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August 16, 2018
As we analyze the impact the Tax Cuts and Jobs Act (TCJA) is having on the construction and real estate industries, it's important to look at how the numerous changes may provide new tax strategies and tax-saving opportunities for your business.
Taxpayers eligible to use the cash method of accounting have been expanded to include businesses whose average annual gross receipts don't exceed $25 million.
The restriction of the cash method for eligible taxpayers who maintain inventories has also been removed and the percentage-of-completion method will no longer be required for construction contracts that are expected to be completed within two years of commencement and are performed by a taxpayer that doesn't exceed the $25 million gross receipts threshold.
The TCJA repeals the domestic production activities deduction (DPAD). Under previous law, taxpayers were entitled to a DPAD equal to 9 percent of their qualified production activities income.
In an attempt to not disadvantage pass-through entities relative to the 21 percent tax rate for C corporations, the TCJA introduced a new deduction for qualified business income of a pass-through entity in lieu of a lower nominal tax rate.
Owners of pass-through entities will be entitled to a deduction up to 20 percent of their aggregate net qualified business income from the pass-through entity. In effect, for taxpayers in the highest tax bracket receiving the full 20 percent deduction, the maximum tax rate on qualified business income of a pass-through entity will be approximately 29.6 percent. This provision won't apply to taxable years beginning after Jan. 1, 2025.
The 20 percent deduction is limited to the greater of two thresholds:
50 percent of the W-2 wages paid by the business
25 percent of the W-2 wages paid by the business plus 2.5 percent of the unadjusted basis of the business' qualified tangible property
These thresholds don't apply to individuals with taxable income less than $157,500 or married couples with income less than $315,000. If a taxpayer has a net qualified business loss for a year, it's carried forward to future tax years to reduce any future net qualified business income.
Owners of service businesses are generally precluded from taking the pass-through entity business income deduction except when the individual owner's taxable income doesn't exceed the thresholds mentioned above.
Engineering and architecture services are excluded from the definition of a service business so they can use the same benefits of the deduction as non-service businesses.
Excess business losses
The deductibility of noncorporate taxpayers' aggregate net business losses will be limited to $250,000 for a single taxpayer or $500,000 for a married taxpayer. Any business losses in excess of these thresholds will be carried forward under the net operating loss provisions. This new excess business loss limitation is applied before the existing passive activity loss rules and no longer applies after 2025.
Net operating losses
There will be no carry back period and net operating losses (NOLs) will be carried forward indefinitely.
The NOL deduction allowed in any given year will also be limited to 80 percent of a taxpayer's taxable income. Under the previous law, NOLs generally were either carried back two tax years, carried forward up to 20 tax years, or both. The 80 percent limitation doesn't apply to NOLs generated before 2018.
Meals, entertainment and travel
For amounts paid or incurred after Dec. 31, 2017, no deduction will be allowed for the following types of expenses:
Entertainment, amusement or recreation
Membership dues for clubs organized for business, pleasure, recreation or other social purpose
Facilities or portions of those facilities used in connection with any of the items above
Qualified transportation fringe benefits for employees
Taxpayers can still deduct 50 percent of business food and beverage expenses.
Research, experimental expenditures
The research and experimental tax credit is unchanged by the TCJA. However, effective for tax years beginning after Dec. 31, 2021, research and experimental expenditures — including expenditures for software development — must be amortized ratably over a five-year period.
Under previous law, these expenditures were expensed in full in the year incurred. Costs attributable to research that's conducted outside the U.S. will be amortized over a 15-year period.
There's also a new limitation on the deductibility of business interest expense.
Generally, business interest expense will only be deductible up to 30 percent of adjusted taxable income of the taxpayer, which is taxable income with several adjustments including adding back depreciation, amortization and depletion — at least for tax years beginning before Jan. 1, 2022 — and the deduction for qualified business income of a pass-through entity.
This limitation applies at the entity level and at the individual level. Any disallowed interest expense will be carried forward indefinitely.
Taxpayers with average annual gross receipts less than $25 million will be excluded from the interest expense limitation. Those engaged in any of the following real property trades or businesses can elect to not have the interest expense provision apply:
Real property development
If a taxpayer elects to not have the interest expense provision apply, they must also elect to use the Alternative Depreciation System rules on their residential rental property, nonresidential real property and qualified improvement property.
Phil Knudson and Alex Ratner are CPAs and senior managers at Moss Adams.