Last December Congress passed the most substantial tax reform legislation since 1986 with the Tax Cuts and Job Act of 2017 (“TCJA”). The months following has seen taxpayers and practitioners posing more questions than the IRS has been able to answer as we all sift through the new legislation. For those who invest in commercial real estate, there are a few changes that will provide an opportunity for significant benefits. Note that unless dates are specifically mentioned below, all changes are effective for tax years beginning after December 31, 2017 and sunset at the end of 2025.
Individual Tax Rates
The TCJA included tax rate cuts across the board with corporate rates being slashed to 21% receiving most of the publicity. The individual rate reductions were not as dramatic, but do provide relief especially with the wider tax brackets.
Example 1: Married taxpayers filing jointly with $450,000 in taxable income would have a tax liability of $124,383 in 2017 and $108,879 in 2018.
Example 2: Single taxpayer with $150,000 in taxable income would have a tax liability of $34,982 in 2017 and $30,289 in 2018.
Qualified Business Income Deduction
Arguably the most beneficial and complex provision in the TCJA, and the one that has the largest impact on commercial real estate investors, is the qualified business income (“QBI”) deduction under Sec 199A. This provision is far-reaching and potentially affects every taxpayer that reports qualifying business income on Schedules C, E or F on their individual tax return, including from passive income sources. Qualifying business income is generally any trade or business income that is not a “specified service” business, which are defined as businesses relying on the skills or reputation of their owners or employees (note: architects and engineers are specifically excluded from this definition). Many of the complexities of this provision fall outside of the scope of this article, which will focus on the benefit to commercial real estate investors.
The QBI deduction is 20% of qualifying income, but there are a number of factors that must be analyzed to determine the actual deduction. The first limitation on the deduction is the greater of: (i) 50% of W-2 wages paid for the qualified trade or business; or (ii) the sum of 25% of W-2 wages paid plus 2.5% of the unadjusted depreciable basis of qualified property held at the end of the year. Since most commercial real estate investments are held in special purpose entities that do not have employees the benefit will be generated by the alternative calculation on a depreciable basis. Keep in mind that income on the sale of property that is treated as capital gains is not considered qualifying income for the purpose of this deduction.
Before going through any of the following analysis, it is worth noting that these limitations only apply to taxpayers with taxable income in excess of $315,000 for joint filers ($157,500 for single filers). For taxpayers below these amounts, the deduction is the lesser of 20% of this qualifying income or 20% of taxable income. This simplified benefit is phased out at taxable income of $415,000 for joint filers ($207,500 for single filers) and subject to the rules discussed below.
It’s also worth noting that commercial rental real estate often generates a tax loss in earlier years because of depreciation and interest expense. To the extent losses are generated they carry forward and offset qualifying income in subsequent years. This deduction is more likely going to benefit those that have investments in more mature commercial properties that have been held approximately 10 years or have very low amounts of debt.
Example 3: Married taxpayers from Example 1 have a 10% investment in an LLC that owns commercial rental real estate. In 2018, their allocable share of rental real estate income is $50,000 (net of any depreciation taken through a Schedule K-1), $0 of W-2 wages and $500,000 of depreciable property. In this example, their QBI deduction is $10,000, which is the lesser of 20% of qualifying income ($50,000 x 20% = 10,000) or 2.5% of depreciable basis ($500,000 x 2.5% = 12,500) since there are $0 of W-2 wages. If the married taxpayers 2018 tax liability was $108,879 it is now $105,379 once you factor in the QBI deduction.
Example 4: Same as Example 3 except the allocable share of depreciable property is $200,000. In this case, the QBI deduction for the year would be limited to $5,000 ($200,000 x 2.5%) instead of based on qualifying income. Their 2018 tax liability is $107,129.
The analysis on the limitation above must be done for each separate qualifying business and then combined to determine the total potential QBI deduction. Dividends from REITs qualify for the 20% deduction to the extent they are not capital gain dividends. Losses from one qualifying business can reduce the overall benefit but excess income cannot increase the benefit.
Example 5: Same as Example 4 except that the couple also fully own a commercial rental property that generates a ($40,000) loss with depreciable basis of $1.5M. In this case, total QBI is $10,000 ($50,000 of rental income from the LLC less $40,000 loss), therefore the QBI deduction is limited to $2,000 ($10,000 x 20%). Their 2018 tax liability is $108,179.
Example 6: Same as Example 4 except that the couple also fully own a commercial rental property that generates income of $40,000 with depreciable basis of $1.5M. The QBI deduction from this rental property is $8,000 which is the lesser of qualifying income ($40,000 x 20% = $8,000) or 2.5% of depreciable basis ($1.5M x 2.5% = $37,500). Combining this deduction with the $5,000 of deduction from the LLC results in an overall QBI deduction of $13,000. Note that the excess limitation on the depreciable basis of the wholly-owned commercial property did not increase the limitation on the LLC QBI deduction. This decreases their 2018 tax liability to $104,329.
After combining qualifying business activities the result is then subject to one final limitation. The deduction is the lesser of the combined QBI deduction and 20% of taxable income before this deduction, same as for taxpayers with taxable income below the limits discussed above.
Example 7: The married taxpayers from Example 1 have a combined potential QBI deduction of $100,000 and taxable income before QBI deduction of $450,000. This results in a QBI deduction of $90,000 which is the lesser of $100,000 based on qualifying income and 20% of taxable income (the maximum QBI deduction). Their ultimate taxable income would be $360,000 ($450,000 less $90,000 QBI deduction). This reduces their 2018 tax liability to $78,579 compared to the $108,879 from Example 1.
The most significant changes to depreciation that impact commercial real estate revolve around bonus depreciation. Except for a brief hiatus from 2005-2007, bonus depreciation has been in place since 2001 in order to encourage investment in capital assets. The concept of bonus depreciation allows for a percentage of the cost of a capital asset to be deducted in the year placed in service with the remaining basis deducted over its standard depreciable life. This percentage has ranged from 30% to 100% over that time and had an original use requirement. The TCJA brought back 100% bonus depreciation thru 2022, meaning the cost may be fully expensed in the year placed in service for qualifying property.
Another taxpayer friendly change was the removal of the original use requirement for assets acquired and placed in service after September 27, 2017. Therefore, both new acquisition and new construction of commercial real estate can perform a cost segregation study and take advantage of accelerated depreciation on the personal property assets inherent in the building. In the process of cost segregation, certain costs are broken out as personal property assets which allow for shorter depreciable lives and accelerates the depreciation deduction.
The final change that we expect to positively impact commercial real estate is the consolidation of the definition of qualified improvement property as depreciable over 15 years, making it eligible for bonus depreciation. Under the old rules, in order to receive 15 year treatment the improvements needed to be qualifying leasehold, restaurant or retail property. Now all improvements to the interior of commercial rental property, excluding the internal structural framework, elevators and escalators, and enlargements of the building, will be classified as qualified improvement property. It’s important to note that in the haste of writing the bill after midnight on December 20, 2017 they inadvertently did not update code section 168 to reflect that that qualified improvement property as 15 year property as was contemplated in the committee report. Most prognosticators expect this to be addressed before year end, but Congress needs to pass a technical correction in order to enact.
For years there has been speculation that Congress intended to significantly restrict the ability for real estate investors to defer their tax bill on the sale of an asset using like-kind exchanges. Fortunately when the TCJA was passed the impact on real estate was minimal. Real property for real property exchanges are still allowed, meaning there is not a requirement to exchange into the same asset type (ie, an apartment complex can be exchanged into a commercial property).
The major change in the like-kind exchange rules eliminates the ability for personal property to qualify for gain deferral. This may have an impact on commercial real estate investments that have utilized a cost segregation study to accelerate depreciation on a portion of the building. In these situations, the proceeds allocated to these assets will be considered boot that cannot be used to defer the gain, resulting in taxable income even if all of the proceeds are reinvested in a replacement property. The ability take 100% bonus depreciation until 2022 reduces the tax impact if a cost segregation study is completed on the replacement property.
Interest Expense Limitation
The TCJA introduces a new limitation that restricts the ability to deduct interest expense in certain situations. Fortunately, commercial real estate should not be impacted in most scenarios. The deduction for interest expense is limited to 30% of taxable income before interest, depreciation and amortization deductions. This limitation only comes into play for large taxpayers that have average gross receipts in excess of $25M over the prior three years. This is a significant amount of rents when the industry norm is to use a special purpose entity to hold each commercial rental property. For these larger real estate taxpayers, there is an ability to opt-out of this limitation, though. In order to opt-out, the taxpayer must use the alternative depreciation system for its assets, which generally will result in reduced depreciation expense. In most situations this should result in lower taxable income compared to being subject to the limitation. The rules for how this limitation may impact the individual investors in an LLC or other pass-through entity are quite complex and beyond the scope of this article. As always, investors are encouraged to discuss the potential impact of this limitation with their tax advisor.
Tax-exempt taxpayers that have investments in commercial rental real estate may be subject to income taxes if certain requirements are not met. The overall rules to when rental income is subject to unrelated business income tax (“UBIT”) did not change under the TCJA, but there was a change in the reporting of those investments that may have a negative impact for those investors. Prior to tax reform, tax-exempt investors aggregated their allocable shares of the revenues and expenses subject to UBIT from all activities to determine their tax liability. For tax years starting after January 1, 2018 losses from any activity are only allowed to offset income or gains from that activity. This inability to net current year losses with income from other activities will likely accelerate tax liabilities for tax-exempt investors that have multiple investments generating unrelated business income and may impact the decision to use an IRA to make additional investments in commercial real estate.
This sweeping tax reform that was passed under the TCJA may impact individuals in a variety of ways, both positively and negatively. Those that are invested in commercial real estate should see benefits beginning immediately in most circumstances. This provides a great opportunity to sit down with your tax advisor and financial advisor to see how the reform impacts you and your investment strategies going forward.
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CrowdStreet will host a webinar on this topic with Trent Baeckl and Ian Formigle on October 4, 2018 at 10:00am pacific. If you are interested in viewing this webinar, you can watch here. To learn more about CrowdStreet and online real estate investing, please download our Investor Guide: Making the Move From the S&P to CRE.