When the Tax Cuts and Jobs Act was enacted in 2017, it was largely heralded as a good move for real estate owners and developers across New York state. However, two new provisions within the law have created unusual dynamics for this group – with one change that may not be pegged as so positive.
One of the law’s benefits for real estate owners and developers was its allowance of used property to receive a bonus depreciation deduction. The previous law only allowed bonus depreciation for original use property (meaning the property had to be new). The new law also increased the bonus depreciation percentage from 50 to 100% for qualified property acquired and placed into service after September 27, 2017, and before January 1, 2023.
On the other side of the coin, real estate owners and developers in New York felt heat from a new limit that was placed on losses from trades or businesses (such as real estate losses, including losses from pass-through entities like limited liability companies). Traditionally, active real estate professionals had no limits on real estate losses to offset other types of income, such as investment income and dividends. The new law set a limit of $250,000 ($500,000 for married taxpayers) on these losses, with losses in excess of the threshold amount carried forward to subsequent tax years. Under prior tax law, business losses not absorbed in the current year could result in a Net Operating Loss carryback and would allow the taxpayer to maximize his or her tax refund.
As proven by cases already seen in the 2019 tax season, these two changes can interact with interesting and not necessarily pleasant outcomes. Specifically, the interrelationship between the 100 percent bonus depreciation and the limitation of business losses can lead to taxable income for New York state purposes with no corresponding Federal taxable income. This is due to the fact that New York does not allow bonus depreciation and mandates modifications increasing Federal taxable income by the amount of bonus depreciation and allowing a deduction under the applicable depreciation method.
As a result, real estate owners and developers must take special steps to ensure they are limiting their tax burdens separately at the state and Federal level. Cost segregation studies have proven to be more challenging and haveresulted in a need to do a more thorough analysis with the new law’s rules in place.
A few these cases where cost segregation studies were especially useful include:
In this first instance, the taxpayer commissioned a cost segregation study that resulted in 25 percent of the cost of a newly constructed building classified as 5 year and 15 year property, which are eligible for 100 percent Federal bonus depreciation. A preliminary projection of the taxpayer’s individual tax return reflected a loss for Federal purposes, but significant NYS income because of the NYS modification for the bonus depreciation amount in arriving at NYS taxable income notwithstanding no Federal benefit was realized in the tax year. As you will see in this case, as well as the two below, the NYS add back was exacerbated by the limitation of real estate losses noted above since the NYS tax return begins with the federal adjusted gross income, which certainly was not a good result. Upon further analysis it was determined that it would be better if the taxpayer took 100 percent bonus depreciation on the 15-year property while electing out of bonus for the 5-year property. After adjustment, the taxpayer still had a projected Federal and NYS loss.
In this next case, the taxpayer had a $5 million federal loss and wanted to do a cost segregation study in 2018 on a residential property they recently developed. The taxpayer concluded that while they would realize a tax loss for 2018, they will likely have taxable income in 2019. They wanted to take advantage of the 100 percent bonus in 2018, which would likely result in a loss carryover to 2019. Once again, the bonus depreciation amount would be added back for NYS purposes resulting in NYS taxable income. After analysis it was concluded that it would be best to do the cost segregation study to maximize allocation of cost to shorter lived assets, but elect out of bonus depreciation. Incorporating the election out of the bonus resulted in no Federal or NYS taxable income – a favorable result.
Finally, a mother and daughter are 50/50 partners in a real estate development that was placed into service in 2018. Historically, the mother has reported adjusted gross income in excess of $5 million. The daughter was projected to have a $2 million loss in 2018. A cost segregation study was contemplated and projected to produce bonus depreciation of $2 million shared by the mother and daughter. While the mother would benefit greatly by the cost segregation coupled with bonus depreciation resulting in a projected tax savings of approximately $450,000, the daughter had a projected $150,000 NYS tax because of the NYS bonus depreciation modification. After a very interesting conversation with the mother and daughter, it was decided that it was still in the best interest of the family to perform the cost segregation study and take the 100 percent Federal bonus depreciation because the family would net a $300,000 reduction in federal and state tax.