The Tax Cut and Jobs Act took effect on January 1, 2018. The new law retains Section 1031 for real estate exchanges. However, Section 1031 may no longer be utilized to defer taxes for transactions involving personal property. So, how will the personal property that is part of a building, and identified by a cost segregation study, be treated going forward? As of this writing, there is no clear guidance on this matter. At this point, one must assume that any such personal property identified via cost segregation study will also not qualify for deferral. However, any potential recapture can be offset by performing a cost segregation study on the replacement real property by use of accelerated first-year depreciation deductions. Accelerated first year depreciation deductions are more generous than ever, as the new law allows bonus depreciation on new AND used property. The bonus depreciation percentage is also increased to 100% through 2022. Therefore, any new or used personal property identified through a cost segregation study can be deducted 100% as depreciation expense if the property was acquired after 27 September 2017.
As tax professionals, we often find taxpayers buying or building commercial real estate to house their primary business, rather than paying rents to a third party. This is a sound financial strategy, as it allows the business owner to participate in the appreciation of the real estate, have peace of mind concerning the location of his business and control the terms of the lease. Per IRC §469(c)(2), rental real estate is an inherently passive activity. However, if a taxpayer rents property to a trade or business in which he materially participates, net rental income is recharacterized as non-passive (§469-2(f)(6)). Net rental losses from the same activity generally remain passive. This being the case, the following potential risks exist when participating in a self-rental situation:
- Net income from self-rental activities cannot be arranged so as to be offset by net losses from other passive activities
- The netting of profits and losses from self-rental activities is not permitted
- Self-rental net income is not portfolio income, i.e., no deduction of investment interest expense is allowed and is not recognized as a source of investment income
Care must be taken by the tax preparer to understand the self-rental rules and properly categorize self-rental net income as non-passive and not include it as passive income on Form 8582.
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