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There Is No Last Minute Real Estate Perk in Tax Reform


The idea was planted by David Sirota, a liberal writer/activist that used to work for Senator Bernie Sanders of Vermont. It’s already been taken on by more responsible tax journalists at Bloomberg, who while acknowledging that real estate owners can ...


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Opinion #BeltwayBrief Opinion #BeltwayBrief Dec 18, 2017 @ 12:43 PM There Is No Last Minute Real Estate Perk in Tax Reform Ryan Ellis , Contributor Opinions expressed by Forbes Contributors are their own. Representative Kevin Brady, a Republican from Texas and chairman of the House Ways and Means Committee, speaks during a House-Senate conference meeting on the Republican led tax reform bill at the U.SCapitol in Washington, D.C., U.S., on Wednesday, Dec13, 2017President Donald Trump promised everyday Americans a "giant tax cut for Christmas" in a speech that the White House billed as his closing argument for a tax overhaul that congressional Republicans finished negotiating on WednesdayPhotographer: Aaron PBernstein/Bloomberg In the last couple of days, a rumor has swirled around the tax world that a special eleventh hour windfall was given to real estate in the new tax reform conference reportThe idea was planted by David Sirota, a liberal writer/activist that used to work for Senator Bernie Sanders of VermontIt's already been taken on by more responsible tax journalists at Bloomberg, who while acknowledging that real estate owners can benefit also walked through the real intent of the provision--to not exclude capital intensive flow through firms from tax rate relief So what's all the hullabaloo about? Tax reform cuts the corporate income tax rate from 35 percent to 21 percentMost businesses, however, are not taxed as corporationsThey are taxed as "flow through firms" where profits are not paid by the business, but by the business owners.  In order to give these companies tax relief, too, Congress went through several iterations of cutting the tax rate substantially on business income without cutting tax rates that aggressively in general (which would be a far more expensive undertaking and swallow up the rest of tax reform) This creates an obvious gaming problem--savvy taxpayers will want to turn in their W-2s for 1099-MISCs, and--voila!--become small business owners taxed at lower effective ratesSo one of the first things each chamber did was to exclude white collar professional business services (think law, lobbying, medicine, etc.) from the lower business rates The House then created a special 25 percent top business rateHowever, if an owner actively and materially participates in her business, only three-tenths of her business profit was eligible for the rate, the other seven-tenths being taxed at ordinary ratesThis was done in order to recognize that, for active business owners, much of their business activity was in fact labor activity for themIt was also to recognize that some of their activity was a return on capital investmentIf a business owner wanted to assert a different labor vscapital ratio, they could do so and work it out with the IRS The Senate took a different approachThere, 23 percent of business profits could be deducted from taxable incomeBut there was a test involved for businesses of a mature sizeThe deduction was limited to the lesser of 23 percent of business profits, or half the W-2 payroll the business paid outThat way, the deduction was limited to businesses that had a good number of employees, a clear sign of an actual business and not a tax shelter The Conference report adopted the Senate approach, but introduced a second testBesides the "half of W-2 salary" limit on the 20 percent flow through deduction (the deduction went down along with the top marginal rate in the conference report), there was a second, alternative test one could opt forUnder this test, the deduction is limited to the lesser of 20 percent of business profit, or the sum of one-quarter W-2 wages PLUS 2.5 percent of the original basis of business assets This second test allowed flow through firms which are very capital intensive but not as labor intensive to qualify for the lower ratePicture a manufacturer with a small workforce and most of the manufacturing done by expensive robot machinesThe business might own the factory and the very expensive robots, but only have a small workforce to manage the operation day to dayThat's clearly a real business, but it would not have been eligible for the full rate relief under the original Senate version."> Representative Kevin Brady, a Republican from Texas and chairman of the House Ways and Means Committee, speaks during a House-Senate conference meeting on the Republican led tax reform bill at the U.SCapitol in Washington, D.C., U.S., on Wednesday, Dec13, 2017President Donald Trump promised everyday Americans a "giant tax cut for Christmas" in a speech that the White House billed as his closing argument for a tax overhaul that congressional Republicans finished negotiating on WednesdayPhotographer: Aaron PBernstein/Bloomberg In the last couple of days, a rumor has swirled around the tax world that a special eleventh hour windfall was given to real estate in the new tax reform conference reportThe idea was planted by David Sirota, a liberal writer/activist that used to work for Senator Bernie Sanders of VermontIt's already been taken on by more responsible tax journalists at Bloomberg, who while acknowledging that real estate owners can benefit also walked through the real intent of the provision--to not exclude capital intensive flow through firms from tax rate relief So what's all the hullabaloo about? Tax reform cuts the corporate income tax rate from 35 percent to 21 percentMost businesses, however, are not taxed as corporationsThey are taxed as "flow through firms" where profits are not paid by the business, but by the business owners.  In order to give these companies tax relief, too, Congress went through several iterations of cutting the tax rate substantially on business income without cutting tax rates that aggressively in general (which would be a far more expensive undertaking and swallow up the rest of tax reform) This creates an obvious gaming problem--savvy taxpayers will want to turn in their W-2s for 1099-MISCs, and--voila!--become small business owners taxed at lower effective ratesSo one of the first things each chamber did was to exclude white collar professional business services (think law, lobbying, medicine, etc.) from the lower business rates The House then created a special 25 percent top business rateHowever, if an owner actively and materially participates in her business, only three-tenths of her business profit was eligible for the rate, the other seven-tenths being taxed at ordinary ratesThis was done in order to recognize that, for active business owners, much of their business activity was in fact labor activity for themIt was also to recognize that some of their activity was a return on capital investmentIf a business owner wanted to assert a different labor vscapital ratio, they could do so and work it out with the IRS The Senate took a different approachThere, 23 percent of business profits could be deducted from taxable incomeBut there was a test involved for businesses of a mature sizeThe deduction was limited to the lesser of 23 percent of business profits, or half the W-2 payroll the business paid outThat way, the deduction was limited to businesses that had a good number of employees, a clear sign of an actual business and not a tax shelter The Conference report adopted the Senate approach, but introduced a second testBesides the "half of W-2 salary" limit on the 20 percent flow through deduction (the deduction went down along with the top marginal rate in the conference report), there was a second, alternative test one could opt forUnder this test, the deduction is limited to the lesser of 20 percent of business profit, or the sum of one-quarter W-2 wages PLUS 2.5 percent of the original basis of business assets This second test allowed flow through firms which are very capital intensive but not as labor intensive to qualify for the lower ratePicture a manufacturer with a small workforce and most of the manufacturing done by expensive robot machinesThe business might own the factory and the very expensive robots, but only have a small workforce to manage the operation day to dayThat's clearly a real business, but it would not have been eligible for the full rate relief under the original Senate version. 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