First Look at the Tax Cuts and Jobs Act

IRC Section 179 Deduction

The allowable IRC section 179 deduction has increased from $510,000 to $1 million for tax years beginning after December 31, 2017. The maximum asset-spending phaseout has also increased from $2 million to $2.5 million for tax years after 2017. The law also now allows for the deduction of qualified improvement property and certain qualified real property—including roofs, HVAC equipment, fire protection, alarm systems and security systems—for nonresidential properties.

It is important to note that the phaseout amount may prevent some businesses from taking IRC section 179 deductions, trusts are not eligible for section 179 deductions at all, and the entity must be profitable in order to take a section 179 deduction.

Bonus Depreciation

Unlike the IRC section 179 deduction, the bonus depreciation can be taken both by businesses operating at a loss and by trusts. The new provision has increased the bonus depreciation deduction from 50% to 100% for qualified assets purchased after September 27, 2017; this will remain in effect until January 1, 2023, when the amount of bonus depreciation will decrease by 20% per year until the end of 2026. Qualified improvement property, which now includes restaurant and retail improvements as well as tenant and building improvements, has been added as eligible property. In addition, the new law allows bonus depreciation on assets that are acquired from a previous user, allowing bonus depreciation if a cost segregation study is performed.

Like the IRC section 179 deduction, bonus depreciation will benefit businesses with cash flow issues by reducing the taxable income, and therefore the tax liability, in the year of the deduction. Another advantage is that there is no limit to asset spending in a given year, nor any limit on the amount that can be taken. Businesses do not have the option to select specific items for the deduction; therefore, in a given year, taking bonus depreciation on one asset requires the company to take bonus depreciation on all assets that fall into that asset class. Many states, such as New York, do not allow bonus depreciation, so the deduction will need to be added back to income on the state tax return. This will result in income for federal purposes being higher than that for state purposes in the year of the deduction and the reverse in subsequent years.

Pass-through Deduction

Many individuals who have net income from pass-through entities think that under the TCJA, they will only be paying tax on 80% of their pass-through income, since the TCJA provides for a 20% deduction of this income. The minimum amount of the income they will pay tax on is 80%, in fact, and they may in fact pay tax on all 100%.

For tax years beginning in 2018, the TCJA establishes a deduction of up to 20% of qualified business income (QBI), generally defined as the net amount of qualified items of income, gain, deduction, and loss from any qualified business of the noncorporate owner. QBI does not include investment income, guaranteed payments, and reasonable compensation income from the business. QBI does include all income from real estate businesses, including management and rental income; however, it does not include gains from the sale of real property.

A single taxpayer with taxable income of $157,500 or less ($315,000 or less for married couples filing jointly) will be entitled to the full 20% deduction, subject to the taxable income limit. All others must take the following steps, separately applied to each trade or business, to determine the amount of their deductions:

• Step 1: Aggregate all QBI from a trade or business, not an entity (i.e., all real estate entities are combined), and multiply this amount by 20%.
• Step 2: Multiply the allocable share of W-2 wages deducted in arriving at net income from this trade or business and multiply it by 50%.
• Step 3: Multiply allocable wages from this trade or business by 25% and add 2.5% of the allocable share of the unadjusted basis of depreciable assets.
• Step 4: Compare the results of steps 2 and 3 and take the greater.
• Step 5: Compare the result in step 4 to the result in step 1; the lower of these is the amount deductible by the taxpayer against pass-through income, subject to the following limitation. If the 20% of the taxpayer’s taxable income after subtracting capital gains is less than the result in step 5 above, then the deduction is limited to this result.

The wages from a real estate management company will qualify, and the management company’s QBI is grouped with all other real estate activities as one trade or business.

It is possible to not be allowed any deduction from pass-through income; therefore, 20% is the maximum possible amount, but this is not guaranteed.

Interest Deduction Limitation

According to the TCJA, beginning in years after December 31, 2017, businesses will only be able to deduct business interest expense up to 30% of its adjusted taxable income plus its business interest income. Adjusted taxable income is defined as income before interest, depreciation, and amortization; beginning in 2022, depreciation and amortization will no longer be added back. As a result, it may be less beneficial for a real estate owner to be highly leveraged.

There are some exceptions to this new rule. A small taxpayer, defined as having average annual gross receipts of $25 million or less for the prior three taxable years, is not subject to the limitation. When computing the $25 million, taxpayers must take into account all related entities (i.e., entities with 50% or more common ownership), and attribution rules apply. For example, assume that Partners A and B equally own an entity with average gross receipts of $10 million; Partners A, B, and C equally own an entity with average gross receipts of $15 million; and Partners B and D equally own an entity with $1 million of gross receipts. All three entities meet the exception, since A and B each own 50% of the first entity and 66.67% of the second, and B owns 50% of the third.

A further exception is for real estate entities, which are entitled to take 100% of their interest deduction if they so elect, but will then be subject to the alternative depreciation system (ADS) on all buildings, building improvements, leasehold improvements, and tenant improvements placed into service beginning in the year of election. Under the ADS, entities will not be allowed to take bonus depreciation on any of their building improvements, tenant improvements, and leasehold improvements. In addition, residential properties must be depreciated over 30 years (as opposed to 27.5 years) and commercial properties over 40 years (as opposed to 39 years). Partnership representatives should therefore be very cautious in electing to take 100% of the interest deduction, since this is a permanent election.

When a partnership’s business interest deduction is limited, the excess interest expense will flow to the partner and can be used in future years when that activity’s interest expense is below the 30% limit, but only up to the 30% limit in any future year. The excess interest expense for a corporation will be “held” at the corporate level until it is able to be used. Any interest deduction not utilized is added to basis.

Taxpayers may want to investigate which liabilities are creating the interest expense to see if there are ways to minimize it. If there are partner or related-party loans, it may be advisable to check whether they can be capitalized in order to remove the interest expense. In the event the loans are disproportionate to ownership, taxpayers should consider changing the loans to preferred equity with a preferred return instead of interest.

Excess Loss Limitation

The TCJA added a provision that limits the amount of net pass-through losses a taxpayer can take in any given year. This excess loss limitation applies to all taxpayers other than corporations and is effective for years beginning after December 31, 2017, and ending before January 1, 2026.

A taxpayer takes the aggregate income and losses (not including investment income) from all pass-through trades and businesses, including sole proprietorships, and if the sum represents a loss of greater than $250,000 for a single filer ($500,000 for a married couple filing jointly), then the excess loss is disallowed in the current year. The amount disallowed (the excess loss) becomes a net operating loss to be used in future years, subject to its own limitation. Note also that the calculation is done after taking into account the passive activity rules.

It is clear that, under this provision, a taxpayer can have wages, interest, dividends, and other income that were used to fund businesses that generated the losses and still have to pay tax. For example, if a taxpayer (married filing jointly) has wages, interest, and dividend income of $2 million and net aggregate losses from trades and businesses of $2 million, the taxpayer would pay tax on $1.5 million of this income ($2 million minus $500,000 of allowable losses). If the taxpayer’s income was already invested into the businesses to keep them afloat, the taxpayer may have difficulty paying this tax.

There is much planning to be done and some important decisions to be made to adjust to this new provision. Decisions that may seem sound at the entity level can have an adverse effect on an individual partner’s taxes. This and other scenarios are quickly proving that one cannot look at a single provision of the TCJA without also looking at how it interacts with other provisions.