Key Tax Considerations for Real Estate Investors in 2023
Real estate investors should weigh important issues and changes in real estate taxation to strategically position their investments. Following, we highlight key tax considerations for real estate investors in 2023.
With a number of unusual and unpredicted trends stemming from the pandemic, the economy is emerging with a long list of uncertainties as we head into 2023. On most people’s mind is whether a recession is on the horizon after a year-long backdrop of inflation, rising interest rates, and geopolitical tensions and how it may impact the real estate market.
Among the economic impacts, real estate investors should also weigh important issues and changes in real estate taxation to strategically position their investments. Following, we highlight key tax considerations for real estate investors in 2023.
Business Interest Expense Deduction – Section 163(j)
Starting in 2022, Section 163(j) business interest deduction limits returned to the original Tax Cuts and Jobs Act (TCJA) rules, which impose a more restrictive limitation on deductions for capital intensive businesses and no longer allows the addback of depreciation, amortization, and depletion in calculating adjusted taxable income (ATI).
As rates are rising, this could have a larger impact on real estate investors and result in less deductions being available.
How It Works
Under Sec. 163(j), the amount of deductible business interest expense in a taxable year cannot exceed the sum of:
- the taxpayer’s business interest income for the year;
- 30% of the taxpayer’s ATI for the year;
- and the taxpayer’s floor plan financing interest expense for the year.
The deduction limit for business interest applies to businesses with three-year average gross receipts of $29 million or more for 2023 ($27 million or less for 2022).
Discuss with your advisor whether your business may qualify for an exemption or if you are eligible to opt out. Certain real property and agricultural businesses are allowed to make a one-time irrevocable election to opt out of the limitation, but be sure to weigh your options before making an election.
Heavily leveraged businesses may also consider relying more on equity financing and less on debt or reclassifying certain revenue as interest income to offset interest expense.
Passthrough Entity Elective Tax (PEET)
On February 9, 2022, California revised its state and local tax (SALT) cap workaround to be more appealing for qualifying owners of passthrough entities. Senate Bill 113 modified certain technical aspects of the elective passthrough entity tax in Assembly Bill 150, significantly increasing and expanding the tax benefit to more qualified taxpayers.
How It Works
The SALT cap workaround allows S corporations and partnerships to elect to pay a 9.3% Passthrough Entity Elective Tax (PEET) on taxable income at the entity level to reduce the amount of federal taxable income passed through to each of the owners. Since the entity is not subject to the Tax Cuts and Job Act’s $10,000 SALT cap, it can deduct a much higher amount than what their qualifying owners are eligible for on their personal returns.
This election does not reduce CA taxable income; however, the tax paid to California flows through to electing owners as a state tax credit on their California income tax return for their portion of the tax paid by the entity.
New for tax years beginning on or after January 1, 2022, the bill updates tax credit ordering rules to allow for the use of other state tax credits before the pass-through entity tax credit.
Additional coverage on this topic and a comprehensive webinar is available at bpw.com.
Be sure to discuss entity formation—and what type may offer certain tax advantages for real estate investors—timing of election and payments, and other considerations with your advisor to determine what strategy makes sense for you and your business.
Sunsetting Bonus Depreciation
The sun has begun to set on 100% bonus depreciation, making 2022 the last year to leverage the full deduction amount on qualifying property. For tax years beginning after January 1, 2023, bonus depreciation is set to be reduced by 20% in subsequent years, eventually phasing out completely in 2027.
How It Works
In 2023, businesses have an opportunity to deduct 80% of qualifying assets with a recovery period of 20 years or less placed in service after Jan. 1, 2023, and before Jan. 1, 2024.
Qualifying new and used property may include:
- Machinery and equipment
- New and used vehicles
- Computers and software
- Furniture and appliances
- Film, television, and live theatrical production
Businesses can also pair Section 179 deductions—currently capped at $1.16 million—with bonus depreciation on most qualifying new and used property. Section 179 deductions are gradually phased out when expenditures exceed $2.89 million.
Businesses could consider a cost segregation study to increase the value of bonus depreciation (especially while deductions are higher) and Section 179 expensing. Performed by a team of engineers, accountants, and construction professionals, a cost segregation study would be able to accurately identify, classify, and calculate all building assets that would be eligible for accelerated depreciation, therefore increasing cash flow and saving you money.
Note that California does not conform to bonus depreciation and §179 expensing is limited to $25,000. Therefore, California businesses will need to addback these special federal deductions when computing their California tax.
CA Proposition 19: Property Tax Transfers and Exemptions
We are only a couple years in with the passage of Proposition 19 and the resultant changes in the ability to transfer property without a property tax base adjustment. Since 2021, we’ve seen a flurry of estate planning activity since the new rules make inheriting family property more challenging than under previous law.
How It Works
Prop 19 makes two major changes to California’s property tax system:
- Transfer of Property Tax Base: Homeowners ages 55 years and older, disabled, or victims of a natural disaster are now allowed to transfer their tax basis of their primary home to any other residence in CA up to three times.
- Inheriting Property: A child or grandchild may now only inherit the lower property tax basis of their parents or grandparents if the property is the primary residence of the parent(s) and the recipient(s) make it their primary residence within one year. In addition, if the property is valued over $1 million more than its assessment, the property will be reassessed, but $1 million will be excluded from the reassessment.
While Prop 19 brought good news for homeowners who transfer tax assessments, inheriting property now entails new tax consequences and makes retaining inherited property more difficult.
Under previous law, parents or grandparents were able to transfer property to their heirs and retain the property’s tax basis under new ownership, but now with Prop 19, inherited primary residences will now be reassessed for its ad valorem tax basis.
A traditional will or trust will not bypass Prop 19 and prevent a reassessment; however, real estate owned by an LLC, partnership, or corporation operates under a different set of rules. In a real estate holding, a tax reassessment will only be triggered if majority interest—51% and above—is transferred. This means, if a family plans to hold property for an extended period of time, implementing a multi-layered entity strategy to avoid tax reassessment may be an ideal long-term planning opportunity. Consult with your advisor to learn more about distributing assets within legal entities to plan around property tax reassessment rules.
BPW’s advisors are well-versed in real estate taxation strategies and will help you navigate tax planning opportunities, optimize real estate succession planning, and develop a comprehensive estate planning strategy to avoid costly oversights.
Contact us with any questions at (805) 963-7811 to speak with Partner Bridget Foreman who leads the firm’s real estate practice.