Many high net worth clients with substantial real estate holdings were relieved to learn that the 2017 tax reform legislation did not eliminate the valuable like-kind exchange rules as they apply to real estate investments.
While this continues to be the case, new complexities added by the Section 199A deduction for the qualified business income (QBI) of certain pass-through businesses could diminish the value and attractiveness of like-kind exchanges under the new tax code.
The IRS has proposed regulations to interpret and govern the Section 199A deduction, and those regulations contain a hidden penalty that may provide an unwelcome tax surprise for certain clients engaging in like-kind exchanges of real estate if those rules are finalized in their current form.
Because of this, clients should remember to include any potential or pending real estate transactions in their year-end tax checkups this year because the 2017 tax reform package may have changed their value from a tax standpoint.
Post-Reform Like-Kind Exchange Rules
As noted, the 2017 tax reform legislation kept the like-kind exchange rules intact as they apply to exchanges of real property, although tax-deferred like-kind exchanges of non-real property assets are no longer permitted.
This means that owners of real estate remain entitled to defer the associated capital gains tax on the gain from a real estate sale if they purchase new real estate with the profits from the sale of the old piece of property.
The Section 199A rules are also now relevant to many like-kind exchanges because many clients who own real estate investments often transfer those holdings into a partnership, and in exchange own a piece of that partnership.
Under the 2017 tax reform legislation, new Section 199A allows certain pass-through entities (such as partnerships, S corporations and sole proprietorships) to deduct 20 percent of QBI (in 2018-2025, unless Congress takes steps to extend the deduction).
While this new QBI deduction may, at first glance, appear to be completely unrelated to the like-kind exchange rules, one piece of the puzzle in determining the value of the new QBI deduction links the two provisions for many clients with substantial real estate investments.
If the taxable income of the entity that holds the real estate investment exceeds the annual threshold levels, the value of the QBI deduction is limited to the greater of: (x) 50 percent of W-2 wage income or (y) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis immediately after acquisition (known as “UBIA”) of all qualified property.