
December 7, 2017
With the Senate passing its bill early Saturday morning, December 2, tax reform is marching forward at a rapid pace, with a realistic possibility that an Act will be signed before year end. This Gibbons Article highlights some key business provisions relevant to real property and pass-through entities.
Real Property Depreciation Deductions
The Senate bill significantly shortens the recovery period for nonresidential real property, which had not changed since the Tax Reform Act of 1986, from 39 to 25 years, and reduces the recovery period for residential rental property from 27.5 to 25 years.
The Senate bill also expands the definition of qualified improvement property to include “any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service.” Under the alternative depreciation system (“ADS”), all qualified improvement property now has a recovery period of 20 years.
The House bill does not address the above depreciable property issues.
Section 1031 Like-Kind Exchanges
Both the House and Senate bills would restrict deferral of gain on like-kind exchanges after December 21, 2017 solely to real property that is not held primarily for sale. These provisions would prevent taxpayers from using Section 1031 to defer gain on exchanges of art or other personal property.
Section 179 Expensing
Both the House and Senate bills would increase the amount businesses can expense from the current cost limit of $500,000 of Section 179 property (generally limited to depreciable tangible personal property purchased for use in the active conduct of a trade or business). The House bill raises this cap to $5 million while the Senate offers a more modest increase to $1 million. The bills also increase the phase-out amount, which currently reduces the deduction dollar-for-dollar when the total Section 179 property placed in service by a taxpayer exceeds $2 million. The House and Senate increase this phase-out amount to $20 million and $2.5 million, respectively, and index these amounts for inflation.
The Senate bill would also expand the definition of qualified real property for purposes of Section 179 to include all qualified improvement property and certain improvements (roofs, heating, ventilation, and air-conditioning property, fire protection and alarm systems, and security systems) made to nonresidential real property.
Interest Deduction Limitations
Both the House and Senate bills would amend Section 163(j) to limit net interest deductions for all businesses to 30% of their adjusted taxable income. The House bill would calculate adjusted taxable income as earnings before interest, taxes, depreciation and amortization (“EBITDA”). The Senate bill utilizes earnings before interest and taxes (“EBIT”), a potentially more forgiving measure than EBITDA as it is calculated before depreciation and amortization, and also before any deductions under the new pass-through rules are taken into account. Both bills exempt small businesses – those with average annual gross receipts under $25 million in the House version and $15 million in the Senate. Disallowed amounts of interest expense would carry over for up to five years under the House bill and indefinitely under the Senate version.
The Senate bill would allow real property trades or businesses (defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business”) to elect out of the Section 163(j) limitation. Electing out would require the use of ADS to depreciate nonresidential real property (still 40 years), residential rental property (30 years reduced from 40), and qualified improvement property (20 years).
Partnership Technical Termination
Under current law, if more than 50% of the total capital and profits interests of a partnership is sold or exchanged, there is a technical termination of the partnership, which has consequences that include the option to make certain new tax elections. The House bill repeals this rule (Section 708(b)(1)(B)), while the Senate leaves it in place.
Pass-through Rates
Currently, the tax rates that apply to pass-through income, e.g., income allocated by partnerships or S corporations to their partners or shareholders, respectively, are the marginal rates that apply to such partners or shareholders as individuals.
Under the House bill, a portion, generally 30%, of net active business activity income would be taxable to the ultimate pass-through individual owner at a 25% rate. The remaining income, e.g., 70%, would be treated as wage income taxable at the ordinary income rates and subject to self-employment taxes, as is often currently the case for the distributive share of partnership income, except to the extent that the taxpayer can show capital investment in the business. Owners or shareholders receiving distributions from passive business activities (including rental real estate) would be able to treat 100% of the distribution as business income taxable at the 25% rate. Service business income, limited partners, and rental income generally would be subject to self-employment tax. Most service businesses (lawyers, accountants, etc.) would not be allowed to use the 25% rate. Certain small businesses would be eligible for a 9% rate.
The Senate bill would allow individual partners, S corporation shareholders and sole proprietors to deduct 23% (increased from 17.4% in the initial Finance Committee draft) of qualified business income (all domestic business income other than investment income). The 23% deduction would not be available for specified service businesses (“health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees”) unless the taxpayer’s taxable income does not exceed $500,000 (for married individuals filing jointly, or $250,000 for individuals). The deduction would be limited to the taxpayer’s allocable share of 50% of the W-2 wages of the pass-through entity, with an exception for those with taxable income below certain thresholds, generally $500,000 for married individuals filing jointly and $250,000 for individuals.
Conclusion
This article addresses some of the more substantial tax items of interest to real estate and pass-through entities covered by the bills under debate in Congress. Investments in real estate, which for U.S. investors are typically structured utilizing pass-through vehicles, would generally stand to benefit from these reforms if enacted. These changes, in concert with the lowering of corporate income tax rates to 20%, may make investing in U.S. real estate significantly more attractive to foreign investors.
If you have questions or concerns with how any of these provisions will impact you or your business, please do not hesitate to contact us.
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