As a new decade begins, will construction and real estate businesses see the ‘roaring twenties’ with continued growth? Or will we witness a collapse as occurred a little over ten years ago? Regardless of how these industries fare in the new decade, a good way to start off this year is to focus on tax planning. Tax planning strategies are always in season whether times are healthy or lean. To get you started, here are 20 tax planning ideas for construction and real estate businesses to consider as we move into 2020:
1. Accounting Methods for Revenue Recognition. The new accounting standard for revenue recognition will impact 2019 financial statements for non-public companies, which could result in earlier recognition of income for book purposes. At the same time, a key aspect of the “Tax Cuts and Jobs Act” (TCJA) was a change in the “All Events Test.” The new rule states that revenue must be recognized at the earliest of these to occur: the income is due; paid; earned; or recognized for book purposes in the Company’s “Applicable Financial Statements” (AFS). Since only audited statements qualify as AFS, the TCJA rule will not apply to taxpayers with review or compiled financial statements.
For some taxpayers, the addition of the AFS prong to the test could result in early recognition of income for tax and book purposes. There are some exceptions to these new rules, and your Sikich tax advisor can assist your business in minimizing any adverse tax consequences.
2. Long-Term Contracts. One exception to the new AFS conformity rule is that contractors are still permitted to use the percentage-of-completion method for tax purposes. Further, there is a TCJA provision stating that small businesses (those with gross receipts of under $26 million) can utilize the tax-favored completed contract method or the cash method.
3. Long-Term Contracts – Exception for “Home Construction Contracts.” Home construction contractors can use the completed contract method and are not required to use the percentage-of-completion method. The 2016 Shea Homes case provided a favorable tax result with the home construction exception for a large development project. It is therefore important to identify and seek these exceptions.
4. 20% QBI deduction. The TCJA established a new tax incentive for businesses - a 20% tax deduction for “Qualified Business Income” (QBI). This deduction is available to a real estate business even if it involves a significant capital investment (perhaps a large real estate development) but with limited wages.
5. Rental Real Estate and the 20% QBI Deduction. The QBI deduction has many complexities associated with it, including whether rental real estate qualifies. Generally, the more involvement and activity handled by the owner of the property, the higher the likelihood the rental will be treated as a trade or business and fall under the QBI rules. Thus, lessors of rental real estate property need to document the work performed with a rental property and should consider revising the duties assigned under the lease.
Further, a triple net lease is generally not viewed by the IRS as having a enough level of activity associated with it and is not entitled to this deduction. However, as is common in the tax law, there are exceptions; and if the property is leased to a related party pass-through entity, the rental can be treated as a trade or business for QBI purposes.
6. Section 1031 Like-Kind Exchange. Any gain from the sale of real estate property can be deferred by reinvesting the proceeds from the sale into another real property (note: personal property is no longer eligible for a like-kind exchange). There are certain rules to follow, but significant tax gains can be deferred through a 1031 exchange. Your Sikich tax advisor can assist you in navigating these rules to maximize the deferral.
7. Interest Expense Limitation. Under the TCJA, a business’ deduction for interest expense is limited to 30% of its taxable income before the deductions for depreciation/amortization and interest expense. This new limitation impacts businesses that are highly leveraged and/or marginally profitable.
There is an exception to this interest limitation that is available for small businesses. Please note that while this exception offers relief, there are several hurdles a business must meet to qualify.
8. Interest Expense Limitation - Real Estate Election. One option available to a real estate or construction business is to elect out of the new interest limitation. Before you jump ahead and make this election, please note that it comes with a price. If a business makes this election, it is not able to claim bonus depreciation on its fixed asset additions, so this may not be the best tax move. Your Sikich tax advisor can assist you in this complicated analysis.
9. Interest Expense Limitation – Safe Harbor Expensing Capitalize and Depreciate. Another possible planning strategy for a real estate or construction business that is subject to the 30% limitation is to forego making the safe harbor expensing election. Instead of making this election to expense certain smaller asset purchases, the businesses could instead capitalize these items and depreciate them using the 100% bonus depreciation. Then, for purposes of the 30% interest limitation, the depreciation is added back, which increases the overall income limitation and leads to more interest deduction.
10. Bonus Depreciation Enhanced to 100%. 100% bonus depreciation is still available for both new and used property. For real estate businesses, this makes a cost segregation study important for both purchased and constructed buildings. Using bonus depreciation for the cost allocated to personal property and land improvements can provide significant tax incentives.
Additionally, the IRS issued detailed and complicated final regulations for the bonus depreciation this year. These regulations provide guidance to a real estate business with unique transactions or property acquisitions in the past year.
11. Section 179 Expensing – Increased Limits and Enhanced Application for Real Estate. TCJA also expanded the Section 179 expensing limit, permanently raising it to $1,000,000, indexed for inflation (with the limit for 2020 at $1,040,000). In addition, the TCJA enhanced the definition of Section 179 property to allow the business to elect to include the following improvements made to non-residential (e., commercial) property after the property was first placed in service:
- Qualified improvement property, which means any improvement to a building’s interior. These improvements do not qualify if they are attributable to: the enlargement of the building; any elevator or escalator; or the internal structural framework of the building.
- Roofs, HVAC, fire protection systems, alarm systems, and security systems.
Taxpayers can accelerate depreciation deductions by maximizing Section 179 and 100% bonus depreciation, resulting in significantly more tax deductions for CapEx additions compared to just a few years ago.
12. New Limitation on Deducting Large Losses. There are several restrictions that taxpayers must navigate before claiming a tax loss. The TCJA added a new limitation for deducting large or excess losses. Large losses are defined as $500,000 for an individual taxpayer filing jointly, and this amount is indexed for inflation (the level for 2019 is $520,000).
Example: If the owner of a real estate business incurs a large loss of $2,000,000 in 2020, under this new provision, only $520,000 would be deductible—and the excess loss amount of $1,480,000 would carry over. This limit applies even if the owner has enough basis to deduct the loss and is actively involved in the operations of the business.
The IRS has not yet issued any regulations on this large loss limitation, so it is uncertain how it applies in some cases. This new loss limitation has received little attention but could apply in many situations with real estate businesses.
13. Outside Capital Contributions by Non-shareholders (Section 118). In many parts of the country, state and local governments seek to attract and retain businesses to their area by offering various incentives such as land for a new development or factory, or even a cash infusion. Prior to 2018, these non-shareholder capital contributions were treated as non-taxable to corporations, but the TCJA removed this exception. While these non-shareholder contributions are now generally taxable to corporations, the corporations can use the 100% bonus depreciation to write off the property received or acquired.
14. Section 754 Basis Step-Up with Real Estate. One of the long-standing provisions of partnership tax law permits a basis step-up to a partnership and its partners on the sale/transfer of a partnership interest. This beneficial and unique election is only available to partnerships. As real estate generally tends to appreciate over time, real estate partnerships should always be on the lookout to make a Section 754 election when a partnership interest is sold or transferred (or a partner is redeemed out of the partnership).
15. IRS Focus on a Partner’s Tax Basis in a Partnership. Starting with the 2018 tax year, there were additional reporting requirements when a partner had “negative” tax capital in a partnership interest. Additionally, for 2020, the IRS decided that a partner’s Schedule K-1 will be required to report the partner’s tax basis in the partnership.
In many cases, this may involve some additional work during 2020 for a partnership and its partners to gather, collect, calculate, and update the tax basis for all partners. It is uncertain if any exceptions will apply to this reporting requirement. Partnerships offer flexibility and significant tax incentives, especially with real estate; however, the IRS now requires more documentation and record-keeping.
16. IRS Focus on a Shareholder’s Tax Basis in an S Corporation. As with partnerships, the IRS is also concerned with a shareholder’s stock basis in an S Corporation. Stock basis is important as any losses are deductible for the shareholder up to the shareholder’s stock and loan basis in the S Corporation.
Further, distributions from the S Corporation to a shareholder are generally not taxed to the extent of the shareholder’s basis. The IRS will likely request shareholder basis schedules upon audit, and this could include the shareholder and corporation looking back to when and how the stock interest was initially acquired for each shareholder. As many construction and real estate businesses utilize the S Corporation structure, the shareholders should be prepared to gather and document the stock basis for each shareholder.
17. Tax Credits Offer Additional Incentives. In addition to taking advantage of available tax deductions afforded to real estate businesses, there are also various tax credits available to the business to further reduce its tax obligations, including the following:
- New Markets Tax Credit (NMTC; extended recently by Congress through 2020);
- Certified Historic Credit for certain rehabilitations, as revised by the TCJA;
- Credit to the Builder of Energy Efficient Homes (also extended recently through 2020);
- Credit for Energy Property, including Solar Panels and Equipment;
- Work Opportunity Tax Credit (WOTC; also referred to as the Jobs Credit. Extended through 2020);
- Employer Credit for Paid Family and Medical Leave provided to its employees (extended through 2020); and
- Various state tax credits that differ from state to state.
18. Opportunity Zones – Investor Considerations. One of the exciting opportunities in the TCJA is just that, the new “Opportunity Zones” (OZ) incentive. The OZ provision is designed to promote economic development in certain designated lower income areas in every state. The basic model is that any taxpayer/investor recognizing a capital gain can invest the capital gain into a Qualified Opportunity Fund (QOF). The QOF in turn invests and develops a business in the designated OZ across the country. The investor realizes several tax incentives for investing in a QOF:
- The initial gain invested into the QOF is deferred.
- Next, there are basis boosts available if certain holding periods of five and seven years are met.
- Last, there is a 100% exclusion of future gain on the QOF project if it is held for ten years by the investor.
The OZ investor provisions are complicated, and the IRS recently issued 500+ pages of final regulations to help investors. Real estate businesses may become involved in several parts of the OZ process, including perhaps, investing any capital gains generated by an individual or business into a QOF. Yes, this is an opportunity for many; but with it comes much due diligence and analysis to see whether to make such an investment.
19. Opportunity Zones - OZ Developer and OZ Businesses. Some QOFs could look for opportunity zone businesses to acquire or develop, and a construction or real estate business might then be involved in these steps. This is where the recently released IRS final regulations for OZ are helpful in clarifying many of the definitions and thresholds. There is much interest of late in these OZ. Now with this IRS guidance, much exploration and kicking the tires about OZ will soon turn into actual OZ projects in many parts of the country. There are even some OZ tax incentives at the state level (in addition to the federal tax benefits), so be aware of these. Your Sikich advisor can help guide you through the OZ maze.
20. Succession Planning – Estate Planning. Once you have grown and developed your construction or real estate business, you’re ready to take it to the next level. Do you want to sell your business? Perhaps transfer it to your employees? Or, might it make sense to explore the sale to a private equity firm or a strategic buyer?
There are many succession options to evaluate, and with each one comes several tax and financial considerations. The TCJA made some sizable adjustments in the estate and gifting transfer amounts, and these could come into play in your analysis. Succession planning is not something that is required every year like a financial statement or tax return, but it is something a business owner needs to address. With the start of a new decade, why not bring your succession planning into focus and begin this process? Your Sikich team of advisors can guide and direct you at every step of this importance process.
That’s it – 20 planning strategies and ideas for 2020. Yes, there are other planning ideas available, but right now it’s time to get started and focus on the above 20 items, as these offer many tax savings opportunities for this year and beyond. Once you have checked all these off your list, we’ll help you identify the next 20! Contact us for help getting started.
