The real estate industry is in constant flux, and the recent tax reform has simply added to the uncertainty. While some experts predict that the new tax law will negatively impact home and other property ownership, the real estate industry as a whole did escape with some major wins. Two of these provisions, (1) the preservation of §1031 Exchange treatment and (2) an exception to the interest expense limitation, are discussed below. These wins, while still positive overall for the industry, may involve some planning to fully leverage. With the help of a tax advisor, real estate businesses can truly understand these tax provisions so that they will be much better prepared to plan for the future.
Win #1: Preservation of Section 1031 Exchanges
Like-Kind Exchanges, formally known as §1031 Exchanges, allow sellers of investment property to defer gains on their sales as long as they invest in replacement property that is “like-kind” to the property they relinquished. Historically, §1031 Exchanges could be used when replacing all types of investment property – artwork, vehicles, real estate, business equipment, and others. However, under the new tax laws, Like-Kind Exchanges can only be applied to sales of real estate. This means that real estate dealers can continue to utilize this pro-taxpayer code section to defer gains when selling a property.
The difficulty arises when sellers of real property are unable (or unwilling) to separate the sale of a building from the sale of the personal property that it inside it. Large equipment or furnishings, for example, maybe difficult to sell separately from the building. Because the gain cannot be deferred on the sale of personal property under §1031, real estate dealers must be able to properly allocate the sales price and the cost basis to the various types of property included in the sale. To do this, they can consider performing a valuation analysis. A formal valuation analysis can be performed with the help of a CPA, and doing so will allow the taxpayer to know what portion of the gain will be deferred under §1031 and which portion must be fully recognized.
Win #2: Interest Expense Limitation Exception
The new tax law introduced a new limitation on how much business interest expense is deductible. Prior to 2018, business interest was generally fully deductible as it was paid or accrued. The newly amended §163(j) of the Tax Code will limit the deduction to be the sum of the following: (1) business interest income, (2) 30% of the business’s adjusted taxable income, and (3) the business’s floor-plan financing interest.
Luckily, taxpayers engaged in real property businesses, including real estate development, construction, acquisition, rental, management, and so many others, are an exception to this rule. They can make an irrevocable election to ignore this limitation and fully deduct all of their business interest expense. While this is great news, included in this election is the promise to use an alternative depreciation system for their properties. Because the alternate depreciation calculation slows depreciation down compared to the standard depreciation tables, it would take taxpayers longer to recover their costs.
Another setback is that taxpayers who make this election may lose out on bonus depreciation. Right now, bonus depreciation is disallowed for all real property acquisitions and most large improvements. However, sometime this year, the IRS is expected to issue a corrections bill that will allow taxpayers to take bonus depreciation on “qualified improvement property.” If this corrections bill passes, certain building improvements would be eligible for bonus depreciation under traditional depreciation rules, but would be disallowed under the alternate depreciation rules. In this instance, taxpayers would have to determine if losing the interest deduction or losing bonus depreciation is the better option.
These two industry wins can come at a cost, and planning ahead when the effects are still uncertain will be difficult to do alone. Luckily, Hanson & Co has a dedicated real estate division full of team members who can help your business prepare for these changes. If you own a real estate business and need more clarification of these changes or any others, contact us directly. We look forward to speaking with you soon.