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Wading through the tax legislation implications of the 2017 tax reform and 2020 CARES Act can be overwhelming for many real estate companies.
But there’s no doubt that the industry should pay attention as there are several significant tax opportunities that can accelerate tax savings to provide liquidity now for real estate investors.
1. First-Year Depreciation Deduction
2017’s tax reform bill increased the first-year depreciation deduction from 50% to 100% for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.
This is significant as it allows real estate companies to deduct the full cost of qualified property in the year of purchase and reduce the after-tax cost of your investment. This deduction will phase down after 2022 so time is of the essence. It is recommended that a cost segregation study be performed to identify the portion of the purchase price that can be written off in the first year.
Example: A partnership that purchased a multi-family property in 2019 is now able to write off more than 25% of the cost of the property in the year of acquisition, whereas prior to the new tax law, they would have only recovered 10% of the cost. The partnership is able to pass out large taxable losses to their investors who used them to offset other real estate income and gains from the sale of properties.
Result: The 10% investor’s allocable share of the first-year depreciation deduction is $1,000,000, rather than $400,000 under the old law. If you assume the investor has other rental income that will be reduced by this deduction, (the rental income would be eligible for the 20% qualified business income “QBI” deduction resulting in an effective federal tax rate of 29.6%). The utilization of the $1,000,000 deduction results in a first-year tax savings of $296,000. Assuming that the $40 million multi-family property is 65% leveraged, this tax savings to the 10% investors’ equity investment of $1,400,000 results in first year return on investment just from this tax savings alone of 21%. See below NOL example if the investor does not have $1,000,000 of 2019 rental income to offset and if they are a rental real estate professional or dealer in real estate.
2. Faster Write-offs for Interior Building Improvements
2020’s CARES Act made a technical correction to the 2017 tax law which made qualified improvement property “QIP” eligible for the 100% bonus depreciation. The CARES Act specifically designates that QIP has a 15-year recovery period for depreciation, which makes it eligible for the 100% bonus depreciation.
QIP is defined as any improvement to an interior portion of a building which is nonresidential real property, if such improvement is placed in service after the date the building was first placed in service. Although expenditures attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building are excluded.
The technical correction is effective for property placed in service after December 31, 2017. Taxpayers or their advisors should review their 2018, 2019 and 2020 fixed asset additions and determine if they are QIP. Once identified, the taxpayer can then either elect to file an amended tax return to correct the depreciation deduction in the year acquired, OR elect to file a change in method of accounting and recompute the missed deductions and bring them forward to the current year and deduct them on their 2019 or 2020 return.
This correction provides unprecedented tax savings for commercial real estate companies.
Example: A commercial real estate partnership acquires an office and retail property in early 2019 and then makes a $2 million-dollar investment to update and retro fit the interior portion of the property.
Result: In addition to the first-year depreciation deduction on the purchase price of the property (discussed in the first example), a partnership can deduct the full $2 million-dollar investment to improve the property in the first year. A 10% investor will receive a $200,000 deduction to offset other rental income. Assuming the other rental income is QBI which carries an effective federal tax rate of 29.6% this investor receives an additional tax savings of $59,200, as a result of the technical correction for QIP.
3. Utilize Net Operating Losses To Create Liquidity
The added deductions described above can be very substantial which can create a Net Operating Loss “NOL” or substantially increase an NOL which did not consider these provisions. The NOL can be used now to obtain immediate tax refunds.
The tax law in place before the changes by the 2020 CARES Act limited business losses to $500,000 and did not allow NOL carrybacks. In addition, the NOL carryforward was limited to 80% of the taxpayer’s income in future years.
But now, under the provisions of the CARES Act, businesses have the choice of recalculating the depreciation that should have been allowed in those prior years and then deciding to either amend those years or bring the added deductions forward and catch it all up in their extended 2019 or in the 2020 returns.
If those deductions are large enough to create net operating losses, taxpayers, including investors in and owners of commercial and multi-family real estate, can carryback those losses and obtain immediate tax refunds for tax paid at any time during the last five years.
Modeling of the potential loss carryback and refund opportunities becomes essential and is highly recommended to determine the highest and best use of the losses. Your losses, if carried forward, might only offset income otherwise taxed at 29.6% versus if carried back they might reduce income that was taxed at 39.6% to provide a refund right now.
Example: If the losses created by the added deductions are not passive losses, then a taxpayer can utilize those losses to offset other income, thereby creating an NOL.
Result: Using the two examples above, a 10% non-passive investor could utilize the $1,000,000 multi- family added bonus depreciation and the $200,000 QIP bonus depreciation to reduce their current year income by $1,200,000. If this investor had $500,000 of other income, then the losses would generate a $700,000 NOL. If the above investments were made in 2019, the $700,000 NOL could be carried back (and assuming $500,000 of income in 2014, 2015,) to obtain a refund of tax paid in those years. A married person filing a joint return that had reported income of $500,000 in those prior years and incurred a $700,000 NOL in 2019 could receive a federal refund of $215,000, in addition to the savings of $145,000 on the 2019 deductions.
These provisions together, create a great opportunity for real estate companies to review their past fixed asset additions, plan for current and future asset additions through 2022, and take advantage of the full write-offs allowed by these new and expanded legislative provisions to provide liquidity right now in the current environment for real estate investors.