Late last year, President Donald Trump signed into law the most far-reaching changes to the American tax system in more than 30 years. While specific elements of the legislation such as tax rate reduction and changes to the mortgage interest deduction have gotten a lot of attention, there are many aspects of the new law that will change the way builders and developers work.
In this article, I will highlight a few of the major provisions of the 470+-page Tax Cuts and Jobs Act (P.L. 115-97) and some its major implications for home builders, their investors and their customers. We’ll focus on six key areas:
- The tax rate changes
- The 20% “qualified business income deduction”
- Changes to deducting interest expense
- The like-kind exchange modification
- A new limit on the ability to use losses
- Some significant new benefits for small builders and developers
For home buyers, I'll look at two new major changes:- Changes to the mortgage interest deduction
- New limits on deducting state and local income and property taxes
The Act generally is effective for tax years beginning after December 31, 2017. Interestingly, many of the Act’s provisions sunset, or self-repeal, after a limited number of years, starting in 2022 and running through 2026.
KEY CHANGES FOR BUILDERS AND DEVELOPERS
Tax Rate Reductions. The headline provision of the Act is a reduction in tax rates, principally for corporations but also for individuals, albeit to a lesser extent. For C corporations, the federal tax rate becomes a flat 21 percent, down from the prior law’s highest marginal corporate rate of 35 percent.
C Corporations, The impact of the law change for publicly traded home builders has been two-fold. First, those public builders have started providing significantly increased earnings guidance to their investors for years beginning with the law change. For some public builders and others who use the C corporation structure, there is a potential negative financial statement impact, however. Corporations with deferred tax assets (“DTAs”) on the balance sheet need to reduce the carrying value of those DTAs to reflect the lower value of the asset caused by the reduction in the effective corporate tax rate. The lower DTA carrying value results in a reduction of corporate equity, thus reducing a company’s net book value (but typically not tangible book value), often an important financial metric in home building.
Some builders may be thinking of changing their legal entity structure from serial partnerships or S corporations to a C corporation. In evaluating that option, builders would do well to remember that, while the federal corporate income tax rate is now below the highest marginal federal rate for individuals, C corporation distributions of current or accumulated earnings and profits still incur a second level of tax as ordinary dividend income when paid to the shareholders. The following table illustrates the point:
|Corporate Taxable Income||$1,000 (A)|
|Federal Corporate Tax Rate||X .21 (B)|
|Corporate Income Tax||$210 (C)|
|After-tax Corporate Income (A-B)||$790 (D)|
|Dividend Distribution to Shareholders||$790 (D)|
|Federal Individual Tax Rate||X .37 (E)|
|Individual Income Tax (D x E) (rounded)||$292 (F)|
|After-tax Individual Income (D–F)||$498 (G)|
|Combined Tax (C+F)||$502 (H)|
|Combined Corporate and Individual Tax Rate (H÷A)||50.20%|
Individuals. The highest statutory marginal tax rate for individuals drops from 39.6 percent to 37 percent and the levels of income to which that rate applies have increased. The reduced rates for capital gains remain in place and the Act did not repeal the 3.8 percent tax rate on net investment income.
Under prior law, individual taxpayers generally were subject to the highest 39.6 percent rate at a taxable income of $250,000 or more. Married taxpayers electing to file separate returns hit the 39.6 percent rate at a taxable income level of half that amount, or $125,000.
The Act applies the lower 37 percent rate to higher taxable incomes as follows, but only through 2025:
Income Level at which 37% Rate Applies
|Married Filing Jointly and Surviving Spouses|| |
|Heads of Household and Unmarried Individuals|| |
|Married Filing Separately|| |
|Estates and Trusts|| |
“Qualified Business Income” Deduction. The Act repeals the 9 percent deduction for “qualified production activities” that was available to all taxpayers and replaces it with a 20 percent deduction for “qualified business income” for taxpayers other than C corporations. Qualified business income essentially is taxable income, excluding net capital gains. Thus, partners and S corporation shareholders (and sole proprietorships), for example, who qualify for the deduction have an effective maximum tax rate of 29.6% on qualified business income. While higher than the statutory corporate rate, the 20 percent shelter should create a powerful incentive for home builders to meet the Act’s requirements.
“Qualified business income” generally is the income from the active conduct of a trade or business, like home building or land development and includes architectural and engineering services. However, it excludes several other professional services (above an income threshold).
W-2 Wages. The Act generally imposes several requirements to qualify for the 20 percent deduction. The first significant limitation for most home builders is a “W-2 wage” rule that phases in above an income limit. The amount of the 20% deduction is limited to the greater of:
- 50 percent of the W-2 wages from the qualified trade or business, or
- 25 percent of the W-2 wages from the qualified trade or business, plus 2.5 percent of the original purchase price all “qualified property.”
In general, “W-2 wages” means wages paid to employees in that trade or business during the calendar year. And “qualified property” generally is depreciable property used in the business that hasn’t yet been fully depreciated by the end of the tax year.
For many home builders, the W-2 wage limitation may be challenging to overcome for several reasons. First, only wages paid to employees count, so salaries and compensation paid to subcontractors don’t make the cut.
Additionally – and probably more challenging – is that the wages must be paid to employees of the trade or business doing the home building. To help mitigate legal liability, many builders use a separate special purpose entity (“SPE”) for each residential community and have an internal payroll or overhead company out of which wages, salaries and benefits are paid. With some thoughtful foresight, the legal entity positioning of the project SPEs and that payroll company can be structured to satisfy the “W-2 wage” requirement. If not, the homebuilder will have the wages in the “wrong” box in his or her legal structure chart. And that means the amount of qualifying W-2 wages will be zero, so that the builder would get little or no 20% deduction.
Let’s take a simple example to illustrate how the 20% qualified business deduction works. Bob owns all the stock of Bob’s Builders Inc. (“BBI”), an S corporation. Every community BBI builds is in a separate qualified S corporation subsidiary (“QSSS”) that is disregarded for federal income tax purposes. All of Bob’s employees work for BBI. For 2018, BBI through its disregarded subsidiaries sold 50 homes with an ASP of $350,000 that generated an 8% pretax margin, so BBI has taxable income of $1,400,000. BBI has 6 full time employees and total employee payroll for the year – as shown on Forms W-2 – was $500,000. As the owner of BBI, Bob receives an annual salary of $150,000.
The deduction. The 20% qualified business income deduction is $280,000, computed as the lesser of: 20% of taxable income (20% x $1,400,000, or $280,000) or 50% of qualifying W-2 wages [50% x ($500,000 + $150,000), or $325,000).
What’s the bottom line? The 20% qualified business income deduction has the potential to significantly reduce the federal income tax liabilities for profitable builders and land developers, but the benefit likely will mean a couple of sessions with a thoughtful tax advisor for the business.
New Limits on the Ability to Deduct Interest Expense
Home building and land development are capital intensive businesses and most builders and developers make extensive use of debt financing. Under prior law, for domestic builders and land developers, the deduction for interest expense incurred in a trade or business was limited essentially only historic debt/equity principals and a very limited “earnings stripping” rule that applied to corporate borrowers, related party intercompany debt or foreign investors. Thus, leverage truly was a business decision based largely on the cost of capital and its availability.
The Act materially extends the reach of the earnings stripping rules, but provides a significant exception for “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage” (the “Qualifying Real Estate Businesses”).
General rule. Under the general rule, business interest expense is limited to 30 percent of the sum of business interest income and “adjusted taxable income.” For this purpose, adjusted taxable income generally is taxable income before the 20% qualified business income deduction, outlined above, and depreciation and amortization – at least through 2021. Essentially, the limitation is earnings before interest, taxes, depreciation and amortization, or EBITDA. For years after 2021, the limitation generally becomes earnings before interest and taxes, or EBIT.
Any disallowed interest is carried forward indefinitely and retains its character business interest expense in the next year.
Real estate exception. Under a key exception to the general rule, a Qualifying Real Estate Business can elect out of the 30% limitation. The “cost” of the election is that the taxpayer must use longer depreciable lives (under the so-called Alternative Depreciation System”) for its depreciable property. Builders and developers will need to run pro forma calculations to determine whether the trade-off is beneficial. For home builders who make extensive use of subcontract labor and developers who contract out physical land development (and don’t own substantial heavy equipment), the analysis may be simple. The calculus may be more nuanced for land developers with extensive capital investment in equipment and earth moving machinery.
Changes to the Like Kind Exchange Rules
The Act constrains the prior law’s ability to defer recognized gains by using like kind exchanges in two important aspects. The Act limits the like kind exchange deferral benefit to real property and that property must either be held for use in a trade or business or for investment. Thus, exchanges of personal property no longer qualify. More significantly, the like kind exchange rules no longer apply to real property held primarily for sale.
For privately held builders and land developers to whom capital gain characterization may be important for land held for investment, this second change should encourage builders and developers to more thoughtfully plan their long term strategic planning for their land investment.
Another Loss Limitation Rule
For noncorporate taxpayers, including partnerships and S corporations, the Act adds a new limitation on the ability to claim losses. The new limitation is on “excess business losses” and applies to annual losses from trades or businesses of more than $250,000 (or $500,000 in the case of a joint return).
The excess business loss limitation applies to all trades or businesses of the taxpayer, so that losses from one business can shelter income from another, but there is just one single annual limitation limit. Additionally, the excess loss limitation rules apply after the passive activity loss rules. In the case of a partnership or S corporation, the limitation applies at the partner or shareholder level. Any excess business loss carries forward as a net operating loss.
The rules apply for years beginning after December 31, 2017, and before January 1, 2026.
Net Operating Losses
The net operating loss (“NOL”) rules have been changed, as well. The ability to carry back NOLs has been repealed. Instead, all NOLs will carry forward for 20 years, rather than the 15-year carry forward period of prior law. And those NOLs may be used only to shelter 80 percent of taxable income.
Good News for Smaller Home Builders and Residential Land Developers
That Act provides some good news for smaller home builders and land developers. That generally includes builders and developers with average annual gross receipts over 3 years of up to $25 million, including affiliated entities.
What’s the good news? First, the smaller builder or developer is freed from accrual accounting and can use the cash receipts method of tax accounting. Second, the builder or developer is exempt from the uniform capitalization rules. Third, the new interest expense limitation rules outlined above don’t apply to smaller builders or developers. Finally, the completed contract method for home construction contracts is extended to construction contracts that expect to be completed within 2 years of the contract commencement date.
KEY CHANGES FOR HOMEOWNERS AND BUYERS
The two key changes affecting home owners and home buyers are the deductions for mortgage interest expense and state and local taxes, whether those taxes are income or property taxes.
The mortgage interest expense deduction. The limit on acquisition indebtedness for a principal residence generally is reduced from $1 million to $750,000 (or $375,000 for married filing separately). The good news is that the new but lower limit applies to acquisition indebtedness of a residence other than a principal residence. So, a married couple filing a joint return can have up to $750,000 in acquisition debt for both a principal residence and a second home. The Act repeals the prior law’s allowance for the deduction interest expense paid or incurred on a home equity line of credit.
Subject to a binding contract exception, the Act applies to acquisition indebtedness incurred after December 31, 2017. The prior law’s $1 million limitation then again applies after December 31, 2025, regardless of the year in which the debt was incurred. Interestingly, interest on up to $100,000 in HELOCs again becomes deductible after December 31, 2025.
Existing debt that is refinanced is grandfathered, so long as the refinanced amount doesn’t exceed the amount of principal refinanced.
State and local income and property taxes. The Act dramatically increases the standard deduction to $24,000. In the political battle between “red state” and “blue state,” the Act limits the deduction for real property taxes and state income taxes to a combined $10,000 (married filing jointly) for years after 2017 and before 2026.
 Calculated as (100% -- 20%) x 37% = 29.6%.
 “Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Section 199A(d)(2)(A) of the Internal Revenue Code of 1986, as amended by the Act (the “Code”).
 $157,500 for individuals or $315,000 if married filing jointly.
 $350,000 x 50 x 8% = $1,400,000.