Early reviews are mixed on how the Tax Cuts and Jobs Act (TCJA) will affect the residential and commercial construction markets.
Here is a review of how the new tax law could affect the construction industry:
Residential Commercial Construction
Growth in residential construction has been fueled, in part, by the tax breaks associated with home ownership. For decades, homeowners have relied on deductions to make the costs of acquisition and maintenance more affordable. Beginning this year, the TCJA waters down or eliminates the tax breaks for some taxpayers. Combined with other tax law provisions, this may have a dampening effect on the residential market.
These three key provisions of the TCJA are expected to strongly affect residential construction:
1. Individual tax cuts. The TCJA replaces the graduated tax rate structure with one featuring lower rates and wider bracket ranges at the upper levels. While this revised structure may lower tax liability for many taxpayers, it also reduces the benefit of offsetting deductions.
In conjunction with the tax cuts, the new law essentially doubles the standard deduction while eliminating or reducing certain itemized deductions. The net result is that a significant number of taxpayers who have itemized deductions in the past will be claiming the standard deduction instead in the future.
2. Mortgage interest. Generally, a homeowner can deduct mortgage interest paid on a loan for a qualified residence, including a principal residence and one other home such as a vacation home. Before the new law, the deduction was limited to interest paid on the first $1 million of acquisition debt such as that incurred to buy or build a home and $100,000 of home equity debt.
For loans after December 15, 2017, the TCJA reduces the acquisition debt threshold to $750,000, while the mortgage interest debt deduction is completely eliminated after 2017. Homeowners with existing acquisition debt are grandfathered. These changes could discourage home buying.
3. Property taxes. Previously, a homeowner could deduct the full amount of state and local property taxes paid during the year, in addition to state and local income taxes or sales taxes. But the new law imposes an annual limit of $10,000 on these deductions. This, too, may lead to more homeowners claiming the standard deduction rather than itemize.
This provision is especially damaging to residents of states where property taxes are high, such as California, New York and New Jersey. Because the full $10,000 deduction wasn’t available until 2018, and isn’t available at all to those who don’t itemize, this cutback is expected to result in declining home values.
There’s no denying that these changes cumulatively hurt homeowners. Current house prices reflect current tax breaks because homebuyers generally factor taxes into their decisions. The reduced tax benefits will translate into lower housing prices.
Some reports say that the new tax legislation will also hit housing through higher mortgage rates. Specifically, at the peak of the new law’s impact on housing prices in 18 to 24 months, reports estimate that national house prices will be 4% lower than they would have been without any tax legislation.
The TCJA generally is seen as an overall boon for big business with some concessions to small businesses (see box below, Tax Incentive for Small Businesses). Many provisions are designed to stimulate business growth and expansion, so the commercial construction market appears primed for an upward trend. Generally, the business tax breaks are effective in 2018, but, unlike the individual provisions, which are scheduled to sunset after 2025, these changes are permanent.
Here are three provisions likely to affect commercial construction:
1. Corporate tax cuts. The new law replaces the graduated tax structure for C corporations with a flat rate deduction of 21%. Previously, the top rate was 35%, so this change represents a significant reduction for larger companies. With corporations able to reduce the tax cost of doing business, they likely will be looking to spend more, including making building acquisitions and improvements.
2. Business expensing. Due to two related changes, business entities will be able to realize instant tax gratification for expenditures on qualified business property:
- Section 179 deduction. Effective in 2018, the maximum expensing allowance for business property is doubled from $500,000 to $1 million and the threshold for phasing out the deduction is raised from $2 million to $2.5 million. Note that the Section 179 deduction is still limited to the amount of business income.
- Bonus depreciation. The previous 50% bonus depreciation allowance is doubled to 100% for qualified property placed in service after September 27, 2017. This 100% deduction is gradually reduced to zero over five years, beginning in 2023. The definition of “qualified property” is expanded to include used property (this already was allowed for Section 179 property).
Because companies will frequently be able to write off the entire cost of equipment and machinery in one year, they may be looking to expand their physical space or find larger quarters.
3. Real estate depreciation. Under the previous law, business buildings were generally depreciated over 39 years. A 15-year cost recovery was allowed for qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. The new law consolidates certain provisions to provide the faster, 15-year write-off period and makes the changes permanent.
The commercial market is expected to benefit overall from these changes, spurring growth for construction firms. Of course, other developments and extenuating circumstances could have an impact and shift trends one way or another. We will continue to monitor the industry in the wake of this monumental new law.
Tax Incentive for Small Businesses
The new law doesn’t just benefit big business.
One key provision creates a deduction of up to 20% for pass-through entities such as S corporations, partnerships and limited liability companies, as well sole proprietors. The deduction is phased out for most service businesses and may be reduced for other entities under a complex set of rules.
With this tax break in hand, smaller businesses may jump on the building bandwagon, resulting in more revenue for construction firms.