Sitting Pretty – Real Estate Industry Among the Big Winners on New Tax Law
JEFFREY NEWMAN, CPA, JD
By passing the Tax Cuts and Jobs Act (TCJA) in late December 2017, Congress granted the holiday wishes of many involved in real estate. While the TCJA brought good cheer for the business community in general, the real estate industry is particularly likely to reap some lucrative rewards.
The Pass-Through Provisions
So-called pass-through entities (partnerships, limited liability companies, S corporations and sole proprietorships) are common among real estate firms. Investors, developers, landlords and real estate investment trusts (REITs) that structure their businesses as pass-through entities have paid taxes on the income at individual tax rates as high as 39.6%.
For 2018 through 2025, the TCJA reduces the highest individual tax rate to 37% and raises the taxable income threshold for that rate to $500,000 for single filers and $600,000 for joint filers. Moreover, it creates a generous new business income deduction that slashes taxable income.
The qualified business income deduction generally allows taxpayers to deduct 20% of income from a pass-through entity, as well as 20% of qualified REIT dividends. Once taxable income exceeds $157,500 for single filers or $315,000 for joint filers, a “wage limit” begins phasing in, whereby taxpayers can deduct the lesser of 20% of qualified business income or 50% of the W-2 wages paid by the business. The wage limit phases in completely at $207,500 for single filers and $415,000 for joint filers.
In addition, an alternative wage limit was added to the TCJA at the last minute — an alternative favorable to firms with few employees but extensive real estate holdings. Under this option, taxpayers will instead deduct the lesser of a) 20% of qualified business income or b) the sum of 25% of wages and 2½% of the unadjusted basis (meaning the purchase price) of tangible depreciable property.
Interest Expense Exemption
While the TCJA introduces a significant new restriction on the interest expense deduction for those businesses that have greater than $25,000,000 in gross receipts, generally limiting the deduction to 30% of adjusted taxable income, it allows real estate businesses whose gross receipts exceed $25,000,000 to elect out of the limit. Loan interest would then remain fully deductible, but the business would be required to use the alternative depreciation system for real property used in the business, regardless of when the property was placed in service, and it wouldn’t be allowed to deduct bonus depreciation. Any disallowed interest under this provision would carry forward.
Unfortunately, the Senate proposal to cut the recovery period for nonresidential real and residential rental property to 25 years didn’t make the final bill — the depreciation periods remain at 39 and 27½ years, respectively. Real estate firms may, however, benefit from changes to the rules for depreciating other types of property.
First, the TCJA expands Section 179 expensing. For qualifying property placed in service in tax years beginning in 2018, it boosts the maximum deduction for qualifying property to $1 million (up from $510,000 for 2017) and the phaseout threshold to $2½ million (from $2.03 million for 2017). These amounts will continue to be annually adjusted for inflation. The TCJA expands the definition of qualified real property eligible for Sec. 179 expensing to include several improvements to nonresidential real property:
- Ventilation and air-conditioning property;
- Fire protection and alarm systems; and
- Security systems.
Further, it broadens the definition of Sec. 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging.
In addition, real estate businesses that don’t elect out of the new interest expense deduction limit may benefit from enhancements to bonus depreciation. The TCJA extends and modifies bonus depreciation for qualifying property (for example, software and qualified improvement property) placed in service after September 27, 2017. It allows businesses to immediately expense 100% of the cost of qualifying property in the year the property is placed in service, through 2022 (with an additional year for certain property with a longer production period). The new law also permits bonus depreciation for both new and used property.
Beginning in 2023, the amount of the allowable depreciation deduction will phase down, dropping 20 percentage points each year for four years and sunsetting completely in 2027, absent congressional action. Under a transition rule, for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50% allowance instead of the 100% allowance.
The Bottom Line
Developers, investors, landlords and REITs should be pleased with the new tax rules overall. Be sure to contact your real estate professional to make sure you don’t miss out on any of its benefits.
Sidebar: But Wait, There’s More
The Tax Cuts and Jobs Act (TCJA) has additional favorable provisions for real estate firms. The Act preserves Section 1031 like-kind exchanges for real estate investors, who can continue to defer their capital gains taxes by reinvesting sales proceeds in certain types of “investment properties.” Under the law, the exchanges can no longer be used for personal investment properties such as heavy machinery, boats and airplanes, and are now restricted to real property. However, real estate investors who regularly use this type of transaction take note: The TCJA restricts exchanges to real property that isn’t held primarily for sale.
The TCJA also retains several credits important to certain kinds of development projects. The House of Representatives’ tax bill would have repealed the new markets tax credit and the rehabilitation credit. The final bill maintained the former and modified the rehabilitation credit to repeal the 10% credit for pre-1936 buildings but keep the 20% credit for certified historic structures, claimed over five years beginning when the building is placed in service. The low-income housing tax credit also continues unchanged.
If you have specific questions or need assistance with your real estate, please contact Jeffrey Newman at [email protected] or call 312.670.6232. Visit ORBA.com to learn more about our Real Estate Group.
Are You Ready for the New Revenue Recognition Rules?
KADIR SUNARDIO, CPA, CFP®
New rules are poised to take effect that could fundamentally change how many in the real estate industry will account for their revenue. Public companies must apply Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, in 2018, while compliance for private companies that follow the U.S. Generally Accepted Accounting Principles (GAAP) begins in 2019.
The updated standard makes some significant changes to the way revenue from real estate sales is recognized. Specifically, the guidance lays out the following five steps that a company must follow to determine when to properly recognize revenue on its financial statements:
Steps to Properly Recognize Revenue
- Identify the Contract
The guidance applies to each contract that a company has with a customer that meets certain criteria. The assessment of whether or not a contract exists will be relatively straightforward for most real estate transactions. However, if the contract includes financing, the seller must evaluate the collectibility of the transaction price, or the probability that the seller will collect the consideration. The new guidance discards the current test — whether the buyer’s initial and continuing investment in the property was sufficient so that the buyer would fulfill its obligation — but provides little guidance on how to determine if the collectibility threshold is met. As a result, a high degree of judgment will be necessary. Developers must continually re-evaluate an arrangement to see if it has become sufficiently collectible to qualify as a contract.
- Identify Performance Obligations
If a contract contains obligations to transfer more than one good or service to a customer, the developer can account for each as a separate performance obligation only if the good or service is distinct or is a series of distinct goods or services that are substantially the same. A contract, for example, might include the sale of property and its development. If those are deemed separate performance obligations, the revenue attributable to the sale generally will be recognized at closing of the sale, with the revenue for development recognized over time. If they are not separate, the revenue from the sale will be deferred until the development is complete.
- Determine the Transaction Price
The company must determine the amount that it expects to receive in exchange for transferring promised goods or services to the customer. The transaction price should include an estimate for variable consideration, including performance bonuses and shared-savings arrangements. That estimate should be recorded only if it’s probable that the company won’t need to reverse the amount of cumulative revenue recognized when it resolves the uncertainty associated with the variable consideration. Under the current rules, variable consideration is estimated and recognized throughout the contract term as it’s collected from the customer. So, revenue from variable consideration might be recognized earlier under the new ASU.
- Allocate the Transaction Price
The transaction price is allocated based on the relative standalone selling price of each specific good or service promised to the customer. For example, if a developer promises both property and management services, it must estimate the standalone selling price for each component and allocate the price accordingly.
- Recognize Revenue
Revenue is recognized as the seller satisfies a performance obligation by transferring control of the promised good or service to the customer. Under the current rules, the focus is on whether the usual risks and rewards of ownership have been transferred, not control. According to the updated standard, when a performance obligation is satisfied over time, rather than at a single point in time, the company also must recognize the related revenue over time. (See “Recognizing revenue over time or at a point in time.”)
Compliance with the new revenue recognition rules will require many real estate entities to collect information they aren’t currently gathering. They may need to modify or even replace existing systems, processes and procedures, as well as add new internal control procedures. Many real estate transactions will be affected by the updated standard, so it’s important for developers to start the implementation process today, rather than wait until the last minute.
Sidebar: Recognizing Revenue Over Time or at a Point in Time
The accounting standard on revenue recognition includes some helpful examples of how developers can assess whether a performance obligation is satisfied at a point in time or over a period of time. It includes a scenario where a developer enters a sales contract for a condo that’s under construction.
In one example, the customer pays a deposit that’s refundable only if construction isn’t complete. The balance is due when the customer takes physical possession. If the customer defaults before completion, the developer is entitled to only the deposit. Thus, the performance obligation isn’t satisfied over time; revenue is recognized when the condo is complete and control (the keys) is transferred to the customer.
In the second example, the customer pays a nonrefundable deposit and will make progress payments. The developer can’t sell the unit to another customer, and the customer can’t terminate the contract unless the developer fails to perform as promised. If the customer defaults, the developer is entitled to the full price if it completes construction. Here, the developer’s performance obligation is satisfied over time, and revenue also should be recognized over time.