By Andrew Smith, Principal, Baker Newman Noyes
December’s federal Tax Cuts and Jobs Act (the “Act”) contains some of the most significant tax law changes seen in decades. Many in the real estate industry will come out ahead as a result of the changes, and this article provides a brief overview of the new rules.
Reduced tax rates
Taxable C corporations formerly faced graduated rates topping out at 35%, but the Act permanently reduced it to a flat 21% beginning in 2018. For flow-through entity owners, the top rate dropped from 39.6% to 37% beginning with 2018 and continuing through 2025. Self-employment tax and the net investment income tax remain unchanged.
20% deduction of flow-through income
Beginning with 2018, most owners of flow-through entities (“FTE”) may deduct up to 20% of that taxpayer’s share of the entity’s business income. Rental income appears to qualify, but the law is vague and clarification is expected. Dividend income, capital gains, an interest income, wages and guaranteed payments do not qualify.
Under complex rules and calculations, filers with taxable incomes that do not exceed $315,000 for married couples, or $157,500 for others, may receive the full deduction; those with higher incomes face potential limitations:
- For certain personal service providers, the benefit is partially phased out when taxable income is between $315,000 and $415,000 for married couples, or $157,500 and $207,500 for others. The benefit is fully phased out if taxable income exceeds those ranges.
- Taxpayers other than certain personal service providers, but whose income exceeds the $315,000 or $157,500 threshold amounts, do not face the phaseout described above, but other reductions of the benefit will apply that can be overcome only if (1) wages paid by the entity to its employees are high enough, or (2) the cost of fixed assets held by the entity is high enough.
Business interest expense limitation
Beginning with 2018, business interest deductions are limited to 30% of income. This limit applies regardless of the entity’s form of business, but exceptions exist for entities with average gross receipts of $25 million or less, banks, and vehicle dealerships.
The 30% limit applies to adjusted taxable income (“ATI”). ATI is generally taxable income other than interest itself, gains unrelated to a trade or business, net operating losses, and the 20% FTE deduction. It also excludes depreciation, amortization, and depletion deductions, but only until 2022.
Interest limited by these rules may be carried forward. Although the limitation is computed at the entity level, special rules allocate disallowed interest (generated in years the limit applies) or excess income (generated in years the limit does not apply) to flow-through entity owners, for their use in a very complex tracking system that preserves the deduction but defers its use.
This deduction was extended through 2026. The percentage of cost that may be deducted depends on the date placed in service:
9/28/17 – 12/31/22 100%
1/1/23 – 12/31/23 80%
1/1/24 – 12/31/24 60%
1/1/25 – 12/31/25 40%
1/1/26 – 12/31/26 20%
1/1/27 and forward 0% (expired)
“Used” property now qualifies if it is “new” to the taxpayer, and was not previously owned by a related party.
This deduction is expanded by allowing expensing of $1,000,000, with a phaseout that begins at costs exceeding $2,500,000. Interior nonresidential real property improvements now qualify, as do HVAC, security systems, and fire alarm and protection systems. Property used to furnish lodging facilities now qualifies. These increases are permanent and indexed for inflation.
Qualified Opportunity Zones
Three new incentives in the form of gain deferral, gain exclusion, or basis increases are provided for those who invest in certain low-income communities known as Qualified Opportunity Zones through the use of Qualified Opportunity Funds.
Net operating losses
Newly-created net operating losses may no longer be carried backward, but may be carried forward indefinitely. However, only 80% of a year’s income may be offset by a loss carryforward.
Excess business losses
This new concept limits the amount of business losses (such as flow-through income from S corporations and partnership) that can offset other income (such as wages or investment income) on a filer’s 1040. The amount useable annually is $500,000 for joint filers and $250,000 for others. Any losses exceeding those amounts are converted to net operating loss carryforwards.
The Tax Cuts and Jobs Act is complex, and the information above barely scratches the surface of the depth and breadth of the rules. However, those involved in many industries, including real estate, should become familiar with the rules and ensure that to the extent possible and reasonable, business is conducted in a way that maximizes the benefit.
Andrew Smith, CPA, is a principal in the tax department of Baker Newman Noyes. He specializes in the real estate and construction industry.