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Pass-through entities and the new tax law

Commercial real estate (CRE) investors were initially concerned about how the consolidated bill will tax “pass-through” entities like partnerships, sole proprietorship, S companies and limited liability companies.

However; the legislation was perceived to be a victory for the CRE industry. The

Senate and House versions of the tax reform bill retain Section 1031 like-kind exchanges and interest deductibility.

However; 1031 exchanges for property types that are not real property will no longer be permitted starting 2018. This covers 1031 exchanges of collectibles, personal property, franchise rights, rental cars, heavy equipment, machinery, trade materials, etc.

Under the new tax law, owners, shareholders, and partners in pass-through entities can get a 20% deduction on business income. However;  not everyone will qualify and those who do might find that the deductions will apply only to a smaller percentage of their income.

Moreover, only pass-through entities that operate in the United States and provide goods and services on American soil will qualify, since the law was initially designed to benefit businesses that perform work and have employees in the country.

Even businesses with production facilities in a different country, but sell products and services in the U.S., will benefit from the deduction, which might apply to a portion of income generated from their sales in the U.S.

However; it’s also worth noting that the new law prohibits businesses in certain sectors from taking a deduction. These sectors include law, accounting, financial and brokerage services, consulting, health, athletics, actuarial sciences and the performing arts.

How it works

The majority of small businesses are pass-through entities. That means that instead of having the business pay tax on its own income, all profits or losses are passed to the owner, who may report it as their personal income. Some of these business owners are investors who can see tax cuts in one of two ways.

Firstly, many business owners will pay a markedly lower rate on taxable income. House Republicans, for their part, initially planned to make income tax “flatter” by narrowing seven tax brackets down to just three. However; the new law retains all seven brackets but with lower rates which in some cases may reach up to include higher incomes.

It’s also worth noting that those with a taxable income that falls between $200,000 and roughly $425,000 — a group that likely includes business owners — will actually experience a minimal rate hike, with taxation jumping from 33 percent up to 35 percent. Likewise, married couples who will jointly file taxable income ranging from $400,000 to $417,000 can also expect a rate hike.

But these individuals don’t need get all worked up about the higher rate, because a bigger windfall is possible through the deduction of pass-through income.

Owners of the previously mentioned pass-through entities will be able to remove 20% off their earnings before they pay taxes on it. This deduction follows the Senate’s proposal, which formerly placed deductions at 17%. This provision passed the chamber as a 23% deduction.

As for CRE owners, the new law allows them to factor qualified property – a property that the business bought and is in use, whether it’s a commercial building or a desk in an office building – into deductions as long as it can depreciate for 10 years at a minimum.