The good, the bad, and the (pretty) good
Last year was a strange political year that ended with the passage of the most significant federal tax reform in the last three decades. The Tax Cuts and Jobs Act (TCJA) was hastily rolled out and passed, creating confusion about what its effects would be. Adding to the uncertainty in the Bay Area was how the new tax law would affect our commercial and residential real estate markets, which are quite different from those in most parts of the country because of the high Bay Area property costs.
As with most laws, the real-world effects will be a mixed bag for homeowners and commercial landlords. Below are some insights on how this might play out in 2018 and beyond.
One of the advantages starting this year will be more expensing under the bonus depreciation rules, which will benefit property owners with certain eligible property. Property owners can now expense 100 percent of these improvements up to $1 million, an increase from $500,000 previously. In addition, this amount can now include items such as heating and air conditioning systems (HVAC), roofs, fire protection, alarms, and security systems. This allows owners to get tax benefits in the year they make improvements to the property rather over time.
In addition, there is a brand-new 20 percent business deduction from qualified pass-through business income. This deduction, however, has limitations based on wages and qualified property basis.
When the Tax Cuts Act passed, homeowners across the country were understandably nervous about the ramifications. This concern was especially palpable in areas – including the Bay Area – where home prices are significantly higher than the national average. The tax implications may not be that great here: home mortgage interest is now deductible on mortgage amounts up to $750,000, down from $1 million. In addition, only $10,000 of state income and local property taxes are deductible. For people who were previously in the alternative minimum tax (AMT) posture, these provisions only mean the loss of about $300 per month in after-tax benefits.
In terms of the business interest deduction, companies with annual gross receipts of greater than $25 million can only deduct their interest payments up to 30 percent of their adjusted taxable income. Real estate companies can, however, elect to not have these provisions apply if they use longer depreciation lives.
Prior law allowed for qualified improvement property to be depreciated over 15 years and eligible for bonus depreciation. The new law intended to maintain and enhance this treatment, but a drafting error has left the bonus depreciation and the depreciable life uncertain (now 39 years instead of 15 years).
The (pretty) good
Then we get to the parts of the act that have the potential for positively affecting taxpayers – but only if they’re in the right industry.
One of the best tax strategies available to businesses over the last few decades has been the so-called Like Kind Exchange, which lets companies defer taxes by trading similar assets. This option has been preserved, but only for the real estate industry. So, if you own property, you can still swap buildings in a tax deferred manner, but if you’re in any other business you are going to lose the ability to use this tax deferral technique.
Of course, complications can arise. For example, when exchanging an apartment complex for another complex, personal property (such as appliances) would no longer be able to be exchanged tax free.
The other area where many private equity businesses dodged a bullet is with the carried interest. This is a performance reward for investment managers for achieving outstanding results. Until the final passage of the TCJA, the continuation of this common arrangement (which taxes the gain at the more favorable capital gains rates) was in doubt, but it managed to survive the final vote.
That’s good news for many executives/investment managers in the real estate industry. For a real property trade or business, the holding period for the favorable capital gain rates continues to be one year, while in non-real estate businesses, the holding period now is three years to achieve the capital gains tax rates.
Of course, no one really knows exactly what the future will hold, as technical corrections and legislative initiatives will ultimately change the final form of the new tax code. By staying on top of the latest developments, property owners – from homeowners to the largest REITs – will have the best chance of getting the best possible outcomes on April 15 and beyond.