Tax Reform and Real Estate Investors:
Insights and Misconceptions
Alex Bagne, JD, CPA, MBA, CCSP – President of ICS Tax, LLC
Greg K. Bryant, CCSP – Managing Partner of Bedford Cost Segregation, LLC
J. Curt Gautreau, CPA, CCSP – President of Cost Segregation Initiative
With the signing into law of the Tax Cuts and Jobs Act (the “Act”), Congress has enacted the biggest tax reform law in thirty years, one that will make fundamental changes in the taxation of businesses. For real estate investors, there are numerous opportunities to reduce tax, but there are also several misconceptions. Below are highlights.
LOWER TAX RATES
For tax years that begin after Dec. 31, 2017, the corporate tax rate, which had been at graduated rates as high as 35%, is reduced to a flat 21% rate. Similarly, pass-through businesses (e.g., sole proprietorships, partnerships, LLCs and S-corps) may be able enjoy lowered tax rates through a deduction of up to 20% of their business income. However the pass-through provisions are complicated and the rate reductions are limited for “specified service trades or businesses” (e.g., businesses that involve performance of services in the fields of health, law, consulting, athletics, financial services and brokerage services). Many taxpayers are already operating on the assumption that the 20% deduction is a “slam dunk” – it’s not.
For most real estate investors, the typical tax planning strategies to push income into future tax years and pull deductions into the current year have added value beyond the time value of money. With lower tax rates for 2018 and onward, shifting deductions into 2017 generates permanent tax savings due to the tax rate arbitrage. As such, said investors may want to review current and past depreciation treatment for their existing portfolios to determine if “look-back” Cost Segregation Studies would produce any favorable adjustments to depreciation (i.e. catch-up depreciation) resulting in a better tax benefit for a 2017 return vs. one for 2018.
In general, taxpayers will want to accelerate the purchase of depreciable assets to take advantage of the 100% bonus depreciation provision included in the Act for property placed in service after Sept. 27, 2017. The bonus rates begin to phase out after 2022 and are fully phased out by 2027. Also note that, under the Act, used property with a MACRS recovery period of 20 years or less now qualifies for bonus depreciation. While most Tax Reform provisions apply to tax years beginning in 2018, the bonus depreciation provision is unique in that it applies after Sept. 27, 2017. With bonus depreciation and its application to used property, Cost Segregation Studies have now been given more importance and value for used buildings purchased from the effective date through 2027. Application of bonus depreciation will be subject to transition rules and other requirements but generally, this is great news for those who plan to purchase, build or renovate properties. Given that Cost Segregation Studies will be utilized to a much greater degree now, the values associated with the accelerated property eligible for bonus depreciation as well as assets assigned 27.5 and 39-year lives will need to be accurate and defensible.
We suspect that many unqualified firms may attempt to “boost” the value of qualified property through “innovative” or “proprietary” approaches. With 100% bonus depreciation at stake and significant risk during audit if studies are sub-standard, it will be incumbent on the taxpayer and their advisors to utilize a Cost Segregation consultant with the requisite qualifications. The American Society of Cost Segregation Professionals (ASCSP) is the industry’s only organization devoted to the training, advancement, ethics and standards development. ASCSP Certified members must have a minimum of 7-years direct Cost Segregation experience and also pass a rigorous examination. Be sure to ask your consultant about their credentials.
§179 EXPENSE ELECTION
The Act increased the maximum amount a taxpayer may expense under §179 to $1 million and increased the phase-out threshold to $2.5 million. These amounts will be indexed for inflation after 2018. There is a state-specific income limitation to be aware of as well.
The Act also expanded the definition of §179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. It also expanded the definition of Qualified Real Property (QRP) eligible for §179 expensing to include any of the following improvements to nonresidential real property: roofs, HVAC property, fire protection and alarm systems, and security systems. For significant renovation projects, many taxpayers will benefit from Cost Segregation to maximize the benefits of the increased §179 Expense Election in the case of phase-out thresholds or inability to utilize §179 since this provision can only be used for expenditures incurred in a trade or business.
QUALIFIED IMPROVEMENT PROPERTY
Prior to the Act, three types of building improvements—Qualified Leasehold , Restaurant and Retail Improvement property—had a 15-year recovery period and were depreciated using the straight-line method. For years after Dec. 31, 2017, the Act replaces these categories with a revamped Qualified Improvement Property (QIP) classification. The legislative intent was to depreciate these over 15 years using the straight-line method therefore making them eligible for bonus depreciation. However, the necessary language was not included in the final tax reform and, absent a Technical Correction; QIP is depreciated over 39 years and is ineligible for bonus depreciation.
By way of reference, 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 date the building was first placed in service except for any improvement for which the expenditure is attributable to (1) enlargement of the building, (2) any elevator or escalator, or (3) the internal structural framework of the building.
Immediately following the release of the Act, many construction-related firms started circulating marketing material stating that Qualified Improvement Property is eligible for 100% bonus depreciation, but absent a Technical Correction, it is 39 year property and ineligible for bonus.
§1031 LIKE-KIND EXCHANGES
Generally effective for transfers after Dec. 31, 2017, §1031 like-kind exchanges are limited to transfers of real property not held primarily for sale. It is unclear as to whether personal property attached to real property is eligible for §1031 treatment. The fact that virtually all buildings contain some §1245 personal property, whether already identified in a Cost Segregation study or embedded in the building’s depreciable 39 year basis, might cause one to wonder how this might work. In the case of a 1031 like-kind exchange, would the §1245 personal property be eligible as a carry-over basis or would it have to remain behind and subject to recapture and higher tax rates? While there doesn’t seem to be any consensus in the industry yet and absent further clarification from the IRS, we are hopeful that personal property that is part of a building would in fact, be considered eligible for the §1031 treatment.
HISTORIC TAX CREDIT
The Act modifies the Historic Tax Credit for years after Dec. 31, 2017. A 20% credit still applies with respect to a certified historic structure (i.e., any building that is listed in the National Register), but it must be taken ratably over 5 years. The 10% credit for qualified rehabilitation expenditures with respect to a pre-1936 building is repealed.
The Act has provisions that limit the deductibility of interest expense, changes to ADS lives, and many others. Please consult the full text of the Act for further detail.