Summary Of Changes For Real Estate Investments After Trump Tax Reform
The incentives introduced by the new tax laws had a wide scope and supported investing into real estate as it has consistently been a key driver of economic growth and the creation of jobs, and the new tax reforms were designed to preserve this. IPX 1031 posted an article about that. Below a summary of the changes to Real Estate investing after the tax reform.
The reformed tax laws still permit taxpayers to defer their gains from real estate that fall within the definition of a 1031 like-kind exchange, where both improved and unimproved real estate are generally considered to be property of a like kind. Where personal property is concerned, however, gain deferral was withdrawn with effect from the beginning of 2018.
Deduction of Business Interest
The tax reform provided the deduction of net interest expenses in the instances of real property trades or business. Taxpayers would then be required to elect out of the newly-introduced interest disallowance for this purpose. Hotels as commercial property qualify as an exception, whether as an operation or as management of such. The exception could also be extended to corporations and Real Estate Investment Trusts, under certain qualifying criteria. An interest limit was introduced and applied to the existing debt, disallowing the deductibility of interest where the net interest expense was more than 30% of EBITDA, which would change to only applying to EBIT from the 2022 tax year. These parameters did not apply to personal property.
The Real Estate Investment Depreciation Deduction has changed under section 168 of the Tax Code.
- The new code takes effect January 1, 2018. That means that 2017 taxes (filed in 2018) are subject to the old laws.
- Section 168 outlines the rules covering accelerated depreciation.
- Section 168(k) allows for some assets to be depreciated completely as a “100% bonus depreciation.”
- The Journal of Accountancy explains that the changes sound good on the surface, since the depreciation is supposed to increase from 50% to 100%, but somehow some of the assets it applies to have simply disappeared from the code altogether.
- The amount of allowable bonus depreciation is then phased down over four years: 80% will be allowed for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026.
- The new rule made bonus depreciation apply to both new and used property, plus it extended the time that some other types of property like the plants, live theatrical productions, films, and television can qualify for the total 100% depreciation amount.
The Recovery of Costs
In general terms, the cost recovery rules for real property were maintained. If, however, taxpayers elected to apply the real estate exception to the interest limit in their return, the real property would need to be depreciated under longer recovery periods, albeit only slightly longer. These recovery periods were set at 40 years for non-residential properties, 30 years for residential rental properties, and 20 years for interior improvements that fell within the qualifying criteria. 100% eligibility for a 5-year period was applied to land improvements such as drainage and parking lots, and tangible personal property used in real property trade or business.
Pass-through tax relief
Since early 2018 a new tax deduction of 20% for pass-through businesses was introduced. Where the income of taxpayers exceeded the stipulated thresholds, the 20% deduction was limited to the greater of (a) 50% of the W-2 wages paid by the business, or (b) 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis (immediately after acquisition), of the depreciable property (structures only, not land).
The dividends earned from Real Estate Investment Trusts, and distributions from publicly-traded partnerships were not subject to the wage restriction. The scope of the pass-through benefit included estates and trusts, but income from a number of specified services businesses, such as health, financial services and law, were ineligible.
Tax Planning for U.S. Real Estate Investors
The Active Loss Limitation
The 2018 tax reform prevented taxpayers from deducting the losses incurred in an active business or trade from their wage or portfolio income, which would usually be the interest and dividends. Investment that already existed at the time was covered by the new provision.
Interest carried forward
The carried interest received in certain types of partnerships, which would include hedge and private equity funds and real estate, was provided for by the tax reform in an extended 3-year holding period for long-term capital gain treatment. This holding period then applied to the assets held by the partnership and the partnership interest also. This 3-year holding period’s requirements were applied to the disposition of assets and interests from the start of 2018.
Local and State Tax Deduction
The limit on the annual deductibility of the state and local taxes imposed by the tax reform was for no more than $10,000. Deductibles such as state and local taxes accrued or paid in carrying on a trade or business, or in activities related to the production of income, were deemed valid. An example, to illustrate the point, would be where an individual is permitted to deduct property taxes levied on a business asset such as residential rental property. The $10,000 allowable claim amount may comprise of a combination of local and state property and income taxes, or the sales taxes on these entities.
Tax Credits: Historic Preservation and Rehabilitation
The 20% tax credit for the rehabilitation of historically certified structures was preserved by the tax reform, with the provision that taxpayers may only claim the credit over a 5-year period and according to a scale of rates. The 10% credit for the rehabilitation of structures that dated pre-1936 was withdrawn.
Tax Credit applicable to Low-Income Housing
The tax reform made no changes to the tax credits previously applicable to low-income housing.
Private Activity Bonds
The tax exclusion for interest on private activity bonds was retained.
Certain tax-free state and local subsidies received by corporations were limited, which extended to the construction contributions or contributions from government entities or civic groups. As an example, for the sake of clarity, land contributions made by a municipality would be taxable but a municipal tax abatement would not be. This provision only applied to contributions made after the effective date of the provision.
Income from Mortgage Servicing
A special rule was included to give recognition to the income related to mortgage servicing. These types of contracts were excluded from the provision that allowed acceleration of the recognition of income in particular circumstances of divergence between the financial and tax accounting processes.
Real Estate Investment and Public Pension Plans
No House proposal was included related to subjecting government pension plans to tax on unrelated business income.
Multinational Groups – Interest Limitation
The amount of U.S. interest expense that a domestic corporation can deduct when it is a member of an international financial reporting group was not limited.
Home Ownership – Mortgage Interest Deductions
The tax reform caps the debt eligible for the home mortgage deduction to $750,000, unless the debt was incurred prior to Dec. 15, 2017, in which case it is limited to $1,000,000. A taxpayer may also include the interest on debt used to acquire a second home in the deduction. The key change in this type of deduction is that the the deduction for interest paid on a home equity loan is removed, and extended the scope to home equity loans already in existence at the time.
Capital Gains Exclusion – Principal Residence
The exclusion of gain on the sale of a principal residence was preserved, and the ownership period by the taxpayer to qualify for the exclusion (being two of the last 5 years), was not extended.
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