By: Heidi Henderson, Executive VP of Engineered Tax Services
Accountants, Real Estate Investors, Taxpayers, Business Owners and Financial Planners are all scrambling to dive into the recently passed Tax Cuts and Jobs Act (TCJA), and to understand its implications. Many of the provisions included in this bill have yet to be defined and interpreted so we expect ongoing dialog over the coming months to clarify its application and impact.
However, here is a summary of what we do know.
- Recovery Periods for Real Estate: The final bill maintains the depreciable life of 27.5 years for residential property, and 39 years for commercial property. However, companies may elect an ADS tax life (40 years commercial, 30 years residential or 20 years for qualified improvements) to opt-out of the limitation on interest deductions. The ADS election likely eliminates the application of bonus depreciation.
Bonus Depreciation of 100% (aka immediate expensing) September 27, 2017-2022: This is big news for real estate owners and investors! Bonus depreciation has existed in prior years, and was 50% in 2017. This bill expands bonus depreciation to 100% but more importantly removed the designation that is applies only to “original use” items. Therefore all tangible personal property either newly acquired, or constructed will qualify.
- Increased 179 Expenses: Qualifying property now includes roofs, HVAC systems, fire protection, alarm systems, and security systems. Additionally the allowable expense has been increased from $500,000 to $1,000,000 in 2018, with the phase-out deduction increased to $2.5M. These rules now include tangible personal property acquired for rental properties, furniture and appliances. Another benefit and increased value of cost segregation.
- Reduced Tax Rates: The corporate tax rate has been reduced from 35% to 21%, and for flow-through entities taxed at the individual level will see a small reduction with a slower incline of rates based upon taxable income.
- Interest Deduction Limitation: Interest is now limited to 30% of a businesses adjusted taxable income, with the exception of businesses with average annual gross receipts of $25M or less. Real property businesses can opt-out of the interest limitation if they elect the ADS recovery period rather than MACRS. ADS recovery periods are 40 years for non-residential property, 30 years for residential, and 20 year for improvement property. The ADS method will prevent taxpayers from applying cost segregation or accelerated depreciation.
- Alternate Minimum Tax (AMT): AMT is repealed for Corporations, and income triggers for individuals are increased slightly for single filers, and married filing jointly.
- State & Local Tax / Property Tax Deduction: The exclusion of local income and sales tax deductions is for non-corporate taxpayers. There is also a $10,000 limit for deductibility of property tax which applies to individuals not businesses.
- 20% pass-through deduction: An allowable 20% deduction for pass-though entities (LLC, LLP, S-Corps) limited to the lesser of: (1) 20% of business income OR the greater of (2) (a) 50% of W2 wages paid or (b) the sum of 25% of W2 wages paid plus 2.5% of the unadjusted basis of tangible property. Note: this deduction does not apply to service trade businesses.
In summary, what does this mean for Real Estate and Cost Segregation? The TCJA provides boarder application and expensing for tangible persponal property, not only for intial use assets, but also for acquired property. When a cost segregation study is applied, the allowable tangible personal property components are identified and separated from the structure, and thereby immediately expensed after September 27, 2017. Depending on the property this could result in roughly 15%-40% of the purchase price as deductible in year 1.
Additionally, for qualifying businesses and individuals, the 20% pass-through deduction may apply to allow taxpayers utilization of passive losses.
The question arises if it makes more sense to apply a Cost Segregation study for a 2017 tax return vs. a 2018 tax return and the answer depends on the structure and ownership. However, given lower tax rates in 2018, additional depreciation will have a higher cash value under the 2017 tax rates thereby creating a reason to act prior to filing 2017 returns!