By Joshua Burd
When it comes to new construction, federal tax reform has left many developers with a choice to make: maximize their business interest deductions or take advantage of accelerated depreciation.
In many cases, the two options are now mutually exclusive. Real estate businesses are automatically exempt from a new limitation on business interest deductions, provided their annual gross receipts are no more than $25 million. Those who exceed the threshold can also become exempt if they agree to a longer depreciation schedule for their properties.
The decision could largely hinge on the developer’s overall business strategy.
“That will have an impact as to what planning will take place,” said George Livanos, a partner in Sax LLP’s real estate practice. “If I’m dealing with an institutional investor who is targeting to acquire, stabilize and then exit, effectively in five years, then they’re going to look to optimize their interest deduction subject to the limitation that’s going to be out there for real estate investments.”
Other short-term owners such as funds will also look to maximize their ability to deduct business interest, Livanos said, while families and other long-term owners may be more inclined to capture the shortest depreciation schedule possible. Those decisions loom even larger in a market such as New Jersey, where the costs of land acquisition and construction are rising. That can translate into complex transactions and additional expenses such as remediation, which can generate interest that a developer might seek to deduct once the project is placed into service.
For those who opt to be exempt from the limitation on business interest deduction, the depreciation timeline is extended from 27.5 to 30 years for multifamily and from 39 to 40 years for commercial.
“So you’re not going to be giving much up on the surface by making that irrevocable election,” Livanos said, adding that a pass through entity that places the project into service this year would have to make the decision by March 2019.
Experts also note that a developer that opts out of the business interest limitation would be giving up the ability to apply so-called 100 percent bonus depreciation, which allows it to immediately write off the entire cost of certain materials and building components. In the process, expenses such as land improvements and furniture would become subject to a longer depreciation schedule.
“This means you will have to depreciate these assets over a longer period of time and will not be able to utilize the new 100 percent bonus depreciation,” Alex Narcise, partner in charge of Wiss & Co. LLP’s real estate and construction services group, wrote in a presentation on the firm’s website. “This will require a lot of planning and communication to ensure the best strategy possible.”
New benefits for pass through businesses
For real estate owners, one of the biggest benefits of the new tax law was the change to how the government taxes so-called pass through businesses. That includes partnerships, LLCs and other structures commonly used by developers and operators, which now enjoy major deductions on taxable income in addition to lower individual tax rates for their owners.
“That’s going to be extremely favorable to our industry as whole,” Livanos said. That deduction is 20 percent for joint filers making less than $315,000, while those who are over the threshold are subject to another formula. For most owners and developers, Livanos said the deduction will be calculated by taking 2.5 percent of their unadjusted basis for property that has been placed into service within the last 10 years and adding it to 25 percent of the wages they pay to employees.
The framework will be especially beneficial to owners of existing property, Livanos said, regardless of asset class.
As a result of the savings, multifamily owners could feel less pressure to raise rents, said Jeff Otteau, president of Otteau Valuation Group, noting that rental rates in New Jersey have increased around 4 percent annually in recent years. Taxes and other operating costs have risen about 2 percent annually during that time, accounting for half of the overall rent increases. Ultimately, a slowdown in rent growth can go even further to convince renters to put off buying a home.