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How to Co-ordinate Cost Segregation with Like-kind Exchange

The Tax Cuts and Jobs Act (TCJA) was signed by the President on December 22, 2017. The TCJA is the most significant overhaul of Internal Revenue Tax code since the 1986 Tax Act under President Reagan. The Committee Report has over a thousand pages of modifications to many areas of the tax code. One piece of the new legislation (that concern most real estate investors) involves changes to the like-kind exchange rules.

When certain conditions are met, no gain or loss is recognized when a taxpayer exchanges property of like-kind (used in a trade or business or for investment purposes). Before the TCJA, a taxpayer could exchange real property for real property; and personal property for personal property (with some restrictions) without recognizing gain on the exchange. For exchanges completed after December 31, 2017, the TCJA limits this tax-free treatment to an exchange of real property only. Personal property no longer qualifies for like-kind exchange after this date. Many taxpayers and tax preparers are asking the question: How does this impact an exchange of real property that went through a cost segregation study?

Cost segregation is a valuable tax strategy to accelerate depreciation deductions. When the timing is right, this strategic tool can save taxpayers thousands of tax dollars. The primary goal of a cost segregation study is to identify all costs that can be depreciated over shorter depreciable lives. By accelerating depreciation, a taxpayer can defer federal and state income taxes and increase cash flow. If timed correctly, a taxpayer can claim more deductions in a high marginal tax year and less deductions in low marginal tax year resulting in a permanent tax savings.

The building costs identified with shorter depreciable lives (by the cost segregation study) are depreciated as Section 1245 property. Most tax preparers believe that means that these assets are personal property. The distinction that needs to be made is between the personal property (machinery and equipment) from the real property fixtures that qualify as 1245 property for tax purposes but are deemed to be real property by state law. State law generally determines the classification of property as real or personal. For like-kind exchange purposes, the courts have held that state law, although not controlling, is generally followed to determine whether property is real or personal. As such, fixtures can be 1245 property with a shorter depreciable life for depreciation purpose but real property for like-kind exchange purpose. Taxpayers still need to be aware of the potential recapture rules under 1245(b)(4) and 1245(d)(4) but this personal property vs. real property distinction should help taxpayers navigate like-kind exchanges with more comfort.

Finally, according to the Committee Report, it is the intention of the Congress that real property eligible for like-kind exchange treatment under prior law continue to be eligible under TCJA. The expert opinion is that this language means that the treatment of real property that went through cost segregation study should continue to be eligible for like-kind exchange treatment as it has in the past.

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Pass-Through Entities and the 20 Percent Tax Break

Small-business owners and partners are scratching their heads over the Tax Cuts and Jobs Act and how the new 20 percent tax deduction for pass-through entities will work.

Here’s a little background

A pass-through entity can be a partnership, S corporation, limited liability company or partnership, or sole proprietorship — basically, most of the country’s small businesses. Owners and shareholders of these entities are taxed on earnings based on individual, not corporate, tax rates. Effectively, company earnings, losses and deductions pass through to the individual’s personal tax rates, which, in the past, were typically lower than corporate rates. The pass-through deduction was a nice tax break.

But things have changed.

In 2017, the U.S. corporate tax rate was 35 percent, one of the highest in the industrialized world. The new bill slices that rate to a flat 21 percent, which is lower than the top individual tax rate of 37 percent. Earners who fall into that top tax tier would be silly to claim a pass-through deduction, because their individual rate is now higher than the corporate rate. Say bye-bye to that tax break.

Not so fast. To even things out, lawmakers have allowed pass-through owners to deduct 20 percent of their qualified business income, or QBI, from their personal income taxes, whether or not they itemize. Unlike the corporate tax cut, which is permanent, this pass-through deduction lasts only through 2025, unless Congress extends it.

A 20 percent pass-through deduction is nothing to sneeze at. If you have, say, $100,000 in pass-through income, you can reduce your income taxes by $4,800 if you’re in the 24 percent income tax bracket.

What is QBI?

QBI is, essentially, the profit a pass-through business makes during a year.

QBI includes:

  • Rental income from a rental business.
  • Income from publicly traded partnerships.
  • Real estate investments trusts.
  • Qualified cooperatives.

QBI does not include:

  • Dividend income.
  • Interest income.
  • S corporation shareholder wages.
  • Business income earned outside the United States.
  • Guaranteed payments to LLC members or partnership partners.
  • Capital gain or loss.

Here’s the hitch

In order to take advantage of the pass-through deduction, you must have net taxable income from your businesses. If you don’t make any profit, you can’t deduct 20 percent from nothing.

The QBI from each business is calculated separately. If you have several businesses, and one or more loses money in a given year, you will deduct that loss from the QBI from the profitable businesses.

More considerations

Hey, if there weren’t always more considerations, you wouldn’t need us. Whether you can take advantage of all, some or none of the pass-through tax deduction depends on how much money you earn and how you earn it.

For instance, if your taxable income falls below $315,000 if married filing jointly or $157,500 if single, you can take full advantage of the pass-through deduction. But if your taxable income is more than $315,000/$157,500, taking the deduction will depend on your total income and the kind of work you do. If you perform a personal service, such as doctor or consultant, you’ll lose the deduction at certain income levels. The details are still unclear, and we’re looking forward to reviewing future guidance.

The new pass-through deduction can be a nice tax break for folks who qualify. Not sure if you do? Contact us at info@cpa-wfy.com, and we’ll help you navigate the murky waters surrounding the new tax law and pass-through deduction. We’ll see if you’re entitled to anything and, if so, how much.

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