The Many Unknowns in The Tax Bill’s CRE Provisions

As 2017 wound to a close residential home owners went into a scramble. With the Tax Cut and Jobs Act limiting the value of the property tax deduction next year, many were rushing to pay their property tax early and claim the deduction on their 2017 returns. In response IRS released a notice warning taxpayers this maneuver would only be allowed if they had their assessment for 2018.

“What was good advice one day suddenly was not actionable the next day based on a new interpretation by the IRS,” John Chang, first VP of research services for Marcus & Millichap, tells GlobeSt.com.

The commercial real estate community can expect a similar scenario to play out, perhaps again and again, over the first and second quarters of this new year. There are, as several experts have told GlobeSt.com, many gray areas in the bill around the provisions for commercial real estate.

“There’s a lot in the bill that’s not necessarily black and white or clear to most people,” Adrian Alfonso, a CPA and member of Kaufman Rossin’s real estate team, tells GlobeSt.com.

Alfonso’s advice to commercial real estate executives is to slow down and not rush into any major decisions. Or, for that matter, follow general advice that you read in the media. Instead, he says, consult with a professional with your questions.

Some of the decisions that need to be made can wait a few months, Alfonso also says. The check-the-box election, for example, is not due until March.

Also, it is widely expected that the IRS will be issuing guidance on issues that are unclear, hopefully during the first quarter.

“This is the largest change to the tax law in 30 plus years,” Alfonso says. “It is going to take time for all of this to settle and guidance to be out.”

Following are some of the areas in the new tax law that experts feel need further clarification before real estate executives can make final decisions.

The Section

199A

What It Says

Taxpayers other than corporations will be allowed a deduction of approximately 20% of their qualified business income, Montgomery McCracken Senior Tax law partner Gary M. Edelson explains to GlobeSt.com. This amount is going to be the lesser of 20% of the qualified business income or the greater of 50% of W-2 wages paid to employees and 25% of W-2 wages plus 2.5% of unadjusted basis of qualified property.

What We Don’t Know About It

One basic question is what a qualified business is, Lorie White, partner, Tax Services for Grant Thornton tells GlobeSt.com. “Typically if you’re holding real estate that would be considered a qualified business. However, if you look at some of the other definitions of real estate that’s in the bill, it talks about owning and managing real estate as a whole.”

It is a possible, therefore, that a management company that manages real estate could be considered a qualified business and would be able to avail itself of the business deduction. Or a developer or construction company. “Which, quite frankly, would be a very big deal,” White says.

Another uncertainty: how the 2.5% of adjusted basis is to be computed. There will need to be guidance about this, Edelson says. This provision was added towards the end of the negotiations, according to Alfonso. “The way I read it, it seems as if they are going to allow you to take 2.5% of the cost of the assets that are used in the trade or business, not taking into account depreciation,” he says. “So you’ll actually be able to get the gross value of the asset right after the acquisition and they’re letting you take that calculation of that number either for a ten-year period, or the last day of the last full year of applicable recovery period for that asset.”

But, he added, there still needs to be clarification as to what exactly is allowed under the rule. “For example, a property under development many not necessarily qualify under this rule because technically that property is inventory — it’s not depreciable property.”

Another question Alfonso has is about 1031 exchanges. “Are we talking about the value of their property prior to the 1031 or about the new adjusted basis property? My gut tells me the new adjusted basis of the property is what you would use to calculate this particular part of the 20% deduction limitation.”

The IRS will have to come out with guidance about that, Alfonso says, as well as guidance about when it is appropriate to increase W-2 wages in order to maximize the 20% deduction. “I think the IRS will crack down on people who are switching to become independent contractors in order to be able to generate qualified business income to get the deduction. They will try to limit that sort of activity with new rules,” he predicts.

The Section

163(j)

What It Says

Interest deduction will be limited to 30% of adjusted taxable income, but there is an exception for electing real property trade or business. “This is technically defined by a cross-reference to the passive activity loss rules,” Edelson says. “An electing real property trade or business must make an election and as a consequence of making that election, must adopt a longer recovery period for depreciation purposes.”

What Might Happen

Section 163(j) will likely result in some real estate limited partnerships and LLCs using preferred membership interests or preferred LLC interests with a high yield in lieu of debt financing, Edelson says. “Lenders may become equity owners in numerous pass through entities owning real estate.”

What We Don’t Know About It

Here too, the question of what entities are viewed as being in real property trades or business arises, Edelson says. He does note that the cross reference to Section 469(c)(7)(C) indicates “that a real property trade or business has to be in business of real estate development, redevelopment, construction, acquisition, rental or brokerage.”

The provision also allows for real estate companies to opt out of the limitation, White says, and that introduces a new series of questions.

She wonders, for instance, whether a company that owns and develops its real property and has a different operational side of the business outside of real estate would still be able to use the opt out of the 30% limitation on their interest expense.

Such a company might buy real estate for use in a different industry such as health care. “Is that entity a real estate company or a healthcare company,” she says. “And how would this 30% limitation apply?”

It’s an important question because if a company makes this election then it can’t use the full expensing provisions that are also in the bill, White adds. Here it should be noted that the law allows for 100% full expensing retroactive to September 2017. So conceivably a company could take advantage of the full expensing in the fourth quarter of 2017 even if it takes advantage of the election to opt out of the interest expense limitation for the tax year 2018, White says. “I think there’s a little bit of a loophole here.”

The Section

179

What It Says

The immediate expensing of personal property was enhanced to include used property purchased from an unrelated person where the basis is a cost basis, Edelson explains. Qualified improvement property will be permitted to be depreciated over 15 years. This is any improvement to the interior portion of a nonresidential building if the improvement is placed in service after the date the building delivered. Section 179 expensing is permitted for similar activities as well as new roofs, heating and ventilation and air conditioning systems, fire protection or alarm and security systems.

What Might Happen

“The fact that they are allowing you a 100% depreciation on any assets in 15 years will lead to a lot of people using cost segregations to maximize those deductions,” Alfonso says. A cost segregation, usually conducted by an engineer, looks at the different structures, such as the air-conditioning/heating unit and plumbing for instance, and then breaks down the building into different buckets, Alfonso explains, with some of the buckets having more favorable depreciation years. “So you’ll be able to expense them a lot quicker especially now that bonus depreciation, which was historically 50%, is now 100% on new and used assets. That gives the taxpayer the ability to expense a good chunk of what they’re purchasing right off the bat.”

What We Don’t Know About It

There are some nuances between the rules for mortgage interest deductibility and their relationship to depreciation timelines, says Marcus & Millichap’s Chang. “So, an investor can write off the mortgage interest on a commercial real estate investment, but if they do then the depreciation timeline of their asset gets extended,” he says.

However, he adds, the way the rule is written is not clear, making it open to interpretation on exactly how the depreciation and mortgage interest deductions on investment property will play out. “Until we have guidelines, we don’t know how it will go. That makes it difficult for investors as they underwrite possible acquisitions in terms of deductions and depreciation.”