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It’s 2020! Let’s take a quick look at some recent tax law changes affecting commercial real estate tax deduction restrictions. Below please find some insight into recent tax changes affecting commercial real estate tax deductions.
Here are some items that come to mind:
(1) The Tax Cuts and Jobs Act enables investment real estate owners to still defer capital gains taxes using section 1031 like-kind exchanges. There were no new restrictions on 1031 exchanges of real property made in the law. However, the new law repeals 1031 exchanges for all other types of property that are not real property. This means like-kind exchanges of personal property will no longer be allowed after 2017 for collectibles, franchise rights, heavy equipment and machinery, collectibles, rental vehicles, trucks, etc. The rules apply to real property not generally held for resale (such as lots held by a developer).
(2) The capital gain tax rates stayed the same so a real estate owner selling an investment property can potentially owe up to four different taxes: (1) Deprecation recapture at 25% (2) federal capital gain taxed at either 20% or 15% depending on taxable income (3) 3.8% net investment income tax (“NIIT”) when applicable and (4) the applicable state and local tax rate.
(3) The tax law creates a new tax deduction of 20% for pass-through businesses. This gets tricky but here goes. For tax years 2018-2025, an individual generally may deduct 20% of qualified business income from a partnership, S corporation, or sole proprietorship. The 20% deduction is not allowed in computing Adjusted Gross Income (AGI), but is allowed as a deduction reducing taxable income.
Restrictions on Tax Deductions
(1) Mostly, the deduction cannot exceed 50% of your share of the W-2 wages paid by the business. The limitation
can be computed as 25% of your share of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis
(the original purchase price) of property used in the production of income.
(2) The W-2 limitations do not apply if you earn less than $157,500 (if single; $315,000 if married filing jointly).
(3) Certain personal service businesses are not eligible for the deduction, unless their taxable income is less than
$157,500 for singles and $315,000 if married. A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. (It appears President Trump liked real estate people but did not like professionals like lawyers, doctors, accountants and other consultants).
(4) The exception to the W-2 limit and the general disallowance of the deduction to personal service businesses is phased out over a range of $50,000 of income for single taxpayers and $100,000 for married taxpayers filing
jointly. By the time income for a single taxpayer reaches $207,500 or $415,000 for a married-filing-jointly
taxpayer, the W-2 limitation will apply in full (i.e. personal service professionals get no deduction).
(5) The new tax law increased the maximum amount a taxpayer may expense under Section. 179 to $1,000,000 and increased the phaseout threshold to $2,500,000. Interestingly, the new law also expanded the definition of Section. 179 properties to include certain depreciable tangible personal property used predominantly to furnish lodging. It also expanded the definition of qualified real property eligible for Section 179 expensing to include the following improvements to nonresidential real property: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems
(6) State and local taxes paid regarding carrying on a trade or business, or in an activity related to the production of income, continue to remain deductible. A rental property owner can deduct property taxes associated with a business asset, such as any rental properties. Don’t confuse such with the itemized deduction for your personal residence or vacation home which is now limited.
(7) While the prior law generally allows a deduction for business interest expenses, the new tax act limits that deduction to the business interest income plus 30% of adjusted taxable income. However, taxpayers (other than tax shelters) with average annual gross receipts for the prior three years of $25 million or less are exempt from this limitation. Real estate businesses can elect out of the business interest deduction limitation, but at the cost of longer depreciation recovery periods—30 years for residential real property and 40 years for nonresidential real property. If a real estate business does not elect out of the interest deduction limitation, then residential and nonresidential real property depreciation recovery periods are maintained at 27.5 years and 39 years, respectively.
Phew-there you have taste of what we’re going or at least as we see general changes directly or even indirectly
affecting real estate peeps. As you can see, the new law will bring a lot of changes (both good and bad) to individual and business taxpayers. On the plus side, this means more planning opportunities for many although looking for answers can be problematic as we all try to navigate through uncertain territory. These comments only touch the surface of one of the biggest tax overhauls in the nation’s history. Stay tuned and do stay close to your tax attorney and accountant.….
Let’s explore Corporate Owned Real Estate. A frequent mistake made by small business owners is to have the operating corporation own the real estate, or to have a separate C corporation own the property and lease it to the business. The reason is that when the company eventually disposes of the property, usually after it has significantly appreciated and been substantially depreciated, a double tax bill will result. First, the corporation will be taxed on the appreciation upon the disposition of the real estate, and then, the shareholder(s) will be taxed on the proceeds of the disposition when they are distributed to them as a dividend or through liquidation. The tax traps are not limited to C corporations. Holding real estate in an S corporation has its own pitfalls. Mortgage debt does not constitute “basis” for tax losses when the accompanying real estate is owned in an S corporation. As most real estate investments yield potentially deductible losses after factoring depreciation on the structure, this could eliminate the tax benefits for a great deal of investors. There are great alternatives to corporate owned real estate.
A Better Approach to Corporate Owned Real Estate
A better approach than corporate owned real estate is for the business owners to own the real estate personally in a limited liability company or in a partnership with other investors, and then lease it to the operating business. Among the advantages:
• The business owner can sell the real estate interest for his or her own account, avoiding tax at the corporate level.
• The owner can refinance the property for his or her own benefit.
• Lease payments received by the property owner are not subject to employment taxes and are deductible by the company as a business expense.
• If the property owner dies while still owning the property, heirs will get it at its stepped-up basis, eliminating tax on all of the gain resulting from appreciation.
It’s particularly important for small business owners to engage in careful tax planning with respect to real estate being acquired for use by their business, and we receive frequent requests for assistance with appropriate tax strategies.
While we’re talking real estate and hopefully that which is not titled in corporate form, do you own a property that has appreciated considerably and that you want to sell? Are you concerned about incurring a large capital
gains tax liability? One option is to structure the sale as an installment sale. Here the buyer pays the cost of the property plus interest in regular installments, frequently for a period of 5 years, enabling the seller to reflect the capital gain for tax purposes over the entire payment period. Sellers who decide on this strategy are cautioned, however, that an installment sale carries more risk than an outright sale of the property. Thus, the seller needs to:
• Carefully assess the creditworthiness of the buyer and possibly obtain personal guarantees, if the purchaser is a business.
• Evaluate the future income producing capability of the property to make sure it provides sufficient cash flow to enable the buyer to make the payments.
• Use an interest rate that is competitive with current market rates in the area so as not to squash the deal.
• Obtain a down payment of at least 20% to have a cushion in the event of buyer default, and to cover the expenses if foreclosure becomes necessary.
Similarly, a topic for another alert is our frequently suggested use of Section 1031 which provides an alternative strategy for deferring the capital gains tax that may arise from a business/investment property sale. As of the writing of this Abo and Company Tip-of-the Month, we’ve read that the days of deferring 100% of gain via likekind
exchanges of real-estate could be numbered if the much talked about tax reform occurs in this particular arena does take place. Republican lawmakers are seeking tax breaks to trim or scrap to offset the cost of significantly cutting the income tax rate for businesses. We’ve seen tax-free real estate exchanges/swaps targeted before nixing like-kind swaps, immediately taxing the full amount of gain or in President Obama’s proposal to cap the deferral at $1 million. If the deferral is curbed, we don’t think the break will be axed retroactively but who really knows at this point.
Business property transactions are often complex, and the services of a knowledgeable CPA (hopefully we at Abo and Company) can be vital in developing strategies that make it possible to bring a contemplated transaction to a successful conclusion.
FOR MORE INFORMATION:
Martin H. Abo, CPA/ABV/CVA/CFF is a principal of Abo and Company, LLC and its affiliate, Abo Cipolla Financial Forensics, LLC, Certified Public Accountants – Litigation and Forensic Accountants. With offices in Mount Laurel, NJ and Morrisville, PA, tips like the above can also be accessed by going to the firm’s website at www.aboandcompany.com.