The Tax Cuts and Jobs Act was signed into law by President Donald Trump on Dec. 22. Many investors want to know what impact the new law will have on their own tax situation. With some quick research, and a lot of help from our certified public accountant, hopefully we can shed some light on the topic. The new tax laws are complicated and subject to change. These comments are only a guideline and not tax advice. Investors should consult with their CPA for advice for their particular situations.
As most investors already know, there are no new restrictions on 1031 exchanges, which is certainly beneficial to all real estate investors. We have selected a couple other changes to discuss below that also are favorable and perhaps less well known.
Depreciation. There is a distinction in the new rules for residential (apartment buildings) and nonresidential for certain depreciation methods. There are two different accelerated methods – Section 179 and Section 168(k) bonus depreciation.
For tax years beginning after 2017, items (for example, nonaffixed appliances and furniture) used in connection with residential buildings (but not the buildings or improvements to them) are section 179 property eligible for immediate expense, subject to limitations. The change expands the definition of section 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with the furnishing of lodging. Examples of this property are beds and other furniture, refrigerators, ranges and other equipment used in the living quarters of a lodging facility such as an apartment building.
The nonstructural improvements with a life of less than 20 years can be depreciated under bonus depreciation and deducted 100 percent in the year placed in service. Apartment buildings along with their structural improvements placed in service after 2017 generally continue to be depreciated over a 27.5-year period.
The Tax Cuts and Jobs Act expands and extends the additional first-year depreciation provision under Code Section 168(k) to allow for 100 percent immediate expensing of the cost of certain business property placed into service after Sept. 27, 2017, and before Jan. 1, 2023. Code Section 168(k) continues to apply only to Modified Accelerated Cost Recovery System property with a depreciable life of 20 years or less, water utility property, computer software and qualified improvement property. Beginning in 2023, the immediate first-year expensing will be reduced to 80 percent, followed by 60 percent in 2024, 40 percent in 2025, 20 percent in 2026, and reduced to 0 percent thereafter. A transition rule in the Tax Cuts and Jobs Act allows taxpayers to elect to expense 50 percent of the cost of eligible business property rather than the full 100 percent for their first tax year beginning after Sept. 27, 2017.
Under amended Code Section 179, the Tax Cuts and Jobs Act allows immediate expensing for up to $1 million of the cost of qualifying tangible personal property placed into service after Dec. 31, 2017, an increase from the $500,000 cap under current law.
New pass-through tax deduction. Most investors hold their properties in pass-through entities such as sole proprietorships, limited liability companies, partnerships and S corporations. Profits from these businesses are “passed through” the entity and the owners pay tax on them at their individual tax rates. The act creates a brand-new tax deduction for people who earn income through pass-through entities (new IRC Sec. 199A). These individuals now may be eligible to deduct an amount up to 20 percent of their net business income. This is in addition to all their other business deductions. If this deduction applies, a pass-through owner is effectively taxed on only 80 percent of business income. Thus, the effective rate for pass-through owners in the top 37 percent tax bracket is 29.5 percent.
This deduction is very complex and varies based on income below $315,000 ($157,500 for singles) or income above $415,000 ($207,500 for singles). The complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the thresholds discussed above.
Consequently, investors should seek advice from their CPA to fully understand the deduction opportunity. This is a personal deduction pass-through that owners can take on their returns whether or not they itemize. This deduction is scheduled to end Jan. 1, 2026.
Clearly these changes are very favorable to real estate investors. Consequently, we expect to see high net-worth individuals shift capital from equities to real estate investments in order to take advantage of the Tax Cuts and Jobs Act. This trend should keep the apartment market on track nationally and here in the metro Denver area.