Farhad Aghdami and I presented “Getting Your Hands Dirty with Real Estate Investors” at the 52nd annual Heckerling Institute on Estate Planning last Thursday, January 25, 2018. I caused a bit of a stir in my summary of new Internal Revenue Code Section 199A as it applies to real estate, and the accountants in the room corrected me afterwards. This was just one of many examples of how all tax professionals need to come together to understand the most expansive tax legislation we’ve had in decades.
At issue is the language in Section 199A(b)(2)(B)(ii) that gives pass-through entities that pay no W-2 wages the ability to deduct the lesser of 20% of their qualified business income or “2.5 percent of the unadjusted basis immediately after acquisition of all qualified property”. Section 199A(b)(6) defines the term “qualified property” to mean, “with respect to any qualified trade or business for a taxable year, tangible property of a character subject to the allowance for depreciation under Section 167” (emphasis added).
In our presentation, I emphasized that the 2.5% calculation only applies to tangible property depreciable under Section 167, and implied that this did not include real estate holdings. But, thankfully for our real estate investor clients, this was only approximately 20% true and 80% false.
Real estate consists of both land and improvements. Estate planners are accustomed to the word “tangible” as it applies to tangible personal property – meaning, items that can be picked up and moved around. As accountants know, however, improvements such as buildings, parking lots, docks, swimming pools and the like are also tangible, and they are subject to wear, tear and decay, which means that these improvements are depreciable under Section 167. Because land is not a wasting asset (although people living on the coastline may disagree), it is not depreciable under Code Section 167.
Treasury Regulation 1.167(a)-2 clarifies that the depreciation allowance “in the case of tangible property applies only to that part of the property which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence. The allowance does not apply to … land apart from the improvements or physical development added to it.”
The end result is good news for real estate owners, who often hire management companies to manage the real estate assets and, as a result, can pay very little in W-2 wages to employees. Consider the following example:
Bob Sponsor owns a 50% interest in a commercial real estate property through an LLC. Bob’s share of the rental income of the LLC is $2,000,000. The LLC pays no W-2 wages, rather, it pays a management fee to an S corporation that Bob controls. The management company pays W-2 wages, but it breaks even, passing out no net income to Bob. Bob’s share of the total unadjusted basis of the buildings and improvements immediately after acquisition of the commercial property is $15,000,000. Bob is entitled to a deduction of $375,000, which is the lesser of: (a) 20% of qualified business income of $2,000,000 (or, $400,000), or (b) 2.5% of the unadjusted basis of $15,000,000 (or, $375,000).
There is a rule of thumb in the real estate world that 80% of the purchase price of an improved property is attributable to the building, and only 20% to the land. Hence, the reason for the statement above that I was only 20% correct that the 2.5% calculation does not include real estate. However, this rule of thumb should not be relied upon for purposes of the 2.5% calculation or for depreciation, especially in populous areas where the value of the land may be higher than the building that sits on it.
In a 2017 Tax Court case called Nielsen v. Comm’r, T.C. Summary Opinion 2017-31, the IRS challenged a taxpayer’s allocation of the purchase price to land versus buildings, and the Tax Court sided with the IRS, finding the Los Angeles County tax assessor’s value of the land to be more reliable and persuasive than the taxpayer’s own estimate.
If the purchaser of real estate does not want to pay for the commission of a separate appraisal of the land being purchased, separate and apart from the structures on it, then the real estate owner should at least rely on the county tax assessor’s allocation, applying to the purchase price the same land-to-total-value ratio arrived at by the assessor.
The purchase price or “acquisition cost” of buildings and other improvements will be critical to the calculation of a real estate pass-through entity’s Section 199A deduction. As a result, it will be more important than ever for accountants and business owners to more accurately allocate a purchase price to land versus buildings and other improvements.