On November 2, Congressional Republicans released the 429-page proposed tax reform bill through the “Tax Cut and Jobs Act” (“TCJA”). The changes proposed to the tax code are broad, but overall the bill is not a dramatic modification. Much of the reform pertains to transnational taxation issues, but there is a significant portion of the TCJA that impacts domestic real estate investors. By the time this bill becomes law, it will most likely be adjusted due to special interest influence and compromise with the Senate. Many of the core ideas, however, are likely to be part of the final package.
With that in mind, we have provided the top nine takeaways specifically geared to domestic real estate investors:
1. Individual Income Tax Rates
There are new individual income tax rates. The following table compares the rates for people who are married and filing jointly:
|Current 2017 Rates||Proposed Rates|
|Low End||High End||Rate||Low End||High End||Rate|
|Standard Deduction = 13,000||Standard Deduction = 24,000|
Takeaway – Fewer categories. Slight increase, decrease, or no change depending on your income level.
2. Corporate Income Tax Rate
Corporate income tax rate reduced from 35% to 20%.
Takeaway – Great news for businesses. Also creates arbitrage opportunity for 2017 tax returns. Taxpayers should use Cost Segregation and other tax strategies to move reported income from 2017 (35% corporate income tax rate) to 2018 and future years (20% corporate income tax rate) in order to generate a permanent net benefit.
3. Bonus Depreciation
Bonus depreciation (currently set at 50% in 2017, 40% in 2018, and 30% in 2019) is replaced with 100% expensing of eligible property. Effective for property placed in service on September 27, 2017 and lasting through 2022.
Takeaway – For ground-up new construction, this will increase the benefit achieved through a Cost Segregation analysis. This might also allow for 100% immediate expensing of any Qualified Leasehold Improvement Property, negating the need for a Cost Segregation study. It would have no impact on the acquisition of existing property.
4. Homeowner Deductions
(1) Mortgage interest deduction remains unchanged for homes that are already owned; however, the cap on mortgage interest deduction will be reduced from home value of $1,000,000 to home value of $500,000 for homes purchased in 2018 or later.
(2) Property tax deduction will be capped at $10,000.
Takeaway – These changes would not directly impact most homeowners in the middle class and below, but will increase the cost of homeownership for the upper middle class and above. This may result in the softening of home values in markets where the typical home is worth more than $500,000. Greater competition for lower priced homes may push people towards the rental market and result in increased residential rental rates and/or an increase in the volume of rental properties.
5. House Flipping
Tax free capital gains on the sale of a homeowner’s primary residence will become stricter. Current rules allow tax free capital gains if a homeowner has lived there for at least two of the past five years. The proposed law changes this to five of the past eight years. In addition, this can be done only once every five years.
Takeaway – It will become more difficult to flip a primary residence, as the intent is to make homeownership a longer term investment.
6. Section 179 Expensing
Section 179 of the existing tax code allows taxpayers to immediately deduct up to $500,000 of qualifying capital expenditures. It phases out as the taxpayer’s total capital expenditures exceed $2 million. The proposed rules will allow up to $5 million of qualifying capital expenditures to be expensed, and it only phases out as total capital expenditures exceed $20 million.
Takeaway – This is a significant boost for smaller businesses. Clarification will be needed as to how much, if any, real property will be eligible for Section 179 expensing.
7. Like-Kind Exchanges
Section 1031 like-kind exchanges appear to be modified to restrict their use to real property only. Thus, capital gains and recapture tax will not be deferred for any personal property that is part of a sale.
Takeaway – Property sellers may need to be careful when selling property and plan for the capital gains and recapture tax liability attributable to personal property. If property is acquired with the intent to hold for a short period of time, this change may motivate the property buyers to characterize more of the property as real property.
8. Pass-Through Entities
Tax structure for pass-through entities is modified to prevent abuse of the potentially large gap between individual and corporate tax rates. Pending legislation has 70% of pass-through income taxed at the business owner’s individual tax rate and 30% of pass-through income taxed at 25% rate.
Takeaway – This is intended to prevent sophisticated taxpayers from abusing the lower corporate tax rate and applying it to what should be individual income.
9. Alternative Minimum Tax (AMT)
The TCJA removes the AMT.
Takeaway – Real estate investors are free to maximize the amount of deductions through depreciation and other means without running into AMT limitations.
Eli Varol is a Senior Director in the Cushman & Wakefield Valuation & Advisory group. Eli has been practicing Cost Segregation consulting for more than 19 years and is a Senior Member of the American Society of Cost Segregation Professionals. He graduated with a Bachelor of Science in Mechanical Engineering and a Masters of Business Administration, both from Washington University in St. Louis.