The 2018 tax filing season began on January 28th, marking the start of the first tax filing that will reflect the Tax Cuts and Jobs Act (“TCJA”) changes. It has been more than a year since the TCJA was initially passed, so we are offering a brief summary of the major changes to consider on your current 2018 tax returns.
1. IRC Section 199A
Section 199A is a pass-through deduction, known as the Qualified Business Income Deduction (QBID), which provides a deduction of up to 20% of taxable income for taxpayers other than corporations. The deduction for each taxable year will equal the lesser of the following:
- 20% of a taxpayer’s net taxable income excluding capitals gains or
- 20% of the taxpayer’s qualified business income after W-2 wage and qualified property thresholds.
To illustrate, assume Jill makes $200,000 in qualified business income and has taxable income of $160,000. Her IRS Section 199A deduction is the lesser of 20% of taxable income or 20% of her Qualified Business Income. Hence, her deduction is 20% of the $160,000 or $32,000.
Please see an additional article in this issue entitled “IRS Section 199A—IRS Provides Trade or Business Safe Harbor for Rental Real Estate.”
2. Section 1031 Exchanges
Prior to the TCJA, under IRC Section 1031 taxpayers could defer gains on like-kind exchanges of personal and real property. Following the TCJA, Section 1031 now only applies to the exchange of real property. As of January 1, 2018 personal property exchanges of equipment, machinery, vehicles, artwork, intellectual property and intangible assets will not qualify for deferral.
3. Qualified Opportunity Zones
The TCJA created Qualified Opportunity Zones (QOZ) as an economic development tool, designed to encourage real estate investments in economically-distressed communities. Investors can elect to defer tax on eligible capital gains by investing that profit into Qualified Opportunity Funds (QOF), which then invest in QOZs. In addition to deferral, investors can exempt up to 15% of the deferred gain based on the time the investment is held. If the QOF investment is held for more than 10 years, it will be eligible for an increase in basis equal to the fair market value of the investment on the date it is sold or exchanged. Therefore, there will be no gain recognition on the appreciation in the investment if it is held for more than 10 years. To apply these tax benefits, the capital gain must be invested in a QOF within the 180 day period from the date of the sale, or from the end of the tax year if deferring gains from another partnership investment.
4. Business Interest Limitation
There is a new limitation on business interest expense deductibility. The taxpayer can now deduct business interest expense up to the sum of business interest income, 30% of adjusted taxable income, and the taxpayer’s floor plan financing interest. The taxpayer can carry forward disqualified interest. The limitation applies to partnerships and S corporations at the entity level. Small business taxpayers with less than $25 million in three-year average gross receipts are exempted from the limitation. A taxpayer with a real estate trade or business can make an election to be exempted from the limitation. However, the electing real estate trade or business must use the alternative depreciation system to calculate depreciation.
5. Bonus Depreciation
Under the prior IRC Section 168(k), taxpayers could deduct up to 50% of qualified property purchased. Following the TCJA, taxpayers can now claim 100% bonus depreciation on qualified property. The percentage phases down by 20% each year for the years 2023 to 2026 and goes to zero for 2027 and after. Qualified property also now includes both original use and certain used property.
However, qualified improvements property was removed from the definition of qualified property, and thus ineligible for 100% bonus depreciation. Qualified improvement property refers to the improvement to a nonresidential building’s interior which are not for the enlargement of the building, elevator or escalator, or the internal structural framework.
6. IRC Section 179 Deduction
IRC Section 179 property can now be expensed up to $1 million instead of the prior $510,000. The phase-out threshold is also increased from $2.03 million to $2.5 million. In addition, the definition of Section 179 property has been expanded to include qualified improvement property and other improvements to nonresidential real property, such as roofs, HVAC, fire protection systems, alarm systems and security systems.
7. Carried Interest Limitation
The new carried interest limitation requires a three year holding period to treat the gain from the sale of applicable partnership interests as long term capital gain. Applicable partnership interests are partnership profit interests issued to taxpayers, such as investment managers, for the performance of services, such as asset management. This is generally referred to as a carried interest. If the carried interest, or the underlying asset generating the gain, is held less than three years, it will be treated as short term capital gain, which is taxed at ordinary income tax rates. As of now, real estate used in a trade or business is excluded from this rule. Carried interests held by C-corporations are also excluded.
8. Excess Business Losses
Beginning in the 2018 tax year, excess business losses are limited to $500,000 for joint returns. This is determined after passive activity and at-risk limitations. Previously, taxpayers could use business losses in their entirety to offset nonbusiness income, such as ordinary wages or capital investments. Any losses in excess of $500,000 will be carried forward.
The application of these changes is complicated. There is uncertainty surrounding many of these provisions. And, to top it off, California has not adopted any of these changes. We would urge our readers to work closely with their tax advisers this tax season.