Many of us are happy to see 2020 end. Of course, it also means it’s time to start thinking about taxes again. The Coronavirus Aid, Relief, and Economic Security (CARES Act) has brought about changes that could have a big impact on your real estate businesses. With the right year-end tax planning, you could save a lot of your hard-earned money.
Here are some moves to consider as you begin planning your 2020 return.
Qualified Improvement Property
Qualified improvement is any nonstructural interior improvement to nonresidential real property. The CARES Act provided a technical correction to the Tax Cuts and Jobs Act (TCJA) that now makes qualified improvement property eligible for 15-year treatment and 100% bonus depreciation. This change is effective retroactively to improvements placed in service in 2018. If qualified improvements were completed in 2018 or 2019 and were not depreciated in accordance with the correction, you could take a deduction to correct depreciation in 2020.
Additionally, bonus depreciation continues to be 100% for qualified assets under the TCJA for 2020. Instead of depreciating over the course of multiple years, qualified assets can be fully written off in the year the asset was purchased.
The section 179 expensing election allows for accelerated depreciation on certain qualified assets that may not be eligible for bonus depreciation. For instance, in certain circumstances, you may be eligible to use section 179 to take an accelerated deduction for roofs and HVAC equipment purchased for nonresidential real property. These improvements are not eligible for bonus depreciation.
Interest Expense Limitations
The TCJA disallowed interest expense over 30% of a business’ adjusted taxable income and business interest income. The CARES Act increased this limitation to 50% for 2019 and 2020, making it a solid tax planning option. This limitation does not apply to businesses with average gross receipts less than $26 million over the previous three years. Interest that is disallowed is carried forward indefinitely.
Real estate companies subject to this limitation under the TCJA can elect to be treated as a real property business. If you choose this option, you must use the alternative depreciation system (ADS) to depreciate residential and nonresidential property and improvements. Assets depreciated using ADS have a longer depreciable life and are not eligible for bonus depreciation.
Before the technical correction for qualified improvement property under the CARES Act, it was better for some real estate companies to make this election and receive a full tax deduction for their interest expense since qualified improvement property was not eligible for bonus depreciation.
With the changes brought about by the CARES Act, you can revoke your previous election to be treated as a real property trade or business. Prior to the CARES Act, the election was irrevocable.
Qualified Business Income Deduction and Safe Harbor
One of the TCJA’s biggest tax savers for businesses is the qualified business income deduction. This deduction applies to pass-through entities such as S corporations and partnerships. It also applies to single member LLCs that are reported on Schedule C as well as qualified rental activities.
Using this deduction, generally, 20% of qualified business or rental income will not be subject to tax. However, the regulations specifically exclude certain types of income such as capital gains, dividends, interest income and guaranteed payments to partners. The regulations also apply various limitations to the deduction.
If the 2020 taxable income on the individual return is greater than $326,600 for joint filers and $163,300 for single filers, the 20% deduction may be limited. The deduction would be limited to the greater of 50% of W-3 wages paid by the business for the year or 25% of W-3 wages plus 2.5% of the unadjusted basis of the business’ qualified property.
For your rental activity to qualify for the 20% deduction, it has to rise to the level of a trade or business. To be considered a trade or business, the activity must have a profit motive and continuous and regular involvement by the taxpayer.
If the rental activity does not fall under the definition of a trade or business, you may be able make a safe harbor election as part of your tax planning strategy. The safe harbor election is applied to a rental real estate enterprise (RREE) which can consist of either an individual property or a group of similar properties. To make the election, the RREE must meet the following qualifications:
- You must keep separate books and records for each real estate entity included under the safe harbor election.
- You’re required to spend at least 250 hours during the year on the rentals included in the RREE. These hours can include services performed by owners, employees, and independent contractors. They cannot include hours spent in the owner’s capacity as an investor, such as arranging financing, procuring property, reviewing financial statements or reports on operations, and traveling to and from the real estate.
- You must keep contemporaneous records that include time reports and logs regarding the hours of all services performed, description of all services performed, dates on which those services were performed, and who performed the services.
- The rental activity cannot be a triple net lease.
Deferring Gains on Property Sales
A 1031 (or like-kind exchange) is a transaction that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset. Recognition of a gain on the sale of the first asset would be deferred. Instead, the cost basis of the new asset is reduced by the amount of gain that would otherwise be recognized.
Like-kind exchanges can provide a tax planning advantage when you sell real estate. The gain deferral allows you to invest in new real estate as opposed to paying taxes—increasing your purchasing power.
To take part in a like-kind exchange, proceeds from your sale must be held by a qualified intermediary until a replacement property is purchased. You have 45 days from the date of sale to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange (such as the seller of the replacement property or the qualified intermediary). Then the entire property exchange must be completed no later than 180 days after the property sale that initiated the like-kind exchange
You can also use installment sales to defer recognition on a portion of gains from the sale of real estate if the sale is seller financed. Since you will not have received the full amount of the proceeds, you can defer the gain on the remaining portion. You’ll recognize a gain over time as you receive principal payments on the loan.
Working with real estate CPAs will ensure you’re using these and other tax planning strategies properly. By monitoring the latest tax laws and updates, they provide a unique and vital knowledge base that help get the most from your return.
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