Year-End Tax Planning in Construction & Real Estate
With year-end rapidly approaching, taxpayers should evaluate their current-year tax situations as well as any potential planning opportunities. While there are many existing planning strategies, the Tax Cuts and Jobs Act (TCJA) introduced several new planning opportunities that all taxpayers should consider during their year-end tax planning. Here are potential strategies to consider.
Overall Accounting Method – Cash vs. Accrual
Prior to 2018, construction companies generally didn’t qualify for the cash method of accounting unless their prior three years’ average annual gross receipts were less than $10 million. The TCJA increased this threshold to $25 million (inflation adjusted to $26 million for tax years beginning in 2019), allowing many previously ineligible contractors to qualify for the cash method of accounting. The decision to change a taxpayer’s overall accounting method can be made after year-end, but the taxpayer may consider managing its year-end payables to potentially increase the tax benefit.
Construction companies that earn revenues from contracts extending over multiple tax years are generally required to determine taxable income using the percentage-of-completion method (PCM). Under this method, income is recognized each year based on the percentage of the total estimated contract costs that have been incurred.
Taxpayers with less than $26 million in average annual gross receipts for tax years beginning in 2019 ($10 million prior to 2018) are exempt from the requirement to use PCM and may instead use the completed contract method (CCM) for contracts lasting less than two years. Under the CCM, revenue isn’t recognized until the year the contract is completed. The change to the CCM is an automatic change and is implemented on a cutoff basis, meaning the new method will apply to contracts starting during or after the year of change.
Qualified Business Income (QBI) Deduction
The QBI deduction is for individuals to claim a deduction of up to 20 percent of QBI earned from pass-through entities. This provision comes with various potential limitations and requires a complicated analysis. Taxpayers should continuously monitor their business income for QBI purposes, especially taxpayers involved in real estate.
Interest Expense Limitation Under Section 163(j)
Prior to 2018, there generally was no limitation on the interest deduction for domestic taxpayers. As a result of the TCJA, any taxpayer that had more than $25 million in average annual gross receipts ($26 million for tax years beginning in 2019) had its deduction for business interest expense limited to the sum of:
- Business interest income
- 30 percent of adjusted taxable income (ATI)
- Floor plan financing interest
The ATI calculation is currently taxable income, plus addbacks for depreciation, amortization and depletion. However, for tax years beginning after 2021, taxpayers can’t add back depreciation, amortization and depletion in their ATI calculation. This change in the calculation may result in more taxpayers’ interest expense deduction being limited starting in 2022. Therefore, taxpayers should start planning now and begin analyzing their borrowings and the potential tax ramifications.
Real estate entities can make a real property election to not be subject to the 163(j) limitation. Since this is a permanent election, the taxpayer should complete an analysis with its advisor before making this decision.
Fixed Asset Acquisitions & Cost Segregation Studies
The TCJA increases the application of 100 percent bonus depreciation to qualified used property in addition to purchases of qualified new assets. Taxpayers may consider acquiring and placing qualifying assets in service before year-end to be eligible for the bonus depreciation deduction in 2019.
Taxpayers also can use 100 percent bonus depreciation on qualifying assets purchased from another taxpayer. Therefore, any taxpayers that made an acquisition structured as an asset deal can immediately expense any of the purchase price allocated to qualifying assets.
Due to the increase of 100 percent bonus depreciation for qualified assets, taxpayers purchasing or constructing buildings should consider a cost segregation study to help take advantage of additional bonus depreciation. A cost segregation study is an engineering-based study that breaks out the components of a building to take advantage of shorter depreciable lives and first-year bonus depreciation, if applicable. If taxpayers purchased or constructed a building in 2018 and didn’t take advantage of the bonus depreciation change, taxpayers may undertake a cost segregation study on the building and file an accounting method change to implement the bonus depreciation treatment on qualifying assets, with the cumulative difference in accumulated depreciation taken as a deduction in 2019.
Qualified Opportunity Zones
There are many articles and discussions around qualified Opportunity Zones. One can defer the tax liability on a recognized capital gain by investing the gain proceeds in an Opportunity Zone Fund (OZF). If a taxpayer has significant capital gain, the taxpayer should discuss whether investing in an OZF makes sense for his or her tax situation. There are several IRS regulations around OZFs; therefore, before investing in an OZF, please reach out to your tax advisor.
Gifting & Estate Tax
The TCJA doubled the estate and gift tax exclusion from a base of $5 million to $10 million for individuals who have passed away after December 31, 2017, but before January 1, 2026. As under prior law, the exclusion is adjusted each year for inflation. The individual exclusion amount for 2019 is $11.4 million. Taxpayers should discuss with their tax advisors if using the taxpayers’ exemption makes sense for their estate planning.
While year-end tax planning has always been essential in the past, it’s now more vital than ever with the TCJA. For assistance with your year-end tax planning, reach out to your BKD trusted advisor or use the Contact Us form below.