The Potential Impacts of Tax Reform to Real Estate & Construction Companies

  |  September 10, 2018

On December 22, President Trump signed the tax reform bill, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018,” into law, marking the largest change to U.S. tax policy since the 1980s.

With most of the provisions already in place, it is critical to understand the bill’s conference process and IRS regulations issued in 2018, as they will provide guidance on how to apply key provisions along with the intent of Congress in drafting the bill.

To help them navigate the key provisions affecting the real estate and construction industries, we’ve summarized the top considerations and implications below.

Read ahead to 5 steps companies organizations should take to tackle tax reform

Provision Summary of Changes
Reduce the Corporate Tax Rate Reduces the top corporate tax rate from 35 to 21%. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Lower Taxes on Pass-Through Business Income Creates a deduction available to pass-through filers of 20% on pass-through income subject to certain limitations. This includes “qualified real estate investment dividends.” [Industry View]
Changes to the Depreciation of Commercial Assets Eliminates the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and provides a general 15-year recovery period for qualified improvement property, unchanged from current law. Depreciable life of commercial assets is unchanged from current law.

Retains the existing 40-year alternative depreciation system (ADS) cost recovery period for nonresidential real property, but would contain a reduced 30-year ADS period for residential property and a 20-year ADS period for qualified property improvement.

Expands bonus depreciation for new qualified property investments to 100% from 50%. Applies to both new and used property. [Industry View]

Effective date: Effective for property placed in service after September 27, 2017.

Expansion of Section 179 Deduction Expands the definition of qualified real property to include improvements to nonresidential real property including roofs, heating, ventilation, air conditioning, fire protection, alarm systems, and security systems.

Increases the amount companies can deduct in purchases from the current ceiling of $510,000 to $1 million and increases the phase out threshold to $2.5 million. [Industry View]

Limitations on Interest Deductibility Revises Section 163(j) and expands its applicability to every business, including partnerships. Generally, caps deduction of interest expense to interest income plus 30% of adjusted taxable income, which is computed without regard to deductions allowable for depreciation, amortization, or depletion. Disallowed interest is carried forward indefinitely. Contains a small business exception. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Eliminate Ability to Carryback Net Operating Losses (NOLs) Generally, eliminates taxpayers’ abilities to carryback NOLs, and will limit the use of NOLs to 80% of taxable income. NOLs will no longer have an expiration period. [Industry View]

Effective date: The elimination of carrybacks is effective in taxable years after Dec. 31, 2017.

Limit 1031 “Like-kind” Exchanges to Real Property Eliminates the exemption for like-kind exchanges except for real property.
[Industry View]Effective Date: Effective for taxable years after Dec. 31, 2017.An exception is provided if the property in the exchange is disposed of or received by the taxpayer on or before December 31, 2017.
Limits Mortgage & Property Tax Deductions Under current law, taxpayers can take a combined acquisition and home equity indebtedness interest expense deduction on $1,100,000 of debt. The new legislation only permits the deduction of interest on acquisition indebtedness not exceeding $750,000 and repeals the additional interest deduction for home equity indebtedness through 2025. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Debt incurred on or before Dec. 15, 2017, is grandfathered into the limitations under current law. Taxpayers who entered into a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchase such residence before April 1, 2018, are also eligible for the current higher limitations.

Scale Back the State and Local Tax Deduction for Individuals Limits the itemized deduction for state and local taxes to $10,000 for the aggregate sum of real property taxes, personal property taxes, and either state or local income taxes or state and local sales tax. Currently, each of those state and local taxes is a separate itemized deduction with no limitation. [Industry View]

Effective Date: The bill prohibits a deduction in excess of the $10,000 limitation for 2018 state and local taxes actually paid in 2017.

Carried Interest Changes Carry from investments held for under three years will be taxed at the higher ordinary income rate rather than the lower capital gains rate. Previously, the threshold was one year. The capital gains tax rate was kept as is, at a maximum of 20%. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Expansion of Cash Method of Accounting Raises the average annual gross receipts threshold from $5 million to $25 million for C corporations, partnerships with a C corporation partner, or a tax-exempt trust or corporation with unrelated business income, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Expansion of Exemption from Percentage-of-Completion Method (PCM) Raises the average annual gross receipts threshold from $10 million to $25 million to exempt small construction contracts from the requirement to use the PCM.  Contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected to be completed within 2 years of contract commencement and (2) is performed by a taxpayer who meets the $25 million gross receipts test. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Exemption from Requirement to Keep Inventory Exempts taxpayers that meet the $25 million average annual gross receipts threshold from the requirement to account for inventories under Section 471. Those taxpayers may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies or (2) conforms to the taxpayer’s financial accounting treatment of inventories. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

Expansion of Exemption from Uniform Capitalization Rules (UNICAP) Raises the average annual gross receipts threshold from $10 million to $25 million for any resellers (as well as producers) to be exempted from the application of UNICAP under Section 263A. [Industry View]

Effective date: Effective for taxable years after Dec. 31, 2017.

 

IMPLICATIONS

Provision Considerations
Reduce the Corporate Tax Rate

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Industry View: Positive

What’s at stake: Reduced tax burden for real estate and construction companies.

Lower Taxes on Pass-Through Business Income

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Industry View: Positive

What’s at stake: Reduced tax burden for real estate and construction companies structured as pass-through entities. This is a big win for real estate.

Changes to the Depreciation of Commercial Assets

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Industry View:  Positive-to-Neutral

What’s at stake: The impact of this provision differs based on a real estate company’s cost recovery structures.

The change is positive for real estate companies that rely on full expensing for personal property and new qualified improvement property with a 15-year recovery period and bonus depreciation.

For real estate companies with cost recovery structures under regular depreciation, this change is neutral.
Taxpayers that have elected to use the real property trade or business exception to the interest limitation would be required to use the longer ADS periods for depreciation.

Additionally, if the property is depreciated under ADS, it is not eligible for a bonus.

Expansion of Section 179 Deduction

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Industry View: Positive

What’s at stake: Eases the tax burden of financing property improvements.

Limitations on Interest Deductibility

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Industry View: Neutral

What’s at stake: Real property trades or businesses are allowed to elect out of the limitation since they do not benefit from full expensing provided to tangible personal property.

Generally, any real property trade or business, including ones conducted by widely-held corporations and REITs, may be considered real property trades or business. Taxpayers electing to use the real property trade or business exception to the limitation on interest deductibility would be required to use ADS methods for depreciation for residential, nonresidential, and qualified improvement property.

Eliminate Ability to Carryback Net Operating Losses (NOLs)

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Industry View: Negative

What’s at stake: Potential cash flow obstacle.

Limit 1031 “Like-kind” Exchanges to Real Property

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Industry View: Neutral-to-Negative

What’s at stake: No material impact for straight real estate sales or replacements such as land for land. However, many transactions involve multi-asset exchanges where a taxpayer sells both real and personal property. Without the deferral for personal property, taxpayers are more likely to recognize some amount of taxable gain. This will put pressure on the allocation of purchase price to minimize potential taxable gain. Additionally, taxpayers may avoid an exchange depending on the amount of recognized taxable gain attributable to personal property.

Limits Mortgage & Property Tax Deductions

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Industry View: Neutral-to-Positive

What’s at stake: For commercial real estate and construction companies, this could be a positive in the long termThe limited deductions could reduce the attractiveness of homeownership, which could lead to increased demand for single and multifamily rentals.

However, homebuilders and residential land developers may see a reduction in demand.

Scale Back the State and Local Tax Deduction for Individuals

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Industry View: Neutral-to-Positive

What’s at stake: Similar to the above, could reduce the attractiveness of homeownership in high-tax states, which could lead to increased demand for single and multifamily rentals in those areas.

However, homebuilders and residential land developers may see a reduction in demand.

Carried Interest Changes

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Industry View: Negative

What’s at stake: This would potentially have a negative impact for service partners of real estate investment funds that sell property that has less than a three-year holding period or service partners who sell their partnership interest without holding it more than three years.

Expansion of Cash Method of Accounting

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Industry View: Positive

What’s at stake: Reduced tax and recordkeeping burden for smaller real estate and construction companies.

Expansion of Exemption from Percentage-of-Completion Method (PCM)

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Industry View: Positive

What’s at stake: Reduced tax and recordkeeping burden for smaller real estate and construction companies. Increased ability to use completed contract method, exempt-contract percentage-of-completion method, or any other permissible method.

Exemption from Requirement to Keep Inventory

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Industry View: Neutral-toPositive

What’s at stake: Most real estate companies don’t generally have inventories. However, certain segments such as hospitality have limited inventories and may see reduced tax and recordkeeping burden as a result of this provision.

Expansion of Exemption from Uniform Capitalization Rules (UNICAP)

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Industry View: Positive

What’s at stake: Reduced tax and recordkeeping burden for smaller real estate and construction companies.

HERE ARE 4 STEPS COMPANIES SHOULD TAKE NOW:

  1. Assess impact. Review the key tax provisions against your company’s specific circumstances to determine the overall impact to your company’s bottom line.
  1. Dig into the data. Assessing the impact of tax reform requires a substantial amount of data to be readily available. Companies will need to model the impact of tax reform by focusing on their specific data.
  1. Establish priorities. When considering which aspects of tax reform to tackle first, focus on the areas that could have the greatest impact on your company. For real estate and construction companies, landmark provisions include: changes that could influence entity choice (reduced corporate tax rates and lower taxes on pass-through business income) and the elimination of NOL carrybacks. As a preliminary step, taxpayers operating in the real estate and construction industries should consider their overall choice of entity to minimize tax liabilities under the new law.
  1. Initiate tax reform conversations with your tax advisor. Tax reform of this magnitude is the biggest change we’ve seen in a generation, and will require intense focus to understand not only how the changes apply at a federal level, but also navigate the ripple effect this is likely to have on state taxation as well.

If you’d like to discuss the changes in the tax law and tax planning for your company, please contact Christina Roderick.

This article originally appeared in BDO USA, LLP’s “BDO Knows Alert” Real Estate & Construction newsletter (January 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com

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