The Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law by President Donald Trump on December 22, 2017. The Act changes many provisions of the Internal Revenue Code, from individual and business provisions, to matters affecting pass-through and tax-exempt organizations. The Act is generally effective starting in 2018.
In this summary, we address the major issues that will affect our clients in the real estate and construction industry.
I. INDIVIDUAL TAX CHANGES
Modifications to capital gain provisions. The Act generally retains present-law maximum rates on net capital gains and qualified dividends. The adjusted net capital gain of an individual, estate, or trust is taxed at maximum rates of 0%, 15%, or 20%. It retains the breakpoints that exist under pre-Act law, but indexes them for inflation using C-CPI-U. The change is effective after Dec. 31, 2017. Barring further legislation, these changes will expire after 2025.
Certain gains from partnership profits interests held in connection with performance of investment services are short-term capital gains if held for three years or less. Before the Act, gains from a profits interest in a partnership (sometimes referred to as a carried interest) typically passed through an investment partnership as long-term capital gains and, thus, were taxed in the hands of the taxpayer at more favorable rates. Thus, for the wealthiest citizens who fell into the 39.6% bracket, long-term capital gains were generally taxed at a rate of 20%.
The Act changes the tax treatment of gains from a profits interest in a partnership (carried interest) held in connection with the performance of services by providing that if one or more “applicable partnership interests” are held by a taxpayer at any time during the tax year, the excess (if any) of (1) the taxpayer’s net long-term capital gain with respect to those interests for that tax year, over (2) the taxpayer’s net long-term capital gain with respect to those interests for that tax year by substituting “three years” for “one year,” will be treated as short-term capital gain. Thus, the Act provides for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer. If the three-year holding period is not met with respect to an applicable partnership interest held by the taxpayer, the taxpayer’s gain will be treated as short-term gain taxed at ordinary income rates. These changes are effective beginning after Dec. 31, 2017.
Excess business loss disallowance rule replaces limitation on excess farm loss for non-corporate taxpayers. Before the Act, if a non-corporate taxpayer received any applicable subsidy, the taxpayer’s excess farm loss for the tax year was not allowed. The amount of losses that could be claimed by an individual, estate, trust, or partnership were limited to a threshold amount if the taxpayer had received an applicable subsidy. Any excess farm loss was carried over to the next tax year.
The Act provides that for a non-corporate taxpayer, the limitation on excess farm loss does not apply. Instead, the taxpayer’s excess business loss, if any, for the tax year is disallowed. In other words, the Act expands the limitation on excess farming loss to other non-corporate taxpayers engaged in any business. Under the new rule, excess business losses are not allowed for the tax year but are instead carried forward and treated as part of the taxpayer’s net operating loss ("NOL") carryforward in subsequent tax years. This limitation applies after the application of the passive loss rules. These changes come into effect after December 31, 2017. Barring further legislation, these changes will expire after 2025.
The Act modifies the CTC by increasing the credit amount, increasing the threshold amounts for the phaseout, and allowing a partial credit for dependents who do not qualify for a full CTC. Under the Act, the child tax credit is increased to $2,000. The income levels at which the credit phases out are increased to $400,000 for married taxpayers filing jointly ($200,000 for all other taxpayers) (not indexed for inflation). In addition, a $500 nonrefundable credit is provided for certain non-child dependents. The amount of the credit that is refundable is increased to $1,400 per qualifying child, and this amount is indexed for inflation, up to the $2,000 base credit amount. The earned income threshold for the refundable portion of the credit is decreased from $3,000 to $2,500. These changes come into effect after December 31, 2017. Barring further legislation, these changes will expire after 2025.
State and local tax deduction limited to $10,000. Before the Act, individual taxpayers were allowed an itemized deduction for state and local taxes ("SALT") and foreign taxes, even though not incurred in a taxpayer’s trade or business.
Under the Act, individual taxpayers may not deduct foreign real property tax, other than taxes paid or accrued in carrying on a trade or business. A taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for marrieds filing separately) for the aggregate of (a) state and local property taxes not paid or accrued in carrying on a trade or business and (b) state and local income, war profits, and excess profits taxes (or sales taxes in lieu of income, etc. taxes) paid or accrued in the tax year. Foreign real property taxes may not be deducted under the $10,000 aggregate limitation rule. These changes come into effect after December 31, 2017. Barring further legislation, these changes will expire after 2025.
Mortgage interest deduction acquisition debt maximum is lowered to $750,000; deduction for home equity interest is suspended. Taxpayers may claim an itemized deduction for “qualified residence interest” ("QRI") (the mortgage interest deduction). Before the Act, deductible QRI was interest paid or accrued on acquisition indebtedness that is secured by a qualified residence, or, home equity indebtedness that was secured by a qualified residence. Prior to the Tax Cuts and Jobs Act, the maximum amount treated as acquisition indebtedness was $1 million ($500,000 for married taxpayers filing separately). The amount of home equity indebtedness could not exceed $100,000 ($50,000 for a married individual filing separately).
Under the Act, the deduction for mortgage interest is limited to underlying indebtedness of up to $750,000 ($375,000 for married taxpayers filing separately), and the deduction for interest on home equity indebtedness is suspended. Taxpayers may not claim a deduction for interest on home equity indebtedness. The Act’s $750,000/$375,000 limit on acquisition indebtedness does not apply to any indebtedness incurred on or before Dec. 15, 2017. Therefore, acquisition indebtedness incurred before Dec. 15, 2017, is limited to $1,000,000 ($500,000 for marrieds filing separately). These changes apply to tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026.
Deductions for moving expenses, unreimbursed employee expenses, tax preparation fees, and investment expenses are suspended until 2026. The deduction for teacher expenses increased to $500. Under current law, certain moving expenses and certain unreimbursed expenses for employees are deductible. Some of those deductions, like certain moving expenses and certain expenses paid by teachers, were deductible regardless of whether the taxpayer itemized. Other expenses were deductible only to the extent such deductions exceeded 2% of the taxpayer’s adjusted gross income.
Under the Act, the above-the-line moving expenses deduction is limited only to active duty members of the Armed Forces in certain situations. The above-the-line deduction for certain expenses paid by teachers is increased from $250 to $500 regardless of whether the taxpayer itemized (called “above-the-line” deductions) . All of the miscellaneous itemized deductions previously subject to the 2% of AGI limitation, including the deductions for unreimbursed employee business expenses (employee mileage, home office expenses and the like), investment expenses, expenses for the production or collection of income, tax determination expenses and hobby loss expenses, are suspended until 2026.
Overall limitation on itemized deductions suspended until 2026. Current law reduces the itemized deductions that certain higher-income taxpayers may claim. For taxpayers with income over certain amounts ($261,500 for a single filer in 2017, $313,800 for joint filers in 2017), their itemized deductions were limited by 3% of the amount their AGI exceeded these thresholds, up to a reduction of 80% of their deductions. Itemized deductions of higher-income taxpayers are no longer reduced under the Act.
Higher thresholds for individual AMT. The individual AMT remains intact but contains several adjustments. The AMT system provides an exemption that a taxpayer deducts from the alternative minimum taxable income before calculating the taxpayer’s ultimate AMT liability. The exemption amounts for 2017 are $84,500 for jointly filing or surviving spouse taxpayers, $54,300 for single taxpayers and $42,250 for married filing separately. The Act raises those exemption amounts to $109,400 for joint filers and surviving spouses, $70,300 for single taxpayers and $54,700 for married filing separately. Currently, the AMT exemption begins to phase out for taxpayers with the following AMT liability: (1) $160,900 for married filing jointly or surviving spouses, (2) $120,700 single taxpayers and (3) $80,450 for married filing separately. The Act raises the phaseout thresholds to $1 million for married filing jointly and surviving spouses and $500,000 for all other taxpayers other than trusts and estates. The phaseout threshold for trusts and estates remains unchanged at $75,000. These changes come into effect in 2018, and all of these amounts are adjusted for inflation under the new inflation adjustment calculations.
II. BUSINESS TAX CHANGES
Section 179 deduction limits increased. For tax years beginning after December 31, 2017, the annual deduction limit for Section 179 property has been increased from $500,000 to $1 million, and the limit on purchases has been increased to $2.5 million (from $2 million). These amounts are now indexed for inflation beginning in 2018. The definition of Section 179 property has been expanded to include certain tangible personal property used in furnishing lodging as well as roofs, heating, air conditioning, and ventilation systems, fire protection, alarm and security systems installed on non-residential real property that has already been placed in service.
Temporary 100% cost recovery of qualifying business assets. For qualifying business assets acquired and placed in service after September 27, 2017, and before January 1, 2023, a 100% deduction for the adjusted basis of the assets is allowed. This repeals the current 50% deduction previously scheduled to go into effect after December 31, 2017. Starting on January 1, 2023 through December 31, 2027, this temporary bonus first year depreciation rate is reduced by 20% each year (80% for 2023, 60% for 2024, etc.) until it sunsets for years after 2026.
Shortened recovery period for certain real property. For property placed in service after December 31, 2017, the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail property are eliminated. Such property is now generally depreciable over a 15-year period using the straight-line and half-year convention. For residential property placed in service after December 31, 2017, the alternative depreciation system (“ADS”) recovery period has been reduced to 30 years, from 40 years. Finally, also beginning after December 31, 2017, a farming business electing out of the limitation on the deduction for interest must use ADS to depreciate any property with a recovery period of 10 years or more.
Deduction for business interest limited. For tax years beginning after December 31, 2017, net interest expense is generally limited to 30% of the business’s adjusted taxable income. Although this limitation is generally determined at the tax-filer level, in the case of pass-through entities, the determination is made at the entity level. For purposes of applying these limitations through January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization, or depletion deductions.
NOL deduction modified. For NOLs arising in tax years after December 31, 2017, the two-year carryback rule is repealed, other than in cases involving certain losses incurred in a farming-related trade or business. Moreover, for NOLs arising in tax years after December 31, 2017, the NOL deduction is generally limited to 80% of taxable income. NOLs may generally be carried over to future years without limitation.
Like-kind exchange treatment to be limited to real property. For transactions consummated in 2018 and later, tax-free exchange treatment under Section 1031 no longer includes personal property and is limited to real property.
Limitations placed on rehabilitation credit. Starting with amounts paid or incurred after December 31, 2017, the 10% credit for qualified rehabilitation expenditures is repealed. A 20% credit is now provided for certain qualified rehabilitation expenditures, and that credit can be claiming ratably over a five-year period.
New deduction for certain pass-through income. Currently, income that “passes through” a partnership, S corporation or sole proprietorship to a partner, shareholder or sole proprietor is taxed at that individual’s marginal income tax rate. The Tax Act adds a new section to the code, Section 199A, which provides a 20% deduction from individual income tax rates for “qualified business income” ("QBI") from a partnership, S corporation or sole proprietorship to non-corporate taxpayers, including trusts and estates. QBI is generally the net income from a business minus any reasonable compensation, guaranteed payments, or other payments to partners/owners that are for services other than as a partner/owner. QBI is determined on a per-business (not individual) basis.
Generally, for businesses whose owners have individual income of less than $157,500 or file jointly with income below $315,000 (the threshold amounts), the deduction is simply 20% of QBI. For owners with income above these amounts, how the deduction is treated depends on the type of business they are in. For those in a “specified service trade or business,” which includes service businesses in healthcare, law, consulting, athletics, financial services, or where the principle asset of the business is the reputation or skill of the business’s owners or employees, such owners will see their deduction begin to be reduced starting at the threshold amounts until completely phased-out (and no deduction available) for individual income of $207,500 or $415,000 for married filing jointly. The formula for determining the reduction in the deduction calculation is based on W-2 wages paid by the business and a portion of the business’s capital assets.
For businesses that are not in a specified service trade or business, the wage and capital limits also begin to apply at the threshold income amounts and apply fully at $207,500 for individuals and $415,000 for married filing jointly. However, unlike for specified service trades or businesses, the deduction is not eliminated above these amounts. This section will be effective for tax years starting after December 31, 2017 and before January 1, 2026.
Look-through rule applied to gain on sale of partnership interest. For sales and exchanges on or after November 27, 2017, gain or loss from the sale or exchange of a partnership interest is “effectively connected” with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership must be allocated to interests in the partnership in the same manner as non-separately stated income and loss.
For sales, exchanges and dispositions after December 31, 2017, the transferee of a partnership interest must withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation.
Treatment of S corporation converted to C corporation. The Act provides that any IRC § 481(a) adjustment of an “eligible terminated S corporation” attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during a six-tax-year period beginning with the year of change. An eligible terminated S corporation is any C corporation that (1) is an S corporation the day before the date of enactment; (2) during the two-year period beginning on the date of enactment revokes its S corporation election; and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of enactment.
In the case of a distribution of money by an eligible terminated S corporation, the accumulated adjustments account shall be allocated to such distribution, and the distribution shall be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount of the accumulated earnings and profits.
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