FEDERAL TAX LAW CHANGES 2018... NOW THAT THE DUST HAS SETTLED

JANUARY 17TH, 2018

NOW THAT THE DUST HAS SETTLED

It is always important to note that the new tax code provisions that just passed the Congress are going to be subject to further regulations and interpretations. We know that the IRS is feverishly working on those and any one of the pieces of information contained in this update may have some fine tuning coming from the IRS as time goes on.

This is just a general overview of some of the many tax law changes and does not replace you seeking competent tax advice for your individual situation. While the Congress indicated their intent to simplify matters, they really made matters more complicated. I think all of you would agree.

INDIVIDUAL TAXATION MATTERS

Individual Taxation Rates and Individual Deductions

*Beginning in 2018, the Act reduces the maximum individual tax rate from 39.5% to 37%. These rate changes are set to expire January 1, 2026. It is important to understand that the corporate rates below are permanent, but the changes at the individual level expire at end of 2025.

*In addition to these rate changes, the standard deduction has been increased from $13,000 for joint filers, and $6,500 for individuals, to $24,000, and $12,000, respectively, while the personal exemption for $4,050 has been repealed.

*The Act also increases the exemption (from $84,500 to $109,400 for joint filers) and threshold amounts (from $160,900 to $1,000,000 for joint filers) for individuals subject to the alternative minimum tax. AMT for individuals is still with us. AMT for corporations is gone.

Miscellaneous Itemized Deductions

*The Act repeals all miscellaneous itemized deductions that were subject to the 2% floor.

*These include, for example, deductions for tax preparation fees, unreimbursed employee business expenses, and investment advisory fees.

Mortgage Interest Deduction

*Beginning January 1, 2018, the ceiling on the mortgage interest deduction has been reduced from $1,000,000 to $750,000 for indebtedness incurred in acquiring, constructing, or improving a residence. Again, like the individual rates, this provision is scheduled to expire January 1, 2026.

*For mortgage indebtedness incurred before December 15, 2017, the Act permits homeowners to maintain the current $1,000,000 ceiling.

*The Act also prohibits the deduction of interest on home equity indebtedness.

State and Local Taxes

*The Act limits annual itemized deductions for state and local taxes (including state and local income, property, and sales taxes) to $10,000. Of course, local taxes in Washington are not relevant.

Medical Expense Deduction

*The Act increases the deductibility of medical expenses by reducing the threshold for claiming the deduction from 10% of adjusted gross income to 7.5% for tax years 2017 and 2018.

Alimony and Maintenance

*Alimony and maintenance payments made pursuant to a divorce and separation agreement will no longer be deductible from income by the payor spouse and includible in income by the recipient spouse.

*To ensure that taxpayers have time to properly account for these changes, this new rule will apply only to divorce and separation agreements entered after December 31, 2018.

CORPORATE AND BUSINESS INCOME TAX MATTERS

Corporate Tax Rates

*The Act permanently reduces the corporate income tax rate from 35% (the prior top corporate income tax rate) to a 21% flat rate.

*The Act also repeals the corporate alternative minimum tax (AMT).

Deduction Available to Owners of Pass-through Businesses

*The Act allows owners of certain pass-through businesses, including partnerships, S corporations, trust and estates, sole proprietorships, real estate investment trusts (REITs), and publicly traded partnerships (PTPs), to take a deduction equal to 20% of “qualified business income” (QBI).

*Assuming the full 20% deduction is available to the taxpayer, the effective marginal tax rate is 29.6% with respect to those taxpayer’s subject to the highest individual rate.

*QBI includes all domestic business income except investment income (i.e., dividends, interest income, short-term capital gains, long-term capital gains, commodities gains, foreign currency gains, etc.). Compensation paid by S corporations and guaranteed payments paid by partnerships are not included in QBI.

*The deduction is subject to many complicated limits and phase-ins; it is important to note that the deduction is capped at the excess of taxable income over capital gains.

*In addition, the deduction is limited to the greater of (i) 50% of the taxpayer’s pro rata share of wages paid by the business, or (ii) 25% of the taxpayer’s pro rata share of the wages paid by the pass-through plus 2.5% of the unadjusted basis, immediately after acquisition, of qualified property (i.e., property subject to depreciation and used in the trade or business).

*This second limitation applies only to partners, shareholders, or sole proprietors with taxable income more than a threshold ($157,500 for single filers and $315,000 for joint filers), and will phase in over the next $50,000 of income ($100,000 for joint filers) above these thresholds.

*In general, the deduction does not apply with respect to certain service businesses (e.g., accounting, law, health, financial services, etc.), except in the case of taxpayers whose taxable income does not exceed the above thresholds.

Bonus Depreciation and Section 179 Expensing for Businesses

*Prior to the Act, taxpayers could take first-year bonus depreciation equal to 50% of the adjusted basis of new “qualified property.”

*The Act increases bonus depreciation to 100% for both new and used “qualified property” acquired and placed in service beginning September 27, 2017 and before December 31, 2022.

*The accelerated recovery is reduced by 20% each year for property placed in service after December 31, 2022.

*In general, “qualified property” is new and used property with a recovery period of 20 years or less like certain computer software.

*A transition rule also allows businesses to elect to apply a 50% allowance instead of the 100% allowance for the taxpayer’s first taxable year ending after September 27, 2017.

*In addition to the foregoing, the amount that a business is allowed to immediately expense under Code Section 179 (e.g., depreciable tangible personal property that is purchased for use in the active conduct of a trade or business, including off-the-shelf computer software and qualified real property such as qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) has been increased from $510,000 to $1,000,000 and the types of real estate improvements eligible for the deduction have also been expanded (e.g., roofs, heating, air-conditioning, fire protection, etc.).

*The $1,000,000 is reduced (but not below zero) by the amount by which the cost of qualifying property place in service during the taxable year exceeds $2,500,000.

Business Interest Deductions Now Limited

*Subject to certain exceptions, the Act limits the business interest deduction to 30% of earnings before deductions for interest, taxes, depreciation and amortization (EBITDA) for tax years beginning in 2018.

*For tax years beginning in 2022, the deduction is limited to 30% of earnings before deductions for interest and taxes (EBIT). This limitation does not apply to businesses with average annual gross receipts not exceeding $25,000,000 over the past three taxable years. Unused interest can be carried forward indefinitely.

*Although real estate businesses are eligible to take first-year bonus depreciation equal to 100% of “qualified property,” in practice, most real estate assets (e.g., land and buildings) are not “qualified property.” As a result, unlike other industries, investors in real estate businesses are permitted to elect out of the 30% limitation. However, in exchange for the election, the real estate business will be required to use an alternative depreciation system (i.e., 40-year depreciable life for nonresidential real property, instead of 39.5 years, and 30-year depreciable life, instead of 27.5 years, for residential real property), rather than the faster depreciation periods offered under the Modified Accelerated Cost Recovery System (MACRS).

Net Operating Loss Deductions

*Prior to the Act, a business could carry back net operating losses (NOLs) to the two preceding years and carry them forward for up to 20 years to offset 100% of taxable income. Under the Act, the deduction for NOLs is now limited to 80% of taxable income. NOLs may not be carried back, but may be carried forward indefinitely. Importantly, existing NOLs can continue to be carried back 2 years or carried forward up to 20 years and can offset 100% of taxable income.

Like-Kind Tax Deferred Exchanges

*While most types of tangible property (such as airplanes and rolling stock) were allowed non-recognition treatment under the like-kind exchange rules, the Act provides that only exchanges of real property would qualify under Code Section 1031. Non-recognition treatment will still be respected with respect to property other than real property if it was disposed of before January 1, 2018.

Entertainment and Other Employer Expenses

*Deductions related to entertainment, amusement or, recreation, and transportation fringe benefits have been eliminated.

*The deduction for 50% of food and beverage expenses associated with operating a trade or business would be retained.

*However, the Act limits deductions for the cost of food and beverages provided to workers to 50% of the cost.

*Beginning with tax years after December 31, 2025, this deduction will be eliminated.

PERSONAL PROPERTY ITEMS IN PURCHASE AND SALE DEALS

Personal property items are generally not a big factor in a residential real estate purchase and sale agreements. In real estate transaction, parties can, and commonly do, include personal property items such as appliances in their transaction. On our “Legal-Line” we have received many inquiries from Brokers that raise issues regarding personal property issues.

In our practice, we also encounter disputes when parties do not specifically include an item which one party regards as “personal property” and another party regards as a “fixture” and, therefore part of the “real estate”, and, accordingly, included as an integral part of the real estate in a real estate purchase and sale agreement transaction.

In 2008, the Washington State Court of Appeals Division One (up in Seattle) decided King v. Rice, 146 Wn. App. 622m 191 P.3d 946 (2008) which discussed the differences between personal property items which are not “real estate” and fixtures which are “real estate”.

*****In King, a Buyer and Seller entered into a real estate purchase and sale agreement.

*****The subject property was primarily vacant land but included a small house and a modular living unit located on blocks.

*****The Seller had placed the modular living unit on the subject property in 1984. The modular living unit included a bedroom and a kitchen but it was never hooked up to utilities and was only used to store tools.

*****The transaction closed and the escrow instructions included a provision stating that: “The Buyer shall have 20 days after closing to remove the house presently built on the parcel”.

*****Less than 20 days after closing, the Buyer demolished the modular living unit with a backhoe.

*****The Seller sued the Buyer for breach of contract, negligent destruction of personal property, and malicious mischief.

FINDING OF THE TRIAL COURT

At the trial court, the Buyer filed a motion for summary judgment to dismiss the Seller’s lawsuit arguing that the Buyer’s claims were unsupported by law because the modular living unit was a fixture and, therefore, part of the “real estate” and accordingly, after closing the Seller had no legal interest in the modular living unit. The trial court agreed with the purchaser and dismissed the Seller’s lawsuit from which the Seller appealed.

FINDING OF THE COURT OF APPEALS

The Court of Appeals reversed the trial court’s decision holding there was a genuine issue of material fact regarding whether the modular living unit was personal property or a fixture.

In doing so, the Court of Appeals recited the definition of a “fixture”: (1) the property is annexed to the realty, (2) its use or purpose is applied to or integrated with the use of the realty, and (3) the annexing party intended a permanent addition to the freehold.

In applying this test to the case at hand, the Court of Appeals reasoned that the modular storage unit was not “annexed” to the realty because it was not attached to the ground or utilities and because it had never been listed on county tax records as part of the real estate.

PRACTICE POINTER: The practice pointer here is that if there is any ambiguity in a situation, include a specific term addressing the subject item. Our attorneys can assist in drafting purchase and sale agreement addendum's to prevent costly litigation. Obviously, the laundry list of items on the multiple listing forms will not create an issue. If you see anything that could create an ambiguity then address it and come to terms. Storage sheds have come up quite often in our practice. If in doubt, don’t depend on the law; depend upon specifically stating what items are being included 

TAX BREAKS FOR THOSE WHO ARE 

SELLING THEIR PRIMARY RESIDENCE

The topic this week is totally based upon e-mails to our “Legal-Line” regarding these tax matters and classes I taught this past week that this topic was a part of the discussion.

We are not talking here about any huge new law, but refreshing all my readers’ memories of a law that was (and is) very favorable to many of your customers, but has been of little or no consequence during the last seven (7) or so years of our nasty and long recession. It regards capital gains taxes and primary residences. I know I have your attention now as this affects all of you. This is a law that was subject to being changed with a longer holding period. That change did NOT occur so we still have this wonderful tax exemption available. Read on!!!

You may want to save this e-mail in your library as the first part DOES go over, in pretty good detail, the actual rules, but there were a few changes that occurred as late as “The Housing Assistance Tax Act of 2008” that are probably new to most of my readers as we were all focused on other matters back in 2008.

Listen up if you have customers who rent out their properties at some point in time as these new rules (well, new as of 2008) can affect how much capital gains tax exclusion they can take if they have a property with what we called “blended use” that is partly owner occupied and partly non-owner-occupied property.

THIS HOMEOWNER EXEMPTION IS BETTER THAN SLICED BREAD…….

The exclusion of up to $500,000.00 of capital gains tax because of the sale of one’s primary residence can be a great tax benefit to home owners especially since they only use the exemption a few times during their lives.

We, as real estate professionals, ALWAYS need to encourage all our customers to seek legal or tax advice as all areas of taxation are complicated and there can be traps for the unwary. The goal of this article is to address some of those traps.

LET’S TALK ABOUT THOSE WHO INVEST IN REAL ESTATE…IS THAT POSSSIBLY YOU?

For those who invest in real estate, this special tax code creates potentially wonderful tax planning opportunities. Imagine if you will, your customer (or you) wants to convert their rental property into a primary residence to take advance of the primary residence tax exclusion and preclude, not only the capital gains as the property was held as an investment, but to tack on along the time of the primary residence holding. When combined with the fact that this exemption can be used every two (2) years, this could be wonderful for a property investor.

Sorry. You weren’t the first to look at this opportunity. In fact, this whole scenario goes back as far as about 15 years ago when this whole exemption came into being. However, there are still opportunities, but read on. The Congress has made some changes:

A.   They in the past did preclude depreciation recapture from being eligible for favorable home owner exemption treatment.

B.   They required a longer holding period (5 years) in a Section 1031 tax deferred exchange for those parties who converted the use of their investment property. [I have a dandy tax exchange class being offered throughout the State of Washington that addresses this issue].

C.   More recently (2008), the Congress has forced gains to be allocated between periods of “qualifying” use and periods of “non-qualifying” use of the property.

THE NUTS AND BOLTS OF THE HOMEOWNER EXEMPTION…….(SECTION 121 OF THE TAX CODE)…

I think most of my readers have a pretty good understanding of the basic rules. It was created in 1997 by our Congress. No longer do we have to buy a new property [That was an old law]. No longer do we have a once in a life-time $125K exemption [That is also old law]. Our current law is called: “The Taxpayer Relief Act of 1997” and has been modified ever since then. It was NOT modified by the 2018 tax law changes!!!!

There are lots of special rules within it and the devil can be in the details. The Publication from the IRS for layman is not a walk in the park, but PUBLICATION 523 can be a great help to understand some of the nuances. Just Google “Publication 523” and you can download and print it out. Again, this short article does NOT replace a good consultation with one of our tax attorneys here at our law office.

That Act allows a homeowner (individual) to exclude up to $250K of capital gain on the sale of a primary residence ($500K for a married couple) so long as the property was owned and the party used the property as their primary residence for at least two (2) of the last five (5) years.

PRACTICE POINTER: Keep in mind that BOTH SPOUSES don’t have to own the house even though this is a community property state. One of the two can own, but BOTH must live at that property to qualify for the $500K exclusion. Isn’t that cool?

One does not have to occupy the property at the time of sale. It is just 2 of the last 5 years. In other words, the time does not need to be even continuous. We just need 720 days in the last 5 years to qualify. If one moves out after qualifying for the initial two (2) years, then one has three (3) years to then sell the property and take advantage of the exclusion rule. Make sure you understand this clearly as it creates many misunderstandings among professionals and homeowners alike.

PRACTICE POINTER: If your seller does not meet the two (2) year rule, still have them talk with their tax counsel as they can get a partial prorated exemption if a change in place of employment, change in health, or “unforeseen circumstances” all of which require a tax attorney or tax counsel to review and advise. As the economy improves folks, your sellers will soon again be experiencing this type of issue.

LIMITATION ON USE OF THE EXEMPTION……. ONCE EVERY TWO YEARS…….

This exemption can be used once every two (2) years.  Remember, so long as the requirement is met there is no limit to the number of times an individual can use that exemption during his or her life. I wonder how many of our customers out there want to move every two years?

VARIATION ON THE THEME…WHAT ABOUT RENTAL PROPERTY?

Most of our customers are not real estate investors. They use this tax savings tool as they move through their life growing a family and later getting smaller as their families mature and move on. During the “good times of rapid appreciation” prior to the recession, many of my clients would “buy up” over time and take advantage of this exemption repeatedly. Remember that this is an EXEMPTION and not a deferral. You don’t have to account for that accrued gain afterward like you do in a tax deferred exchange.  

Those same people would many times also own rental property and would creatively attempt to move into their rental property taking advantage of the holding period and then excluding ALL the gain (not only the gain while they lived in the property as well as the gain while it was used as an investment property).  Pretty great ideas!!!! In addition, because of depreciation the gains in the investment part would generally accrue faster and thus a pretty good bang for their tax savings buck if they could pull it off!!!

WHAT IS TOO GOOD TO BE TRUE IS GENERALLY TOO GOOD TO BE TRUE…. ALONG COMES CONGRESS…….

Over a period of time, the Congress modified Section 121 (the residence exemption rule) to limit those strategies. The initial rule eliminated the exemption to apply to any gains attributable to depreciation taken on the property when it wasn’t being used as a primary residence. This came into effect on May 6^th, 1997 when the original exclusion rule came into effect. So even if you have a blended property and you meet the two-year residence rule, that portion of the capital gains that is attributable to

depreciation taken will be subject to recapture at generally 25% rates. However, one must read on.

IN 2008, CONGRESS PASSED FURTHER LIMITATIONS…HOUSING ASSISTANCE TAX ACT OF 2008…….

So, we must read what happened above and understand that in 2008 Congress further limited the use of this wonderful exemption (in Section 121(b)(4)) specified that the exemption is only available when we have the property ACTUALLY used as a primary residence. The date of that Act is January 1^st, 2009.

So, this is interesting. The Congress deemed all gains are occurring pro-rata during the whole period of ownership whether owner occupied or not. Periods when the property is owner occupied are “qualifying”. Periods when used for investment are “non-qualifying”. Non-qualifying gains are not exempt!!!!!

This is where it can get complicated and this is where I like to have the client come in and we sketch out the whole transaction and run out the numbers. This is part of our $150 initial consultation program. This is an area of tax that we practice daily.

LET’S TALK ABOUT THIS WHOLE SUBJECT AND TAX DEFERRED EXCHANGES………BIG PART OF MY PRACTICE……

Before the Recession literally 98% of my day was involved in matters of Tax Deferred Exchanges. Kevin Hummel and I have worked together over 15 years now. I got started in tax exchanges in about 1983. They are a wonderful area of practice. Along comes the Recession and we aren’t as busy, but short sales to a great degree took their place.

Now the market is improving and tax exchanges are back in full swing. This issue of blended property or converting rental property or investment property into a primary residence is a big issue for discussion. Folks this is huge.

Notably, there is an additional “anti-abuse” rule applies to rental property converted to a primary residence that was previously subject to a 1031 exchange. For instance, let’s imagine a situation where an individual completes a 1031 exchange of a small apartment building into a single-family home, rents the single-family home for a period of time, then moves into the single-family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!). Does this sound like you or one of your customers?

To limit this activity, the Congress created “The American Jobs Creation Act of 2004 (now IRC Section 121(d)) affecting specifically tax deferred exchanges. That Act stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.

The strategy to exchange an investment rental for a new investment rental in a location where you or your customer may wish to retire takes some planning, but will maximize their tax savings in the end. When one exchanges their current investment rental property into a new investment rental property, they defer the tax they would normally have to pay on the gain. This is reflected in the lower basis assigned to their new replacement property. This, of course, is basic Section 1031 knowledge.

When they sell their current principal residence, they may exclude the gain up to the Section 121 limits. Then, after they convert their replacement property into their new principal residence, they become eligible once again for exclusion of up to $250,000/$500,000 of gain after they have owned the replacement property for five years and used it as a principal residence for two years. The five-year ownership rule on a principal residence only applies to properties that have come to your client from an exchange. Capital gains tax will be due on gains above the Section 121 limits and any depreciation taken after May 6, 1997.

If your customer just acquired a property by doing a like-kind exchange, they must hold the new property as an investment, rental, or business property to qualify for the exchange itself. We look at the facts and circumstances surrounding the exchange at the time of the acquisition. No one can tell your client how long the exchange replacement property must be held in investment status before they convert it to personal use, but most of our attorneys in our office recommend not less than one year. IRS issued Revenue Procedure 2008-16 which defines a safe harbor and includes a two-year holding period of limited personal use and a rental period if you want to be safe. We are happy to meet with clients and help you design a transaction that allows you to convert from investment to primary residence use.

Another issue we need to revisit in relation to tax deferred exchanges is that effective January 1, 2009, the IRS Section 121 was changed to require parties whether inside or outside an exchange to allocate gain based upon use. Before the President signed H.R. 3221, the Housing Assistance Tax Act of 2008, on July 30, 2008, a revenue-raising provision first promoted by Representative Charlie Rangel (D, N.Y.) was included by the conference committee as Section 3092 of the bill. This provision was an amendment to Section 121 and has had a major impact on small landlords and taxpayers who were planning to convert their rental or second home to a principal residence and then exclude any gain from their income when they sell the property.

The term “Period of Non-Qualified Use” referenced in the amendment is very important and means any period during which the property is not used as the principal residence of the taxpayer, the taxpayer’s spouse, or a former spouse.  Importantly, the period before January 1, 2009, is excluded. January 1, 2009 is the date upon which this statute became law.

In addition, subsection (4)(C)(ii) of the amendment provides additional exceptions to the Period of Non-Qualified Use. These exceptions are (1) any portion of the five-year period (as defined in Section 121(a)) which is after the last date that such property is used as the principal residence of the taxpayer or spouse, (2) any period not exceeding 10 years during which the military or foreign service taxpayer, or spouse, is serving on qualified official extended duty as already defined, and (3) any other period of temporary absence (not to exceed a total of two years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the HUD Secretary.

The amendment states “gain shall be allocated to periods of non-qualified use based on the ratio which (i) the aggregate periods of non-qualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.”

How does this affect your client’s planning?

EXAMPLE FOR ILLUSTRATION:  Suppose the married taxpayer exchanged into an investment property and rented it for four years. They moved into it at that time and lived in it for two additional years. The taxpayer then sold the residence and realized $300,000 of gain.

Under prior law, the taxpayer would be eligible for the full exclusion and would pay no tax. Under the new law, the exclusion will have to be prorated as follows: four-sixths (4 out of 6 years) of the gain, or $200,000, would be taxable and thus would be ineligible for the exclusion. Two-sixths (2 out of 6 years) of the gain, or only $100,000, would be eligible for the exclusion.

Importantly, non-qualified use prior to January 1, 2009, is not considered in the allocation for the non-qualified use period, but is taken account for the ownership period.

EXAMPLE FOR ILLUSTRATION:  Suppose the taxpayer had exchanged into the property in 2007, and rented it for three years until 2010, and then converted the property into a primary residence. If the taxpayer sold the residence in 2013, after three years of primary residential use, only one year of rental, 2009, would be considered in the allocation for the non-qualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion. Why? The period before 2009 is not counted as the law was not in effect until 2009.

SPECIAL RULES FOR PRIMARY RESIDENCE CONVERTED TO RENTAL PROPERTY

In general, the allocation rules only apply to time periods prior to the conversion into a principal residence and not to all time periods after the conversion out of personal residence use. Thus, if your customer converts a primary residence to a rental and never moves back in, but otherwise meets the two-out-of-five-year test under Section 121, the taxpayer is eligible for the full exclusion when the rental is sold. This rule only applies to non-qualified use periods within the five-year look-back period of Section 121(a) after the last date the property is used as a principal residence. The rule allows the taxpayer to ignore any of the non-qualifying use that occurs after the last date the property was used as a primary residence although the 2 out of the last 5 rules must be satisfied.

EXAMPLE FOR ILLUSTRATIVE PURPOSES: Your client owns a primary residence. Your client bought it and lived in it since 2008. Your client gets a job offer from California in 2014, but the economy is still in recession and decides NOT to sell then, but to hold on until the market improves. She rents it out in 2014 and takes depreciation on the house. It is now 2015 and the client wants to list the property with you for sale. Can she take advantage of Section 121 or will she be a landlord or will she be required to allocate her gain?

Even though there have been one (1) or potentially two (2) years of non-qualifying use as a rental it won’t count against her and all amounts will be excludable except for depreciation recapture. Even though your client does not live in the house as a primary residence, the client has still used the property as a primary residence two of the last five years (as she lived there in 2012 and 2013 before renting in 2014).