1. PASS-THROUGH INCOME DEDUCTION
What is in the bill: It has been widely publicized that the bill provides a substantial drop in the tax rate imposed on corporations to 21%. In order to establish a more even playing field between corporations and pass-through entities, the bill proposes a deduction of a partner/shareholder’s allocation of pass-through income from a partnership or S-Corporation. The deduction is set at 20%, but subject to specific limitations.
Impact on real estate developers: A significant number of real estate developers use a pass-through structure for their business as opposed to a C-Corporation structure. A potential deduction on pass-through income is likely to impact the real estate developer’s business. The key aspect of the limitation resides in the fact that the limitation is not restricted to a percentage of W-2 wages paid as defined in the original Senate bill. Real estate developers often pay little in the way of W-2 wages, instead preferring to employ a management company. The limitation in the final bill can be calculated as the lesser of 20% of the allocated income or 25% of the partner’s share of W-2 wages plus 2.5% of the unadjusted basis of property used in the production of the allocated income.
Example: Real Estate, LLC is a partnership that purchases a commercial building for $1 million. The LLC does not pay any W-2 wages, but engages a management company to provide property management services for the commercial building. Real Estate, LLC generates taxable income of $100,000 in 2018, of which 50% is allocated to Partner A and 50% is allocated to Partner B.
Under the Original Senate Bill
|Partner A's Income Allocation||$50,000|
|50% of W-2 Wages Paid||$0|
Under the Final Bill
|Partner A's Income Allocation||$50,000|
|25% of W-2 Wages Paid||$0|
|2.5% of Unadjusted Basis of Property||$25,000|
|20% of Income Allocation||$10,000|
Partner A’s taxable income from Real Estate, LLC under the final bill is only $40,000 due to the 20% deduction that is now available.
2. NET OPERATING LOSSES
What is in the bill: The bill would repeal the Net Operating Loss (NOL) carry back provision, which allows taxpayers to carry their NOL back two years to offset taxable income in prior periods. In addition to repealing the NOL carry back, the bill also limits the NOL carryforward to 80% of taxable income. NOL’s generated after the 2017 tax year will be subject to the 80% limitation.
Impact on real estate developers: Real estate developers with large carryover losses in years after 2017 will only be able to use them to offset 80% of their taxable income.
- Mr. Smith is a real estate developer with a Net Operating Loss Carryforward of $1 million that originated in 2018.
- In 2019, Mr. Smith has $200,000 of taxable income.
- Under the rules existing prior to the TCJA, Mr. Smith can use the $1 million NOL carryforward to completely eliminate is $200,000 of taxable income resulting in $0 of taxable income and $0 tax liability.
- With the TCJA in place, his $1,000,000 Net Operating Loss Carryforward can only reduce his taxable income by 80%, or $160,000, resulting in taxable income of $40,000.
Mr. Smith’s income is $40,000 higher under the proposed bill due to the 80% limitation.
3. INTEREST EXPENSE DEDUCTION LIMITATION
What is in the bill: The bill limits the deduction for interest expense to 30% of adjusted income, which roughly translates to EBITDA. Although the bill puts in place a limit on the deduction of interest expense, it is possible to elect out of the limitation. If the election is made, then the Alternative Depreciation System (ADS) must be used on property placed in service.
Impact on real estate developers: As real estate developers often use debt to finance the purchase and/or construction of real property, the interest expense that is incurred can be substantial and is paramount in minimizing taxable income. Real estate developers must carefully weigh their options of electing out of the interest expense deduction limitation. The benefit of expensing the full amount of interest expense must be compared to the potential accelerated depreciation deductions, namely bonus depreciation, that would be unavailable under ADS.
4. LIKE-KIND EXCHANGES
What is in the bill: Section 1031 is retained in the bill allowing for the deferral of taxable gain if qualifying replacement property if purchased within a specific timeframe after a sale. There is a change to the current law, however, which allows Like-Kind Exchanges for real property only, namely land and buildings and Section 1031 will no longer be applicable to tangible personal property such as automobiles and equipment.
Impact on real estate developers: Real Estate Developers often use the Like-Kind Exchange to defer taxes on property that is sold with a low tax basis and high fair market value. The fact that Section 1031 is retained in the bill, despite its slight changes, is significant for the real estate industry and will continue to be a useful mechanism to lower tax bills for real estate developers as they buy and sell property.