The 2017 “Tax Cuts and Jobs Act” is the most significant change to U.S. tax law in 30 years. It lowered the maximum federal corporate tax rate from 35 percent to 21 percent, as well as lowering rates for many individuals, though nearly all individual reductions sunset at the end of 2025.
Below are highlights of particular interest to commercial real estate owners and developers. In general, while the tax code changes will reduce taxes for many commercial real estate owners and developers, the long-term impact of these changes is difficult to predict. Fundamentals should remain the market driver for commercial real estate.
- 1031 Exchanges Remain for Real Estate. There was discussion of eliminating all “like-kind” exchanges, which would have had a significant effect on the market. In the end, the law eliminates the tax break for exchanges of personal property (e.g., furniture, fixtures, equipment, vehicles), which will now be taxed on sale or exchange. Real estate capital gains generally remain tax-deferred if a qualified investment is made in like-kind replacement property.
- Business Income. Developers who organize their businesses as pass-through entities, such as partnerships and LLCs, as most do, can now take a deduction of up to 20 percent of their “qualified business income,” subject to certain limitations. This does not include short- or long-term capital gains, but it does include certain REIT dividends. A late addition to the law allows many businesses with sufficient depreciable real property to benefit.
- Business Interest Deduction. Under the new law, the business interest deductions of a taxpayer with average annual gross receipts of more than $25 million are limited to the sum of business interest expense plus 30% of “adjusted taxable income” (roughly compared to EBITDA in years through 2021 and EBIT beginning after 2021). Disallowed deductions are carried forward. Real estate businesses can opt out of the limits by extending the period over which they depreciate real property—from 27.5 years to 30 years for residential property and from 39 years to 40 years for non-residential property.
- Extension of the “Carried Interest” Holding Period. Under the new law, the holder of a “carried interest” in a partnership or LLC is taxed at long-term capital gains rates on the holder’s allocable share of any gain recognized by the partnership on the sale of its investment property, but only if the property was held for more than 3 years (rather than 1 year under prior law). It appears that the new 3-year holding requirement also applies to a sale of the carried interest by the partner. Although most real estate investments are held for longer than 3 years, this extended holding period may affect situations where there has been significant appreciation over a short period.
Other reforms will also benefit investors, such as the expansion of the types of nonstructural improvements to the interior of non-residential buildings subject to bonus depreciation. Improvements now eligible for bonus depreciation include used property, as well as improvements to roofing, HVAC systems, and fire protection, alarm, and security systems. Though annual state and local tax (SALT) deductions (other than property taxes incurred in a business or other income producing activity) are now capped at $10,000 for individuals, which will affect investors’ personal pass-through income, the changes described above and others may make doing business in a high-tax state like California somewhat more palatable.
Have a question? Contact Allen Walburn.
Your comments are always welcome!