The Act did not change the recovery period for residential or nonresidential real estate. The existing recovery periods, 27.5 and 39 years respectively, remained unchanged. If a taxpayer in a real property trade or business elects out of the 30 percent limitation on the taxpayer’s interest deduction (discussed below), the taxpayer will be required to use the alternative depreciation system. Under the alternative depreciation system, as modified by the Act, the recovery periods for nonresidential depreciable real property, residential depreciable real property and qualified improvements (a new category described below) are 40 years, 30 years, and 20 years, respectively.
A new category of real property, qualified improvement property, was created and qualified improvement property can be depreciated over 15 years. Qualified improvement property is any improvement to an interior portion of nonresidential building real property if the improvement is placed in service after the date the building was first placed in service and where the improvement does not enlarge the building, is not an elevator or escalator, and is not part of the internal structural framework of the building. The former separate Code provisions providing recovery periods for qualified leasehold improvements, qualified restaurant improvements, and retail improvement property have been repealed.
The Act creates a special deduction for qualified business income of a taxpayer earned through passthrough entities, such as partnerships and limited liability companies taxed as partnerships, S corporations and disregarded. Trusts and estates are eligible for the special deduction. In combination with the reduction in individual income tax rates, an individual taxpayer would face an effective maximum marginal tax rate of 29.6 percent (plus the Medicare tax on unearned income to the extent applicable), for taxpayers entitled to the full 20 percent deduction. The new deduction is subject to a number of limits, however, that may reduce its availability:
- There is a specific exclusion from the definition of qualified business income for income earned by the taxpayer from performance of services (i)in health, law, accounting consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests or commodities.
- The deduction is limited to 100 percent of the taxpayer’s combined qualified business income so that, if the taxpayer’s aggregate qualified business income is less than $0, the taxpayer’s deduction would be $0.
- There are limits imposed on the amount of the deduction that are a function of the taxpayer’s share of 50 percent of the W-2 payroll expense of the qualified business or a combination of 25 percent of W-2 payroll expense of the qualified business plus 2.5 percent of the original cost of depreciable tangible property (not land) used in the qualified business.
The Act creates a new statutory framework for the issuance of a “carried interest,” or “profits interest,” in exchange for the performance of services. New Code Sec. 1061 provides that, if a taxpayer owns an “applicable partnership interest” during the year, the excess of the excess (if any) of (i) the taxpayer's net long-term capital gain with respect to such interests for such taxable year, over (ii) the taxpayer's net long-term capital gain with respect to such interests for such taxable year calculated as if the holding period for long-term capital gain property was three years and not one year, is taxed short-term capital gain. This recharacterization applies without regard to any Code Sec. 83(b) election made by the taxpayer.
- The Code requires that gains attributable to interests that are, in part, capital interests and, in part, profits interests, be bifurcated.
- On its face, the new rules appear to apply to applicable partnership interests regardless of their date of issuance, i.e., the new rules could apply to gains attributable to interests owned less than 3-years that were issued before 2018.
- An applicable partnership interest is one that was issued in exchange for services and conducts a trade or business that is regularly and continuously carried on which involves raising or returning capital, and either (i) investing in (or disposing of) “specified assets” (or identifying specified assets for such investing or disposition), (ii) developing specified assets.
- In the absence of guidance, it is unclear whether the new Code Sec. 1061 reaches a customary profits interest issued to employees of routine real estate businesses that are not involved in raising capital from investors.
The Act has amended Code Sec. 118 to eliminate the ability of corporations to exclude contributions received from any governmental entity or civic group (other than a contribution made by a shareholder as such). For example, a contribution of land by a municipality, grants made to encourage infrastructure improvements or capital investments by the corporation that are not in exchange for stock (or for a partnership interest or other interest) of equivalent value are considered contributions to capital that are includable in the corporation’s gross income. This will have a material effect on the tax treatment of governmental grants used to encourage the relocation of corporate and business entities to the extent the property acquired with the grants is owned by the corporation.
Although the Code generally prohibits a deduction for a taxpayer’s lobbying expenditures, there had been a limited exception available to taxpayers for ordinary and necessary expenses incurred in connection with any legislation of any local council or similar governing body. For example, this permitted taxpayers who incurred expenses for appearances before, the submission of statements to, or communications to the committees or individual members of a local council or body with respect to legislation or proposed legislation of direct interest to the taxpayer, or in direct connection with communication of information between the taxpayer and an organization of which the taxpayer is a member with respect to any such legislation or proposed legislation that is of direct interest to the taxpayer and such organization, or a portion of the dues paid to the organization by the taxpayer, to claim a Code Sec. 162 deduction for those amounts. Effective for amounts paid or incurred after December 22, 2017, the general rule disallowing lobbying and political expenditures will apply to such amounts.
Although the Act retained the ability of taxpayers holding real property for investment or for use in a trade or business to defer taxable gain by means of a Code Sec. 1031 like-kind exchange, it revoked like-kind exchange treatment for all other classes of property. Accordingly, unless a mobile home or manufactured housing (i.e., the improvement and not the site or pad) satisfies the requirement to be treated as “real property” under local law, owners of mobile homes and manufactured housing will no longer be able to defer taxable gain by means of a like-kind exchange.
The interest expense of taxpayers is generally limited to 30 percent of the taxpayer’s adjusted taxable income. "Adjusted taxable income" for the purpose of this limitation generally means the taxable income of the taxpayer computed without regard to any item of income, gain, deduction, or loss not properly allocable to a trade or business and increased by (i) any business interest expense or business interest income, (ii) the taxpayer’s deduction for income from a passthrough entity, (3) the amount of the taxpayer’s NOL deduction and (4) for taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
- The 30 percent limitation will not apply to interest incurred by the taxpayer in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business, provided that the taxpayer makes an election and does not have average annual gross receipts for the three-year tax period ending with the prior tax period in excess of $25 million. The cost to a taxpayer of making the election is that the taxpayer must use the alternative depreciation system to calculate the depreciation deductions with respect to its real property, i.e., a longer depreciation recovery period.
- The 30 percent deduction limitation is applied at the partnership level. Interest not allowed as a deduction is carried forward at the partner, not partnership, level and is deductible in future periods subject to certain complex ceilings and floor.
Finally, the Act also (i) limits the deduction for interest incurred on debt used to acquire, construct or improve a principal residence to interest on up to $750,000 of debt (down from $1,000,000 under prior law) and (ii) eliminates the deduction for interest on home equity debt.