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.
Impact of the Section 199A Regulations
As a result of the new rules, for businesses that exceed the annual threshold levels, calculation of UBIA becomes important. In the case of like-kind exchanges, a question arose as to which acquisition date is relevant for determining basis. While many clients had hoped that the IRS would allow use of the purchase price of the new real estate as the relevant cost basis in this equation, the actual proposed rules went in the opposite direction.
The proposed regulations provide guidance on how UBIA should be calculated in the case of a like-kind exchange, and follow the Section 168 regulations in providing that property acquired in a like-kind exchange is treated as MACRS property, so that the depreciation period is determined using the date the relinquished property was first placed into service unless an exception applies.
As a result, most property acquired in a like-kind exchange under the new rules will have two relevant placed in service dates. For calculating UBIA, the relevant date is the date the taxpayer places the property into service. For calculating its depreciable period, the relevant date is the date the taxpayer placed the original, relinquished property into service.
This means that for some like-kind exchange, the relevant figure for determining basis is the purchase price of the original property less any depreciation that the owner was able to take over time.
This would substantially reduce the value of the QBI deduction for business owners who make like-kind exchanges, especially where the business owner has significant property holdings, but few employees with W-2 wages, as is often the case with partnerships that are formed to hold real estate investments.
While the new regulations are not yet finalized, it is important that business clients with significant real estate holdings pay attention to the potential tax impact upon like-kind exchanges to avoid unpleasant future tax surprises if the regulations are finalized as written.
- See previous coverage of the Section 199A QBI deduction in Advisor’s Journal.
- For in-depth analysis of the like-kind exchange rules, see Advisor’s Main Library:
- Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.
Robert Bloink, Esq., LL.M., has taught at the Texas A&M University School of Law and the Thomas Jefferson School of Law; he has his own insurance practice and previously served as a senior attorney in the IRS Office of Chief Counsel for the Large and Mid-Sized Business Division.
William Byrnes, Esq., LL.M., CWM, is an executive professor and associate dean of special projects at the Texas A&M University School of Law. A pioneer of online legal education, he also is the author or co-author of 20 tax books and legal treatises.