Paying Up

 TAX REFORM 01The new federal tax law offers pluses and minuses for construction. 

By Elizabeth Boone

The changes brought about by the 2017 federal tax act are likely to be recorded on both sides of the construction industry’s ledger. On the positive side is the decrease in effective tax rates for both corporations and individual owners of partnerships and other types of so-called pass-through entities. The construction industry is sure to also welcome increased bonus depreciation and expensing as well as a higher historic rehabilitation tax credit. 

Negatives in the tax act include limits on the deductibility of business interest expense — a sore point for businesses that rely on loans to finance their projects. Construction firms operating as a sole proprietorship or a pass-through entity such as a partnership will be limited in their ability to deduct excess business losses. The reduced mortgage interest deduction could dampen profits for residential construction firms with customers located in affluent areas. 

Construction firms typically purchase machinery and equipment, which can generally be depreciated or expensed. Enhanced provisions in this area will likely help reduce tax bills for the construction industry.

Bonus Depreciation Increase

Bonus depreciation is increased from 50 percent to 100 percent under the new tax law.  Taxpayers are generally not permitted to expense the full cost of acquiring property for business use in the year they purchase it. Instead, they must take depreciation deductions allocated over the “useful life” of the property. The act permits taxpayers to immediately expense 100 percent of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The act removes the requirement for taxpayers to be the original user of the property so long as the property is not acquired from a related person or entity. This additional expensing is set to phase down 20 percent every year after 2022, and ultimately is set to expire for property placed in service after January 1, 2027. The incremental phase down is one year longer for property with longer production periods.

Expanded Expensing of Depreciable Assets

Recognizing the need for smaller businesses to immediately expense new machinery and equipment, the act permits businesses to elect to expense up to $1 million (increased from $500,000), subject to phase out if the costs exceed $2.5 million (increased from $2 million). The act also expands the definition of qualified real property to include all qualified improvement property and certain improvements – such as roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems – made to nonresidential real property.

Further, the $25,000 cost limitation for SUVs is also indexed for inflation for tax years beginning after 2018.

Historic Rehabilitation Tax Credit

The construction industry should benefit from an increased historic rehabilitation tax credit. The act provides a 20 percent credit to be claimed ratably over a five-year period beginning in the tax year when the structure is placed in service for qualified rehabilitation expenditures with respect to a historic structure. This provision replaces a one-time 10 percent credit. The act generally is effective for amounts paid or incurred after December 31, 2017, with a transition rule for specifically qualified buildings.

Some provisions will likely limit deductions for construction firms with limited capital or business losses. 

Business Interest Expense Deduction

Large construction businesses with more than $25 million of annual gross receipts will encounter rules that may modify the deductibility of interest expense, depending on how leveraged the business is. The act limits the deductibility of interest expense to the sum of business interest income and 30 percent of the business’s adjusted taxable income.

Business interest not allowed as a deduction in a tax year can be carried forward indefinitely; the act provides that adjusted taxable income is computed without regard to any deduction allowable for depreciation, amortization, or depletion, for tax years beginning before January 1, 2022.

The construction industry does have an advantage, however. The act allows real property trades or business using the alternative depreciation system to elect not to be subject to the business interest deduction limitation.

Limitation on Losses 

For tax years beginning in 2017, the act disallows an excess business loss of a taxpayer other than a C corporation. An excess business loss is treated as part of the taxpayer’s net operating loss carryover to the following year, and may be carried forward indefinitely. An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount ($500,000 for married taxpayers filing jointly; $250,000 for all other taxpayers (indexed for inflation)). The limitation applies at the partner or S corporation shareholder level. The limitation expires after December 31, 2025. 

At least one tax act provision may have an indirect effect on the construction industry. 

Mortgage Interest Deduction

Residential construction companies could be negatively impacted by a reduced mortgage interest deduction for their customers. The act reduces the mortgage interest deduction to interest on $750,000 of acquisition indebtedness interest for debt incurred after December 15, 2017. The $1 million limitation remains for older debt.

The deduction is not limited to interest on a taxpayer’s principal residence, as originally proposed, which provides some relief for builders in vacation areas. For tax years beginning after December 31, 2025, the limitation reverts to $1 million regardless of when the debt was incurred.

Unfortunately for contractors, the act suspends the mortgage interest deduction for interest on home equity indebtedness for tax years beginning after December 31, 2017, and before January 1, 2026, and could slow home improvement projects. 

Whether the 2017 tax act will be good or bad for the construction industry depends on a variety of factors. A lower tax rate and enhanced deductions for businesses that buy machinery or equipment will likely help to reduce tax bills for much of the construction industry. But new limits on deductions for interest and business losses could pose difficulties for businesses running short on capital. Similarly, the curtailed mortgage interest deduction might add to residential construction industry woes if the economy cools down.     

Elizabeth Boone is the tax law editor for Bloomberg Tax. She can be reached at eboone@bloombergtax.com.

 

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