Tax Reform: 10 Crucial Things to Know for New Yorkers

Taxation

Late last year, I published a client newsletter speculating about how final tax reform legislation would look and some of the steps you should take in anticipation of the President signing a bill into law.  Now that the Tax Cuts and Jobs Act of 2017 has officially passed, the time has come to break down what the new laws actually say and how they might affect you as a New York taxpayer.  While we’re still waiting on the IRS to write regulations and issue other necessary guidance to tell us how the agency will interpret the new laws, those developments won’t change how the law works at a fundamental level.  In our estimation, here are the ten aspects of the new tax law you most need to know:

  1. Everybody’s Rate Has Been Cut. Marginal income tax rates for individuals went down across the board.  While most brackets saw a 2-4% rate cut, a married couple filing jointly will see a whopping 9% cut for all income between $237,950 and $315,000 – a nearly $7,000 windfall.
  2. Changes to Deductions. The federal government doubled the standard deduction from about $6,000 per person to $12,000 per person ($18,000 head of household).  With a $24,000 standard deduction for a married couple, most taxpayers will not itemize anymore, moving America closer to the GOP’s stated goal of “filing on a form the size of a postcard.”  Those taxpayers itemizing will see the loss of almost every traditional deduction except medical expenses, and student loan interest up to $2,500.  This includes the repeal of the deduction for union dues and tax preparation fees.
  3. SALT in the Wound. The major drawback for New York taxpayers is the limitation on the deduction for state and local income, property, and sales taxes to $10,000 per filer.  This means both a married couple and a single filer may only deduct up to $10,000 annually for those expenses.  For most affected taxpayers, the limitation on this deduction will eat into most or all of the benefit from reduced marginal rates.  Without question, it’s a tough pill to swallow for New Yorkers and their brethren in high-tax jurisdictions.
    Governor Cuomo signed two potential workarounds into law.  First, New York will allow individuals to make a “charitable” contribution to a state fund in lieu of paying taxes.  The problem with this idea is its dependence on IRS guidance that can (and likely will) be easily reversed.  Second, employers may increase payroll taxes (deductible to the employer) to decrease individuals’ state-level income taxes (not deductible to the individual).  This approach may be sound depending on employers’ willingness to go through the trouble of adopting it, but it’s no help for business owners or others who do not receive W-2 wages.
  4. Real Estate Changes Hurt, Too. The mortgage interest deduction is now limited to the first $750,000 of principal, reduced from $1,000,000 previously.  Whereas interest on a home equity loan was deductible up to the first $100,000 of principal, home equity loan interest is not deductible at all under the new law.  The IRS has stated they will take the position any loan taken out to repair, improve, or expand an existing home will still get an interest deduction – but the $750,000 total principal limit will still apply.  So if you borrowed $800,000 to buy your home and borrowed another $250,000 to improve the home, only the interest on the first $750,000 of principal will be deductible.
    For New York homeowners, this outcome is awful.  Anyone trying to sell a home with a purchase price of about $1 million or more will see a decrease in the number of buyers willing to shoulder a mortgage in excess of $750,000.  For homeowners with existing mortgage balances of $750,000 or higher, any further loans to improve the home will not have deductible interest.  In a place like Long Island, owning a home may actually be less financially fruitful than renting – a real shocker when you consider the region’s history.
  5. Businesses Get a Big Tax Cut. Big business won out most on this one; C-Corps now pay a 21% flat rate, down from a 35% top rate under the old regime.  For all sole proprietorships and pass-through entities (i.e., all business that are not C-Corps), a 20% deduction applies for all income derived from business activities, but complicated rules apply.  The most impactful rule: “service businesses,” defined rather vaguely in the statute, are not eligible when taxpayers breach a certain income tax bracket.  Watch out for regulations and other IRS guidance to clarify this in the coming months.
  6. But Businesses Lose a Treasured Deduction. Congress repealed the 50% deduction for entertainment, long used to pay for golf outings, tickets to the ballgame, and a host of other activities.  A debate among practitioners rages on about how this change impacts business meals, but by our reading, business meals appear to remain deductible.
  7. Bonus Depreciation Gets a Big Boost. The new law provides that certain business property will be eligible for 100% bonus depreciation (i.e., an immediate write-off) until 2023.  This property includes most business equipment, computers and other IT hardware and software, furniture, certain vehicles, and real estate fixtures.  Consult your accountant to figure out how you might take the most advantage of this change.
  8. 1031 Exchanges Survive. Though Congress narrowed Section 1031 to apply only to real estate, that was by far the most popular use anyhow.  Section 1031 exchanges for vehicles, intellectual property, artwork, and other non-real estate property no longer exist.
  9. The Estate, Gift, and GST Exemptions Have Doubled. Whereas the exemptions were previously about $5.5 million per person, they’ve now doubled to about $11 million per person.  However, keep in mind New York State assesses its own estate tax, and the exemptions remain $5.5 million per person.  Note as well that New York’s exemption is not “portable” between spouses, so planning will be necessary if your net worth exceeds about $5 million.
  10. It’s the “Fiscal Cliff” All Over Again. To meet the requirements of the so-called “Byrd Rule,” Congress stipulated that all individual tax changes (basically, everything except the C-Corp rate cut) will “sunset” on December 31, 2025 and revert back to the old law.  Congress’s decision to extend these changes will probably wait until the last minute again.  But you didn’t think this version of the tax law would be “permanent,” did you?

The foregoing is not meant as tax or legal advice.  Kindly consult us and/or your accountant for individualized advice.  Subsequent actions by Congress and/or the IRS may change the nature or accuracy of this information.  Contact us at any time if you have any questions or you’d like to discuss any of this material further.

Posted by Matthew Rappaport

Section 1031 Exchanges: A Primer

Taxation

Section 1031 of the tax code allows taxpayers who hold property for either investment or productive use in a trade or business to swap such property for other property of “like kind” without incurring any federal income tax, which would normally be due without this special rule. Most real estate investors are familiar with the concept of a like-kind exchange, and many investors use like-kind exchanges to their advantage. Even so, like-kind exchanges can take on many forms and can even be used for non-real estate assets. You should be familiar with the way like-kind exchanges work to better identify opportunities to seize the benefits. Below, I provide some frequently asked questions about like-kind exchanges and my answers to those questions.

  1. How does a like-kind exchange usually work? The taxpayer will engage a qualified intermediary (QI), who serves as facilitator of the exchange and escrow agent for the money involved. The taxpayer will negotiate a sale of qualifying property, then assign the rights to the contract of sale to the QI at closing. The QI will hold the sale proceeds in an escrow account. Within 45 days of closing the sale of the “relinquished property,” the taxpayer must identify candidate replacement properties. Within 180 days of closing the sale of the relinquished property (135 days after the identification deadline), the taxpayer must close on any combination of the identified candidate properties. It is important to know that the taxes due on the sale of the relinquished property are deferred, not avoided entirely; when the replacement property is sold, all of the deferred income tax will eventually be due.
  2. What types of assets can I use in a like-kind exchange? Any asset held for either investment or productive use in a trade or business can qualify for a like-kind exchange, except inventory, securities, notes payable or receivable, or ownership interests in a business. Most people think of real estate as the only asset to use in a like-kind exchange, but other eligible assets include medical and dental equipment, construction equipment, business vehicles, intellectual property, computers, hard drives, servers, and office furniture. When it comes to real estate, keep in mind that primary personal residences and property developed for sale (such as “flips”) are not eligible. Vacation homes, sponsor units in co-op and condo communities, and dual-use property usually require planning to qualify. The same goes for artwork and other collectibles, such as classic cars.
  3. What property qualifies as “like-kind?” In the real estate world, “like-kind” is defined quite liberally to include almost any type of asset considered real property. Raw land can be exchanged for a brick-and-mortar office building and vice versa. Residential real estate can be exchanged for industrial real estate. Even air rights can be exchanged for any other type of real property, so long as the property is held for investment or productive use in a trade or business. For non-real estate assets, “like-kind” is usually defined narrowly. For instance, a truck should only be exchanged for a truck, and an MRI machine should only be exchanged for an MRI machine.
  4. Do I have to reinvest all of my sale proceeds in like-kind property? No. Any money not reinvested in like-kind property will simply be taxed as normal. For instance, if the relinquished property is sold for $3 million and the taxpayer reinvests $2 million in like-kind property, the remaining $1 million will be taxed, most likely as a long-term capital gain.
  5. How can an exchange fail, and what happens if an exchange fails? Exchanges can fail in many ways, such as:
    • Failing to meet the 45-day identification deadline or the 180-day closing deadline — these deadlines are absolute, so no extensions are available. If the taxpayer fails to identify and/or fails to close on time, the taxes from the sale of the relinquished property are due, regardless of whether the taxpayer actually closed a purchase of replacement property.
    • Defective identification — the taxpayer identifies the replacement property incorrectly. Taxes are due, regardless of whether the taxpayer successfully closes a purchase.
    • Closing on unidentified property — regardless of whether unidentified property would otherwise be considered like-kind, taxes are still due.
    • Prohibited use of escrow funds — while the relinquished property sale proceeds are in escrow with the QI, the taxpayer cannot access them, borrow or pledge against them, or otherwise have beneficial use of them.
    • Prohibited use of replacement property – if the replacement property does not meet the requirement of investment or business use, taxes are still due. For instance, a taxpayer cannot use a replacement property as a personal residence immediately after the conclusion of the exchange.
  6. When it comes to real estate, what possibilities exist that might help me if I have the right legal assistance?
    • One property may be exchanged into multiple properties, and multiple properties may be exchanged into one.
    • Even though partnership or LLC interests are not eligible for exchange, multiple partners can make different exchanges of ownership interests in the same property.
    • Exchange funds may be used to develop or construct real property.
    • Taxpayers may exchange into joint ventures, syndicated deals, and other investments with complicated structuring.
  7. Besides the format you described in Question 1, what other methods exist to complete a like-kind exchange? The most important alternative method to know is the “parking” or “reverse” exchange, in which a taxpayer may buy a property first and sell a property second. This format requires the assistance of tax counsel to execute properly, because a taxpayer may not buy property in his or her own name.

What we hope you take away from this primer is that you can use Section 1031 advantages in more ways than you might think to achieve optimal tax outcomes. Not only can we assist in the real estate transactions involved in an exchange, we can also help you structure the exchange to comply with the tax laws.

Posted by Matthew Rappaport