Depending on how your real estate ownership is structured, the new tax law can benefit you by reducing taxes, increasing expense deductions and accelerating the traditional advantages of owning commercial property.
Here are a few highlights of the new law.
Investors in pass-through entities such as LLC’s, Partnerships and S-Corps will benefit from a new 20% deduction. By design, these entities pass through profits and losses to their members via K-1 statements, creating a single level of taxation at the individual level. The new tax act includes a new Section, 199A, that allows owners in S corps and partnerships (including LLC’s treated as partnerships) to take a 20% deduction against the qualified business income (essentially ordinary income, not capital gains or losses.) This effectively reduces the top tax rate on qualified business income from 39.6% under the current law to 29.6% under the new law (a new top rate of 37% less the 20% deduction.) In order to take advantage of this deduction, the following factors need to be considered:
For married couples filing jointly and singles with taxable income of $315,000 and $157,500 respectively, the 20% deduction is limited to the greater of (i) 50% of the allocated W-2 wages paid by the pass-through entity or (ii) the sum of 25% of the allocated W-2 wages paid plus 2.5% of the allocated cost of the real property. Since most real estate ownership pass-through entities don’t have employees, they will fall under (ii).
As an example of the first factor, assume Joe is a 50% partner in an LLC that owns properties with unadjusted basis of $6.5 million, generating $1 million of allocable income. Joe and his spouse have more than $315,000 of taxable income. The LLC has no employees, so no W-2 wages. The deduction would be $81,250, calculated as the lesser of:
$100,000 (20% of Joe’s $500,000 share of the income);
and the greater of:
$0 (50% of $0 allocated W-2 wages), and
$81,250 (25% of allocated $0 W-2 wages + 2.5% of Joe’s $3.25 million allocated property basis)
The new tax law doubles the currently-deductible Section 179 property amount from $510,000 to $1,000,000. Commercial property improvements such as roofs, fire protection and alarm systems and HVAC units – and potentially even leasehold improvements – are now eligible for deduction under the language of Section 179 of the new tax code. The new language of the code is less restrictive than the previous versions and should be a benefit for value-add private real estate investors looking to make more significant improvements to the properties they acquire. The $1 million deduction phases out dollar for dollar beginning at $2.5 million of qualifying assets placed in service. For example, an entity spending $3 million would only be able to expense $500,000.
The new limitation on the deduction for business interest expense can be waived by real estate investors. While most businesses will be limited in deducting interest expense to 30% of their adjusted taxable income, taxpayers in the real property development, construction, acquisition, rental, operation, management, leasing, or brokerage business can elect to have the limitation not apply. The trade-off is that real property owned by businesses electing to be excluded from the limitation must be depreciated over 40 years for nonresidential property, and over 30 years for residential property.
What this will mean for CRE owners and investors:
More private capital will flow into commercial real estate.
Overall the new tax law should entice more people to buy into commercial real estate as an investment vehicle. Private equity investment funds can market themselves as an even more attractive tax efficient investment vehicle for those looking to diversify their investment strategies.
With more attention will come more competition.
As more private investors flock to pass-through real estate entities seeking commercial real estate investments, and institutional capital that has been sitting on the sidelines waiting for certainty on tax reform starts to deploy, the increased competition for quality assets will drive up pricing.
What other market ramifications do we anticipate?
An increase of capital flowing into the commercial real estate market and retention of the 1031 exchange rules could be very beneficial to those who were active buyers over the past 3 or 4 years. Both factors are expected to create greater liquidity in markets that have typically had longer liquidity lead times. In addition, buyers and lenders could become more aggressive on their due diligence and closing time frames in order to give themselves a competitive advantage in a stronger more competitive CRE Market.
A Colliers International | Minneapolis-St. Paul broker can help you make the most of the new tax law.
Are you an investor and think now might be the time to act? Do you have an asset and want to know its value in today’s market? Tracking economic shifts, analyzing data and interpreting trends is an important part of our client advisory services at Colliers International | Minneapolis-St. Paul.
Contact Investment Sales Specialist David Berglund, Senior Vice President | 952-897-7789 | firstname.lastname@example.org to learn how to make the most of the new tax law for your business.
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