The following article was written exclusively for SoCal Real Estate.
By Michael Silvio
Hall & Company CPAs and Consultants
The tax landscape for real estate investors has been as murky as ever over the past year, starting with sweeping reform measures known as the Tax Cuts and Jobs Act (TCJA). As soon as the ink dried on the TCJA, fresh rumors of a “Tax Reform 2.0” spread quickly leading up to the November 2018 midterm elections, only to be squelched by a Democrat takeover of the U.S. House of Representatives, elevating a new class of lawmakers bent on rolling back the TCJA.
So where does all of this leave us? In a word: gridlock.
A split Congress means that the chances of a new tax deal being worked out before the 2020 election are extremely unlikely due to changes in leadership. However, thanks to the gridlock, the short-term tax outlook is expected to be refreshingly stable for real estate investors.
During this time, the two main issues real estate investors should keep a close eye on are capital gains taxes and accelerated depreciation.
Most real estate investments that are held for longer than a year require the owners to pay a long-term federal capital-gains tax up to 20 percent depending on the investor’s income level. In addition to the capital-gains tax, the owner could also be subject to the net investment income tax (NIIT) of 3.8 percent. This is in addition to California’s state capital-gains tax, which is treated as “ordinary income” and can be as high as 12.3 percent.
With Southern California’s real estate investment community being relatively affluent and fewer income-related write-offs likely to remain intact for several years following the TCJA, most investors should expect a combined capital-gains tax bill of at least 36 percent on each real estate sale.
A savvy investor may defer this cost through the use of a 1031 tax-free exchange. However, there is a catch: accelerated depreciation. Typically an advantageous tax break for real estate investors, depreciation allows owners to show that their asset has lost value at a faster rate than normal (known as straight-line depreciation). During the life of the asset, this means more tax write-offs, but when it comes time to sell that asset, it means more capital gains tax or recapture of accelerated depreciation as ordinary income.
Another advantage that real estate investors should consider is whether or not a costs-segregation study on the real estate property is warranted. In a costs-segregation study, a detailed engineering analysis is performed on the components of the building structure. Basically, the items found during this analysis that are not structural items can be reclassified to a shorter depreciable life of five, seven, or 15 years. This means that depreciation on these items can be accelerated and, in some cases under the TCJA, can qualify for bonus depreciation. These studies can be extremely beneficial during the life of the building and can result in significant tax savings in the earlier years of the building life due to the accelerated depreciation benefit.
The analysis gets a bit more complex when accounting for property within each building due to bonus appreciation schedules. The TCJA doubled the previous 50 percent bonus depreciation deduction to 100 percent for qualified property placed in service after Sept. 27, 2018. It will likely be gridlocked in for the near-term but then phased out if nothing changes in the longer term.
Bonus depreciation applies to business assets with a cost recovery period of 20 years or less such as machinery, equipment, computers, appliances, furniture, and certain plants. Under the TCJA, these assets can be depreciated according to the following timeline:
• 100 percent for property placed in serviced by Q4 2018
• 80 percent by 2023
• 60 percent by 2024
• 40 percent by 2025
• 20 percent by 2026
• 0 percent for property placed in service after 2026
Real estate investors have a lot of moving parts to track over the next 10 years, and more changes could come after the 2020 presidential election. As post-midterm strategies become implemented, keep the longer-term cost analyses in mind with one eye fixed on the news, and make sure to consult an experienced tax CPA who specializes in real estate investment strategies within Southern California.
Michael Silvio, CPA is the tax director of Hall & Company CPAs and Consultants. He has nearly 30 years of experience in public accounting and tax planning, and he has served a variety of businesses in the commercial and residential real estate industries.