2018 Income Tax Update - Commercial Real Estate

Transcription

1 2018 Income Tax Update - Commercial Real Estate Stephen M. Lukinovich, CPA, PFS, CVA Andrew J. Ackermann, CPA, CVA Kentucky Commercial Real Estate Conference Louisville, KY October 30, 2018

2 Tax Cuts and Jobs Act A Member of PrimeGlobal An Association of Independent Accounting Firms 2

3 Commercial Real Estate Taxation 2018 Agenda 1. Expired income tax provisions 2. New tax reform 3. Depreciation updates 4. Updates on tax incentives 5. Opportunity zones 3

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5 Energy Efficient Incentives Expired Effective 1/1/2018: Section 179D Deduction o Up to $1.80/square foot deduction Section 45L - Energy Efficient Home Tax Credit - $2,000 5

6 179D Lookback Rules Announced by IRS in December 2010 Applies for prior year missed 179D Now available for more than 3 previous tax years Do not amend prior-year tax returns Reflect prior year 179D deductions missed on current year tax return - Form 3115, 481(a) full year deduction - Federal, AMT and State 6

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8 Federal Income Tax Reform Legislation Commercial Real Estate Substantially unchanged are: The rules regarding depreciation tax lives of commercial real property (39 years) Residential real property (27 1/2 years) Long-term capital gain tax rates, generally 20% The application of the 3.8% Medicare Surtax Section 1250 unrecapture rules/tax rate of 25% The tax rules regarding Low Income Housing Tax Credits 8

9 Qualified Business Income Deduction Effective for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, an individual taxpayer generally may deduct 20% of domestic qualified business income from a partnership, LLC, S corporation or sole proprietorship Deduction amount for a tax year is the sum of: 1) the lesser of: a) the combined qualified business income amount ; or b) 20% of the excess of taxable income over the sum of i) net capital gain and ii) qualified cooperative dividends; plus 2) the lesser of: 20% of qualified cooperative dividends; or taxable income minus the taxpayer s net capital gain 9

10 QBI Deduction - continued In the case of a partnership or S corporation, the provision applies at the partner/shareholder level Partnership. Each partner takes into account the partner s allocable share of each qualified item of income, gain, deduction, and loss, and is credited with W- 2 wages for the tax year equal to the partner s allocable share of W-2 wages of the partnership Partner s allocable share of W-2 wages is required to be determined in the same manner as the partner s share of wage expenses S corporation Each shareholder of an S corporation takes into account the shareholder s pro rata share of each qualified item of income, gain, deduction, and loss, and is credited with W-2 wages for the year equal to the shareholder s pro rata share of W-2 wages of the corporation. 10

11 QBI Deduction - continued The deduction is generally limited based on greater of a) 50% of W-2 wages paid, or b) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property held by the business (Note: this limitation is phased in above a threshold amount of taxable income) Qualified property must 1) be depreciable tangible property, 2) held at the close of the tax year, 3) used to produce qualified business income, and 4) the property s depreciation period cannot end before the close of the tax year (later of 10 years or last day of MACRS recovery period). The deduction is generally not allowed for certain specified service trades or businesses (Note: this disallowance is also phased in above the threshold amount of taxable income) Threshold amount is $315k MFJ ($157,500 for other taxpayers) Phase-in range is $100k MFJ ($50k for other taxpayers) Fully phased in at $415k MFJ ($207,500 for other taxpayers) 11

12 QBI Deduction - continued Qualified trade or business any trade or business other than a specified service trade or business (phase-in threshold) and other than the trade or business of being an employee Specified service business is any trade or business: involving the performance of services in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law, or the performing arts; or involves the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities; or where the principal asset of such trade or business is the reputation or skill of one or more employees or owners. Note: engineering and architecture are not specified service businesses 12

13 QBI Deduction - continued Commercial and residential rental real estate activities (for this purpose only) will generally be considered a trade or business unless in the form of a triple net lease arrangement Self-rental arrangements will need to be carefully reviewed for eligibility of the 20%/2.5% deduction Economic unit self-rental arrangements will require further guidance Owners who are passive, with passive income, will be entitled to this new 20%/2.5% deduction 13

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15 Beginning 1/1/2018 New EBIDTA Interest Expense Limitations 30% EBIDTA Interest Expense limitation applies The 30% of EBITDA interest expense limitation applies to commercial rental real estate activities The 30% interest expense limit is determined at the entity level Entities with less than $25 million in annual sales are exempt Real estate development activities with sales in excess of $25 million can elect ADS depreciation deductions instead o 40-year tax life for commercial rental real estate o 30-year tax life for apartments/single rental residences o 20-year tax life for QIP o Real estate developers that elect ADS depreciation will not be able to take bonus depreciation 15

16 Beginning 1/1/2018 New Like-Kind Exchange Rules Only commercial/investment real estate activities are eligible for tax-free exchange treatment Personal property is no longer eligible If real property (building) has Section 1245 property (personal property) embedded, especially pursuant to a cost segregation study, that portion of the property is ineligible for Section 1031 tax-fee treatment Important to determine the value of Section 1245 property embedded in real property upon pursuing a Section 1031 exchange Cost segregation studies on the replacement property, identifying Section 1245 personal property, with 100% bonus depreciation expense (especially on used property) should assist in minimizing the impact to this tax-free treatment limitation 16

17 Effective 1/1/2018 through 12/31/2025 New Loss Limitation $500,000 Trade or business loss new annual loss limitation Losses incurred by trade or business activities will continue to have basis limitations and the historical passive loss limitations apply $500,000 (MFJ)/$250,000 (MFS/Single) loss limitation Excess loss amounts will be carried forward Watch Cost Segregation Studies 17

18 Cash Basis Method of Accounting Reminder for Commercial Real Estate Activities The new 1/1/2018 $25 million revenue threshold does not apply to commercial rental real estate ventures Since rental real estate ventures do not have inventory, the cash basis method of accounting is generally available to pass-through commercial rental real estate ventures regardless of the level of sales revenue Syndicates are generally required to use the accrual basis method of accounting If 35% or more of the commercial rental real estate venture is owned by passive investors, and losses exist, generally, the activity must be accrual basis method of accounting 18

19 1/1/ Reduced C-Corporate Tax Reduced Tax Rate: Rate Tax years beginning after December 31, 2017, all C- Corporations, including personal service corporations, will be taxed at a 21% flat corporate tax Graduated rate structure is eliminated Corporate AMT repealed Any unused AMT credit carryforward is refundable beginning in 2018 refundable credit is equal to 50% of excess of the credit over amount allowable against the regular tax liability (100% beginning in 2021) 19

20 1/1/2018 Other New Tax Reform Rules Watch for new built in loss rule - applies if $250,000 loss is allocated to an incoming member Most individual income tax rates are lowered, and the top marginal rate is reduced from 39.6% to 37% Expires 12/31/2025 The Tax Reform Bill still permits individuals to itemize and deduct state and local taxes (including property taxes), but only up to $10k 20

21 Kentucky State Tax Update House Bills 366 & 487 broaden tax base Effective 1/1/18 Flat 5 % on business & individuals Effective 7/1/18 Sales tax on services Landscaping & lawn services Janitorial services Labor charges on installation of tangible personal property Others 21

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23 Rental Real Estate Depreciation Effective 1/1/2018: 39 year and 27 ½ year tax lives maintained Special real property depreciation categories eliminated, except for Qualified Improvement Property (QIP) Section 179: $1 Million per year, beginning 1/1/2018 $500k per year through 12/31/

24 New Bonus Depreciation % s - through 12/31/2027 Bonus Depreciation Rates 09/11/01 05/05/03 30% 05/06/03 12/31/04 50% 01/01/05 12/31/07 0% 01/01/08 09/08/10 50% 09/09/10 12/31/11 100% 01/01/12 9/27/17 50% 9/28/17 12/31/22 100% 01/01/23 12/31/27 80% - 20% Watch property with construction contract prior to 9/28/2017 Property no longer needs to be new, beginning 9/28/

25 100% Bonus Depreciation 9/28/2017 through 12/31/2017: Normal qualified real estate categories remain through 12/31/2017, along with their historical tax lives Qualified Leasehold Improvement Property ( QLHI ) Qualified Improvement Property ( QIP ) Qualified Restaurant Property and Qualified Retail Property Used commercial property is now eligible for bonus depreciation, beginning 9/28/2017 QLHI and QIP property that is acquired during the abovereferenced period of time is now eligible for 100% bonus depreciation 25

26 100% Bonus Depreciation 9/28/ /31/2027: Embedded personal property/section 1245 property acquired during this period of time, pursuant to a cost segregation study, qualifies for 100% bonus depreciation, new and used You can elect a lower 50% or 0% bonus depreciation rate, per class effective 9/28/

27 Bonus Depreciation Phase Out 100% Bonus depreciation 1/1/ /31/2022 Bonus depreciation is scheduled to phase-out beginning 1/1/2023 The only qualified real estate property provision that survived, beginning 1/1/2018, is QIP QIP s tax life is now understood to be 15 years Note: There is an anticipated Technical Correction to be issued to permit the tax life of QIP at 15 years and make it eligible for bonus depreciation 27

28 Section 179 Beginning 1/1/2018 is $1 million/year Certain non-residential real property items qualify (QIP, HVAC, roof, security systems, and fire protection systems) NOTE: Normal Section 179 limitations apply. You need formal trade or business income; commercial rental real estate income typically does not qualify for Section 179 unless rising to the level of a formal trade or business activity 28

29 Rev. Proc New Retail & Restaurant Remodel Refresh Safe Harbor Taxpayers engaged in the trade or business of operating a retail establishment or restaurant with safe harbor method of accounting - audited financial statements Includes owners of shopping centers or corporate office with retail shopping Not included: 1245 property, automotive dealers, other motor vehicle dealers, gas stations, manufactured home dealers, nonstore retailers, hotel and motel business operators, civic or social organizations, amusement parks, theaters, casinos, country clubs, caterers 29

30 Rev. Proc New Retail & Restaurant Remodel Refresh Safe Harbor 75% deduction of qualified costs, remaining 25% capitalized and depreciated No disposition of prior costs capitalized 30

31 Qualified Leasehold Improvement Property Any improvement to an interior portion of a building that is nonresidential real property; excludes enlargements, elevators/escalators, common area work and internal structural framework Recovery period: 15 years Straight line method; half-year convention Can be included in Section 179 deduction if trade or business 31

32 Qualified Leasehold Improvement Property Eligible for 50% bonus depreciation 3 year rule applies - placed in service more than three years after the date the building was first placed in service Landlord or lessee can make interior improvement but must be made pursuant to a lease Landlord and tenant cannot be related parties Expires 12/31/

33 Qualified Restaurant Property Any section 1250 property that is a building - new building or existing structure - or an improvement to a building, If more than 50% of the building s square footage is devoted to the preparation of, and seating for onpremises consumption of, prepared meals Recovery period: 15 years Straight line method; half-year convention 33

34 Qualified Restaurant Property Can be included in Section 179 deduction trade or business normally tenant Not eligible for bonus depreciation unless qualified leasehold improvement property 2015 or Q.I.P. in year rule does not apply - placed in service more than three years after the date the building was first placed in service Encompasses the entire building structure as well as interior costs. Can be an acquired building Landlord and tenant can be related parties Expires 12/31/

35 Qualified Retail Improvement Property Effective 1/1/2016 Any improvement to an interior portion of a building which is nonresidential real property. Retail establishments that qualify include those open to the public and primarily in the business of the sale of goods (tangible personal property) to the general public and not services (grocery stores, clothing stores, hardware stores, and convenience stores) Recovery period: 15 years Straight line method; half-year convention Can be included in Section 179 deduction trade or business 35

36 Qualified Retail Improvement Property Effective 1/1/2016 Now eligible for 50% bonus depreciation 3 year rule applies - placed in service more than three years after the date the building was first placed in service Excludes enlargements, elevators/escalators, common area work, and internal structural framework Landlord and tenant can be related parties Building can be owner occupied Expires 12/31/

37 Qualified Improvement Property New category 1/1/2016 Effective 1/1/2016 Qualified improvement property is any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building was first placed in service, excluding: enlargements, elevators/escalators, and internal structural framework The improvements do not need to be made pursuant to a lease, and the building can be owner occupied 39 year tax life, through 12/31/ year tax life, beginning 1/1/2018 Technical Corrections 37

38 Qualified Improvement Property Straight line method; mid-month convention Can be included in Section 179 deduction trade or business Eligible for 50% bonus depreciation 3 year rule does not apply - placed in service more than three years after the date the building was first placed in service Excludes enlargements, elevators/escalators, common area work, and internal structural framework Landlord and tenant can be related parties Building can be owner occupied 38

39 Section 179 Commercial Rental Through 12/31/2017: Real Estate Section 179 deductions of $510,000 with a phase out starting at $2,030,000 Trade or Business only A deduction of $510,000 of Qualified Real Property (Qualified Leasehold Improvement Property, Qualified Restaurant Property, and Qualified Retail Improvement Property) is retroactive for 2017 Max $510,000 39

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41 Historic Tax Credit Historic Tax Credit (HTC): The 10% credit was repealed for pre-1936 buildings The 20% credit for Qualified Rehabilitation Expenses (QRE) was retained with a modification. The credit allowable over a 5-year period Making the credit 4% per year of the QREs 41

42 1/1/2018 New HTC Rules, continued Transition rule to determine if the HTC is claimed under the old law: Was the full 20% in the year placed in service or under the new law, 4% per year over 5 years The taxpayer has a 24- or 60-month window to claim expenditures during rehabilitation If the taxpayer selects to start the window outside of 180 days after December 22, 2017, then the new law applies, otherwise the old law is still in effect 42

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44 Qualified Opportunity Zones Enacted as part of sweeping federal tax legislation commonly referred to as the Tax Cuts and Jobs Act of Significant tax incentives for taxpayers to reinvest capital gains in certain property and businesses located or operating in specially designated tracts. ( QO Zone ). Encourage economic development in low income areas by providing various tax incentives for private investments in qualifying areas Estimated $6.1 trillion in unrealized capital gain at the end of This significant amount of capital available for reinvestment makes the QO Zones program potentially the largest economic development initiative in the country. Designed to channel more equity capital into distressed markets 44

45 Opportunity Zone Designation Treasury has designated QO Zones in all 50 states, the District of Columbia, and five U.S. possessions. In Kentucky, Treasury designated 144 low-income census tracts in 84 counties across the state as QO Zones. 19 designated QO Zones in Jefferson County. 2 designated QO Zones in Bullitt County. In Indiana, Treasury designated 156 tracts in 58 counties covering all or portions of 83 cities and towns throughout the state as QO Zones. 5 designated QO Zones in Clark and Floyd counties. The zones will effectively not change IRS has a listing by state States have websites for confirming QOZ locations 45

46 Designated O Zones in Kentucky Source: 46

47 Designated O Zones in Louisville Source:

48 Designated O Zones in Southern IN Source: 48

49 Designated O Zones in Southern IN Source: 49

50 QO Zone Benefits Qualified Opportunity Zone Funds (QOFs) Defer taxes by making timely investments when invested in Taxpayers Qualified Opportunity Zone Property 50

51 QO Zone Benefits There are three separate investment incentives that a taxpayer can elect to take advantage of with respect to their investment. 1. Initial gain deferral 2. Partial forgiveness 3. Permanent exclusion of gain on appreciation 51

52 Gain Recognition Gain deferral is temporary because the taxpayer must recognize the income in the tax year the investment is sold or the tax year that includes December 31, 2026, whichever is earlier. Gain is calculated as the lessor of: 1. Amount of gain deferred OR 2. The fair market value of investment in QOF interest less the basis in the QOF interest * * Basis is QOF is initially deemed to be zero 52

53 Deferral Period The period of capital gain tax deferral ends upon the earlier of: 53

54 Partial Forgiveness and Permanent Exclusion of Additional Gains Within 180 Days Basis increased by 10% of the deferred gain Up to 90% taxed Basis increased by Additional 5% of the deferred gain Up to 85% taxed Basis is equal to Fair Market Value Exclusion of gains on appreciation of investment 54

55 Example Before April 28, 2019 Taxpayer contributes the $1M of capital gain to a QOF QOF makes a timely investment of the $1M in Qualified Opportunity Zone Property April 28, 2026 (7 years) Taxpayer s basis in investment in QOF increases another 5% from $100k to $150k April 28, 2029 (10 years) Taxpayer sells its investment for $3M. The basis is equal to the FMV. No additional tax is owed on the appreciation. Oct. 30, 2018 Taxpayer enters into a sale that generate $1M of capital gain April 28, 2024 (5 years) Taxpayer s basis in investment in QOF increases 10% from $0 to $100k December 31, 2026 $850k of the $1M of initial capital gains are taxed and the basis in QOF investment increases to $1M Notes: The Taxpayer s initial basis is deemed to be $0 in the QOF investment 55

56 Investment Types in Opportunity Zones Real Estate Development and Rehab Project in Opportunity Zones New Businesses created in Opportunity Zones Expansion of Businesses already in Opportunity Zones Businesses expanding into Opportunity Zones 56

57 Qualified Opportunity Fund - Purpose A QO Fund is any investment vehicle organized as either a partnership (including an LLC treated as a partnership for tax purposes) or corporation that was formed for the purpose of investing in qualified opportunity zone property ( QOZ Property ). At least 90 percent of the QO Fund s assets must consist of QOZ Property. Fund can self certify 57

58 Qualified O Zone Property There are three categories of QOZ Property permitted: 1. Qualified Opportunity Zone Stock (Qualified Opportunity Zone Business) 2. Qualified Opportunity Zone Partnership Interest (Qualified Opportunity Zone Business) 3. Qualified Opportunity Zone Business Property 58

59 Qualified O Zone Stock and Partnership Interests The investment must be acquired after December 31, 2017 solely in exchange for cash; Must be a qualified opportunity zone business, or is being organized for the purpose of being a qualified opportunity zone business; Must remain a qualified opportunity zone business for substantially all of the qualified opportunity fund s holding period 59

60 Qualified O Zone Businesses A trade or business in which substantially all of the tangible property owned or leased by the taxpayer is qualified o zone business property At least 50% of income derived from active conduct Less than 5% of unadjusted basis of property is nonqualified financial property 60

61 Ineligible Businesses Sin Business Golf courses Race tracks Gambling facilities Liquor stores Country clubs Massage parlors Hot tub facilities Tanning facilities 61

62 Qualified O Zone Business Property Tangible property used in a trade or business Acquired by purchase from an unrelated party (20% threshold) after December 31, 2017 During substantially all of holding period, substantially all the use is in a QOZ Substantially all is defined as 70% Original use in the QOZ commences with the taxpayer OR Taxpayer substantially improves the property during any 30-month period after acquisition, additions to basis exceed an amount equal to the adjusted basis of such property at the beginning of such period Guidance allows for reasonable working capital 62

63 Basic Model for Rental Real Estate or direct ownership of QOZ Business Property within 180 days Investors QOF QOZ Partnership QOZ Business Property Rental Real Estate New construction Substantial improvement of adjusted basis excluding land 63

64 Civil Penalties for Noncompliance Failure to meet investment standard results in per month penalty % of shortfall multiplied by underpayment rate No penalty if failure is due to reasonable cause 64

65 Questions? 65

66 IRS Circular 230 Disclosure As a result of perceived abuses, the Treasury has recently promulgated Regulations for practice before the IRS. These Circular 230 regulations require all accountants to provide extensive disclosure when providing certain written tax communications to clients. In order to comply with our obligations under these Regulations, we would like to inform you that any advice given in this presentation, including any attachments, cannot be used to avoid penalties which the IRS might impose, because we have not included all of the information required by Circular 230, nor have we performed services that rise to this level of assurance. 66

67 Thank You! Stephen M. Lukinovich, CPA, PFS, CVA Andrew J. Ackermann, CPA, CVA