The Tax Cuts and Jobs Act (TCJA) will have a significant impact on those in the construction and real estate industries. It’s perhaps the most significant change to the tax law in over three decades, including reducing the top corporate tax rate to 21%, and providing a 20% taxable income deduction for certain pass-through entities. These two provisions alone will likely result in lower taxes paid by corporations and flow-through owners.
There are also hundreds of other new provisions, modifications, and repeals of existing provisions along with numerous effective and phaseout dates. These are the most important changes affecting those in the construction and real estate industries in 2018 and beyond.
Unless otherwise indicated, the following provisions are effective for tax years beginning after December 31, 2017.
First-Year Bonus Depreciation
Effective for qualified property placed in service after September 27, 2017, taxpayers can deduct 100% of the cost of qualified business assets as additional first-year depreciation. The bonus depreciation provisions will apply to new and used assets and there are no income thresholds or phaseouts on the amount of bonus depreciation that can be taken each year. The 100% bonus depreciation deduction is effective until December 31, 2022, when it’s scheduled to begin phasing out over four years at 20% each year, down to 20% in 2026.
The benefit of Section 179 expensing is somewhat reduced due to the enhanced bonus depreciation provisions; however, the maximum amount a taxpayer can expense under Section 179 is increased to $1 million and the phaseout threshold is increased to $2.5 million.
The TCJA eliminates the asset classifications for qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, but retains the classification for qualified improvement property (QIP). It appears that the intent of Congress was to reduce the QIP recovery period to 15 years from 39 years and have it retain its bonus eligibility. However, in an apparent drafting error, the statute retains QIP’s 39-year recovery period and eliminates its eligibility for bonus deprecation. QIP is now eligible for Section 179 expensing as well.
The definition of qualified real property eligible for Section 179 expensing is expanded to include the following:
- Fire protection and alarm systems
- Security systems that are installed on nonresidential real property after a building was placed in service
The TCJA modifies the Section 1031 like-kind exchange provisions by limiting their application only to real property. Taxpayers will no longer be able to defer the gain on vehicles, equipment, machinery, and other nonreal property assets.
Taxpayers eligible to use the cash method of accounting has been expanded to include businesses whose average annual gross receipts don’t exceed $25 million. The restriction of the cash method for eligible taxpayers who maintain inventories has also been removed and the percentage-of-completion method will no longer be required for construction contracts that are expected to be completed within two years of commencement and are performed by a taxpayer that doesn’t exceed the $25 million gross receipts threshold.
Domestic Production Activities Deduction
The TCJA repeals the domestic production activities deduction (DPAD). Under previous law, taxpayers were entitled to a DPAD equal to 9% of their qualified production activities income.
Pass-through Entity Business Income Deduction
In an attempt to not disadvantage pass-through entities relative to the 21% tax rate for C corporations, the TCJA introduced a new deduction for qualified business income of a pass-through entity in lieu of a lower nominal tax rate.
Owners of pass-through entities will be entitled to a deduction up to 20% of their aggregate net qualified business income from the pass-through entity. In effect, for taxpayers in the highest tax bracket receiving the full 20% deduction, the maximum tax rate on qualified business income of a pass-through entity will be approximately 29.6%. This provision won’t apply to taxable years beginning after January 1, 2025.
The 20% deduction is limited to the greater of two thresholds:
- 50% of the W-2 wages paid by the business
- 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of the business’ qualified tangible property
These thresholds don’t apply to individuals with taxable income less than $157,500 or married couples with income less than $315,000. If a taxpayer has a net qualified business loss for a year, it’s carried forward to future tax years to reduce any future net qualified business income.
Owners of service businesses are generally precluded from taking the pass-through entity business income deduction except when the individual owner’s taxable income doesn’t exceed the thresholds mentioned above. Engineering and architecture services are excluded from the definition of a service business so can use the same benefits of the deduction as nonservice businesses.
Excess Business Losses
The deductibility of noncorporate taxpayers’ aggregate net business losses will be limited to $250,000 for a single taxpayer or $500,000 for a married taxpayer. Any business losses in excess of these thresholds will be carried forward under the net operating loss provisions. This new excess business loss limitation is applied before the existing passive activity loss rules and no longer applies after 2025.
Net Operating Losses
There will be no carry back period and net operating losses (NOLs) will be carried forward indefinitely. The NOL deduction allowed in any given year will also be limited to 80% of a taxpayer’s taxable income. Under the previous law, NOLs generally were either carried back two tax years, carried forward up to 20 tax years, or both. The 80% limitation doesn’t apply to NOLs generated before 2018.
Meals, Entertainment, and Travel Deductions
For amounts paid or incurred after December 31, 2017, no deduction will be allowed for the following types of expenses:
- Entertainment, amusement, or recreation
- Membership dues for clubs organized for business, pleasure, recreation, or other social purpose
- Facilities or portions of those facilities used in connection with any of the items above
- Qualified transportation fringe benefits for employees
Taxpayers will still be entitled to deduct 50% of business food and beverage expenses.
Research and Experimental Expenditures
The research and experimental tax credit is unchanged by the TCJA. However, effective for tax years beginning after December 31, 2021, research and experimental expenditures—including expenditures for software development—will be required to be amortized ratably over a five-year period. Under previous law, these expenditures were expensed in full in the year incurred. Costs attributable to research that’s conducted outside the United States will be amortized over a fifteen-year period.
There’s also a new limitation on the deductibility of business interest expense. Generally, business interest expense will only be deductible up to 30% of adjusted taxable income of the taxpayer, which is taxable income with several adjustments including adding back depreciation, amortization, and depletion—at least for tax years beginning before January 1, 2022—and the deduction for qualified business income of a pass-through entity. This limitation applies at the entity level and at the individual level. Any disallowed interest expense will be carried forward indefinitely.
Taxpayers with average annual gross receipts less than $25 million will be excluded from the interest expense limitation. Those engaged in any of the following real property trades or businesses can elect to not have the interest expense provision apply:
- Real property development
If a taxpayer elects to not have the interest expense provision apply, they must also elect to use the Alternative Depreciation System rules on their residential rental property, nonresidential real property, and QIP.
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The application of these provisions to any organization’s specific facts and circumstances will be unique and will likely require detailed planning.
For more information on how the new tax law could affect you and your business, please contact your Moss Adams professional. You can also visit our dedicated tax reform page to learn more.