OWNERS OF INCOME PROPERTY are among the biggest beneficiaries of the Tax Cuts and Jobs Act (TCJA) enacted by Congress at the end of 2017.
When President Donald Trump signed the bill into law on December 22, he lauded the new tax law as “a big, beautiful Christmas present” for Americans, and at least for commercial property investors there were some “goodies” in Santa’s bag.
The National Association of Realtors® worked throughout the tax reform process to “preserve the existing tax benefits of homeownership and real estate investment,” as stated in its analysis of the new law. “Many of the changes reflected in the final bill were the result of the engagement of NAR, and its members, not only in the last three months, but over several years.”
Three of the most significant measures for investors are the retention of Section 1031 “like-kind” exchange provisions; increased, accelerated and “bonus” depreciation advantages; and the expansion of tax deductions for Section 179 expenses.
"Changes in the overall tax code because of TCJA will provide more tax advantages to property investors than to homeowners, and are expected to benefit investors in multifamily properties."
SECTION 1031 ‘LIKE-KIND’ EXCHANGES
Section 1031 of the Internal Revenue Code, allowing investors to postpone capital gains taxes on investment property by “exchanging” the sold property for a replacement investment in similar, or “like-kind” property, was first added to the tax code in 1921.
While proponents of the provision argued that it encourages investment in income producing property, Section 1031 had increasingly been criticized as a tax loophole.
Cutbacks in the provision had been recommended beginning with President Bill Clinton’s tax proposals in 1997 and continued more recently as a part of President Barack Obama’s proposed tax changes.
The final 2017 bill retained the Section 1031 provisions postponing taxes on exchanges of “real property,” but whittled down its benefits by eliminating tax deferrals for exchanges of “personal” property such as machinery, equipment, vehicles, airplanes, investment art or collectibles.
The new law still requires the use of a “qualified intermediary” to facilitate the tax deferred exchange. William Horan, owner of Realty Exchange Corporation and a spokesman for the 1031 exchange industry during the congressional debates, explained, “Section 1031 establishes that it is unfair to tax investors who immediately reinvest their proceeds in different ‘like-kind’ replacement property.”
ACCELERATED AND ‘BONUS’ DEPRECIATION USING COST SEGREGATION
The new law also continues the use of accelerated depreciation, allowing investors to write-off a higher percentage of building costs than they could by using a straight-line depreciation schedule. An engineering study, referred to as cost segregation, assigns values to building components such as moldings, cabinets, electrical, landscaping, HVAC, etc., that can be depreciated more quickly and thereby reduce property owners’ taxable income.
According to Fred Clapp, regional director for Cost Segregation Services, Inc., which performs such engineering studies, “Investors could save between $35 and $50 thousand for every $500 thousand in building value by using the additional benefits of accelerated depreciation.
“This is the sleeping giant of cash flow,” Clapp explained. “Every commercial property owner in America should consider using a cost segregation study for [his or her] building.”
Congress also increased the benefit of “bonus” depreciation to encourage property owners to purchase equipment and property that qualifies for the higher depreciation treatment. Before TCJA, the bonus depreciation percentage was 50 percent, and it only applied to new construction. For acquisitions since September 28, 2017, the percentage increases to 100 percent and applies to all building types, both previously owned and new construction.
“A cost segregation study will find the costs that qualify for the accelerated and bonus depreciation under TCJA,” Clapp predicted. “At least 60 percent of commercial property investors are likely to benefit from these changes.”
SECTION 179
Section 179 of the tax code allows small businesses to expense qualified capital expenditures in the year that they were purchased to reduce their taxed income. Under TCJA, the annual business expense limits increase from $500,000 to $1 million, and the qualified investment limits increase from $2 million to $2.5 million. Additionally, write offs for roof, HVAC, fire and security system costs are permitted. There is a financial benefit to taking the full deduction for the items that depreciate immediately, rather than spreading the deduction over the item’s years of usability.
OVERALL IMPACT
Changes in the overall tax code because of TCJA will provide more tax advantages to property investors than to homeowners, and are expected to benefit investors in multifamily properties. This may result in increased rental demand.
Many of the TCJA changes are subtle and may require specific expertise to understand deductions. To provide helpful advice to clients, commercial Realtors® should recommend subject matter experts who are uniquely qualified to find tax dollar savings in the new tax code. This bill is a major accomplishment for large corporations, but business owners of all sizes need to obtain guidance on how the code applies to them.