Originally published on Forbes.com.
The Tax Cuts and Jobs Act was generally friendly to real estate interests. There is that nice 20% 199A deduction if you have enough in the way of depreciable property and no questions asked for REIT dividends. Really exciting is the expensing provisions of Code Section 168(k) that can allow you to immediately write off a significant percentage of an acquisition, if you have a good cost segregation study.
There are a couple of flies in the ointment though. And one of them supports President Trump’s contention that some of his rich friends were mad at him over the tax bill. I stumbled on it while looking at the other fly in the ointment, which I had stumbled on while I was looking into one of the most taxpayer positive provisions. Here’s the story.
The 1031 Problem
There’s always somebody to rain on your parade. When I was looking into whether you need to make sure that you absolutely have to have your cost segregation report, which carves shorter-lived items out of the price of a building, done by someone certified by the American Society of Cost Segregation Professionals, Professor Jay Soled assumed I must be calling him about Code Section 1031.
He pointed out to me that by doing the cost segregation study, you might be disqualifying part of your building from like-kind exchange treatment. Actually he was pretty insistent on it.
Now that does not seem good, but how bad is it? Just for background I need to remind you that not everything in the Tax Cuts and Jobs Act was a tax cut. One rather nasty provision was the elimination of the deferral of gains from like-kind exchanges (Code Section 1031). An exception was made for real estate. Fellow Forbes contributor Brad Thomas credits Julio Gonzalez with keeping 1031 for real estate, by the way.
It happens that this sort of problem is pretty much in my wheelhouse, but I still thought it would be good to find somebody to reach out to, not just on this issue, but also on a couple of the fine points of cost segregation.
I spoke briefly with Charles Egerton, an Orlando based tax attorney who was Chair of the ABA Tax Section. Mr. Egerton and I have some mutual clients. I spoke at some length with Ken Weissenberg. Mr. Weissenberg is Partner-in-Charge of the Real Estate Services Group of EisnerAmper. And it was Mr. Weissenberg who pointed out to me the provision that is really troubling some of the masters of the real estate universe.
It Is Not An An Election But It Might As Well Be
The tax law gives you choices in how you account for and report a variety of things. Those choices are called elections. A very common one, that many people don’t realize is an election, is filing a joint return. Another common election is the one under Section 179 to expense depreciable personal property (Starting in late 2017, you will have to elect to not expense many types of depreciable property). Not screwing up or missing elections is a big part of tax practice. There is usually a specified time and manner of making the election and there will be rules about whether the election is revocable or irrevocable.
Using Section 179 as an example, think about you and I each owning a retail operation and buying trucks each for $60,000. You are having a great year and want to expense it, so you make the election. I am not doing so well and have charitable contribution carryovers, so I would just as soon stretch the deductions out and don’t make the election. That’s fine.
And then we come to acquiring a building. You and I each acquire $2,000.000 properties to run our business out of. In both cases the land is worth $500,000. You hire a cost segregation specialist to break out the five and fifteen year property. So maybe 30% of your $1.5 million in basis is depreciated more rapidly than the excruciatingly slow 39 year life that a building is written off over. Being penny wise and pound foolish, I begrudge the few thousand dollars to the tax savvy engineer. Does that mean that I have elected to depreciate the whole smash over 39 years?
Not in so many words, but that is effectively what Mr. Egerton and Mr. Weissenberg say is the case from a practical viewpoint. Why can’t I relying on the Cohan rule and do a kind of back of the envelope computation? If my client gets audited, let the IRS send in their own engineer. How wrong can it be?
The implication seems to be that since I didn’t hire an engineer I have all 39 year property, but that can’t be the right answer. At any rate both Mr. Egerton and Mr. Weissenberg seem to think that I am being a little silly, although they are both too polite to put it that way.
Mr. Weissenberg remarked that there would be no point in my false economy, since cost segregation studies are so inexpensive relative to the tax dollars at stake. Well according to his bio, he has been involved in over $50 billion dollars in real estate transactions in the last thirty years. I have never gone to the trouble of compiling that statistic for myself, but I’m pretty sure I would come up with a much lower number dollar wise , but just possibly maybe a similar number of deals and I have encountered frugality here and there when it comes to that sort of thing.
Still, there does seem to be a pretty strong practical consensus that cost segregation is, in effect, an election. If you just write everything but the land off over 39 years, the IRS won’t bother you, but if you do a back of the envelope sort of cost segregation, they will be all over you. I might have a brave theory about why that is wrong, but, as my father used to say “Discretion is the better part of valor”.
No Study On The Way Out
Let’s go back to our $2,000,000 properties. Five years have gone by and they are now each worth three million. My basis is going to be around $1.8 million. Your basis will be around $1.55 million. You would think I might get to mock you now when we sell our buildings. I am going to have a capital gain of $1.2 million and you will have a capital gain of $1.45 million much of which is ordinary income recapture and you will have more of a gain taxed at the 25% rate than I do.
Only that is not the way we tend to do things either in the minor leagues where I play or the big league where Mr. Weiseneberg bats. Who needs an engineer when you are selling? The strong temptation is to figure that all the five year property from, you know, five years ago now has negligible value and that the fifteen year property and even the building probably really did depreciate and almost all the appreciation is in the land. Of course the buyer might not see it that way, but the circumstances in which we have to compare notes are limited.
The 1031 Problem
It is possible that the IRS might start taking a different view on not worrying so much about people who let everything rest as 39 year property under the new ban on like-kind exchanges for anything other than real property. Suppose you swap your $3,000,000 property for another property of the same value that a cost segregation would carve out as being 20% five year property. That is $600,000 worth of property not of like-kind – maybe – and possible gain recognition to that extent. And the same problem might exist with the property surrendered.
There is another possibility which both Mr. Egerton and Mr. Weissenberg think may have some merit. Many of the items that a cost segregation specialist might carve out as five year property might, nonetheless, be considered real estate under local law (“fixtures”) and, hence, good for 1031 as both relinquished and targeted property. I think we have a cloud of uncertainty there.
Is The Uncertainty Creating Problems? And What Is The Big Concern About The Tax Bill?
Apparently from what Mr. Weissenberg told me this uncertainty is not slowing down the deal flow. Things are still OK in the heady reaches of billion dollar deals, but there is something in the tax bill that is troubling the masters of the real estate universe. This one was kind of a surprise to me. And once again I have to think about apologizing for having unkind thoughts about our President. In an interview with Kelly McEvers in November, President Trump is quoted as saying
This is going to cost me a fortune, this thing. Believe me. Believe. This is not good for me. Me, it’s not so – I have some very wealthy friends – not so happy with me. But that’s OK.
What could he possibly have been talking about? Silly me. New Section 461(l) is a limitation on the excess business losses of non corporate taxpayers.
To make up an extreme example consider Bruno Bigbuilding. Bruno supports his family with a modest $10 million salary that he takes from his development and management company. His net worth is close to a billion and it is based on real estate interests in which he is 90% leveraged. That produces a lot of depreciation, the deduction that President, then developer, Trump said he loves so much in The Art of The Deal:
I don’t have to please Wall Street, and so I appreciate depreciation. For me the relevant issue isn’t what I report on the bottom line, it’s what I get to keep.
After sheltering the income from the real estate, there will be plenty left over to shelter the $10 million salary. Not anymore.
The real estate losses will be “excess business losses” which can only shelter $500,000 in salary and other “non-business income”. It’s a real problem for people who couldn’t possibly support their lifestyle on a measly $500,000 and are now faced with the god-awful prospect of having to pay some income tax. I suggested to Mr. Weissenberg that maybe they could solve the problem by lowering the amount of leverage, but paying down debt is also not so popular in those circles.
So I can really imagine old Bruno there at Mar-a-Lago saying something like “ Donny, you’re killing all your old friends. What were you thinking when you put this thing through? My accountant is driving me crazy about it. ”
Other Coverage
Tony Nitti covered the excess business loss provision earlier this month in one of his interviews with people who are even more tax geeky than he is. Alan Kufeld et, al. have something about the effect that 461(l) will have on fund managers, another bunch of people who don’t get too much sympathy.
I haven’t been able to find anything really good on the possibly unfortunate interaction of cost segregation and like-kind exchanges, so maybe you got to read about it here first. Or maybe it will turn out to be not such a big deal.