At present, it’s impossible to know what version of Tax Reform will become law in 2017—the House version, the Senate or a hybrid compromise position. We’ve kept you informed of the possible cross-industry impact of the President’s “September Tax Reform Framework” and potential problems with the House Tax Reform Bill on general tax provisions. Now, we’re taking a closer look at tax reform impact on real estate. This Property Matters article outlines the similarities and differences between the two plans and gleans critical insights that can directly impact you and your industry.
INDIVIDUAL TAX PROVISIONS
Home Mortgage Interest:
- Senate: Retains the mortgage interest deduction for loans up to $1 million. Suspends for 10 years the deduction for interest incurred on home equity loans and lines of credit
- House: Caps the mortgage interest deduction at $500,000 on new homes. Also repeals the deduction for interest on home equity loans and interest on vacation home loans
- Both: Grandfather existing first mortgage loans
|Observation: Neither bill addresses the subject of a recent court case involving the co-ownership of a home by two unmarried individuals. The court ruled that each was entitled to deduct interest up to the $1 million limit. Presumably, each would now be entitled to deduct interest up to the $500,000 limit.|
State and Local Taxes:
- Senate: Fully suspends all state and local tax deductions
- House: Property taxes remain deductible up to a cap of $10,000
|Observation: In the Senate bill, both provisions are suspensions of the deduction for eight years—not outright repeals. This parallels the sunsetting of the reduced individual income tax rates.|
|Comment: In the absence of certainty when it comes to meaningful mortgage interest or property tax deduction, it is likely that many prospective homebuyers, first timers and existing homeowners may opt to enter or remain in the rental market. This may result in increased rents and shortages of product in some areas.|
Exclusion of Gain on Sale of Personal Residence:
- Both: Extend the time you have to live in the home prior to sale to five out of the previous eight years. Currently, the rule is two out of the previous five years. The exclusion could be used for only one sale every five years. The exclusion amount is unchanged – at $250,000, ($500,000 for married couples filing jointly).
BUSINESS TAX PROVISIONS
Interest Expense Deduction
- House: Generally limited to business interest plus 30% of the business’ adjusted taxable income (pre-depreciation earnings). Interest expense of small businesses and real estate companies is not limited
- Senate: Limited to the sum of business interest income plus 30% of the business’ adjusted taxable income (post-depreciation). There is an exemption for small businesses. Real estate businesses can elect out if they use the alternative depreciation system to depreciate applicable real property used in the trade or business
|Observation: It’s unclear how real estate business will be defined. For example, is a hotel owner in the real estate business? It may be important to restructure activities to isolate borrowings in real estate entities, and put other property businesses in non-leveraged entities.|
Section 1031 Exchanges:
- Both: Deferral of gain limited to exchanges of real property
|Observation: If this passes, tax would be owed on exchanges of property other than real estate. For example, furniture and fixtures, equipment, automobiles, goodwill, etc. Therefore, it will be necessary to pay close attention to purchase price allocations.|
- House: The bill provides 100% expensing of qualified property. Qualified property includes used property but not property owned by real estate businesses or public utilities. This provision would start as of September 27, 2017 but expire in 2022.
- Senate: The Senate bill similarly allows 100% expensing of qualified property. Qualified property does not include used or public utility property. Real estate property may be qualified under the Senate proposal to the extent that the real property trade or business does not elect out of the interest deduction limitation. Effective date and expiration provisions appear to be the same.
|Observation: Detailed analysis will be necessary to optimize deductions between interest, bonus depreciation and regular depreciation. Particularly, in light of the requirement to elect the longer lived Alternative Depreciation System to take advantage of the other provisions.|
Section 179 Deduction:
- House: The bill increases the annual limit to $5 million. The phase-out would begin at $20 million.
- Senate: The Senate is less generous, increasing the limit to $1 million with the phase-out beginning at $2.5 million.
- Senate: While the House bill does not alter the current depreciation system (other than what is mentioned above), the Senate would reduce the recovery period for non-residential real and residential rental property to 25 years. The bill would eliminate the various qualified improvement property designations (currently 15-year property) and create a new 10-year recovery period for qualified improvement property.
Pass-through Tax Rate:
- House: 100% of passive and 30% of active flow-through income taxed at 25% for certain activities. There is an alternative calculation based on capital invested in the business.
- Senate: Creates a 17.4% deduction for business income. The deduction would be limited to 50% of the taxpayer’s allocable share of the company’s W-2 wages. The W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $500,000 for married individuals filing jointly or $250,000 for other individuals. The application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly, or $50,000 for other individuals.
The modification further provides that the exception, which allows the 17.4% deduction in the case of certain taxpayers with income from a specified service business, applies to those whose taxable income does not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly, or $50,000 for other individuals.
|Observation: Both bills effectively treat REIT dividends as business income, making them eligible for the reduced tax rates, but it is not clear if the W-2 limitation applies.|
House: Not currently discussed in what has been published about the Senate bill, the House bill would require a three-year holding period for partnership interests received in connection with the provision of services to be eligible for long-term capital gains tax rates.
- House: The bill would repeal the new markets tax credit, historic tax credit, and non-historic rehabilitation tax credit. The Low Income Housing Tax Credit would be retained, but private activity bonds would be repealed, meaning the 4% credit is also repealed. The name would also be changed to the “Affordable Housing Credit.”
- Senate: The Low Income Housing Tax Credit would be retained. The Historic Tax Credit would be retained but the percentage is reduced to 10% from the current 20%. The non-historic rehabilitation tax credit for pre-1936 properties would be repealed.
|Observation: With the corporate tax rate reduced to 20%, the value of Low Income Housing Tax Credits, and the amount corporate investors would be willing to pay for them, would be diminished.|
Partnership Technical Terminations:
House: The bill would repeal technical terminations, which generally serve as a trap for the unwary whose major impact is resetting depreciation and all other partnership elections. Discussions of the Senate bill do not mention this topic.
One word of caution, because a provision is described as “permanent” or has a sunset date, neither is ever true. Expiring provisions are often extended – temporarily or “permanently” – and Congress has rarely hesitated to change laws otherwise thought to be permanent. As always, we will keep you updated on developments. Please contact your Friedman LLP professional with any questions.