Real Estate Related Provisions of the Tax Reform Act
On December 22, 2017, President Trump signed into law tax reform legislation (the “Act”) formerly known as the Tax Cuts and Jobs Act. The Act provides the real estate industry, including REITs, with some significant benefits. The key provisions of the Act impacting real estate include the following:
Treatment of Pass-through Income. The Act creates a new 20% deduction for certain amounts earned through pass-through entities. The deduction is the lesser of (a) 20% of the taxpayer’s qualified business income from the qualified trade or business or (b) the greater of (i) 50% of the W-2 wages relating to that qualified trade or business or (ii) the sum of (x) 25% of the W-2 wages relating to that qualified trade or business and (y) 2.5% of the unadjusted basis immediately after acquisition of all qualified property. “Qualified property” is defined as depreciable property (a) held by and available for use in the trade or business at the close of the tax year, (b) used for the production of qualified business income during the tax year, and (c) with a recovery period that has not ended before the close of the tax year.
By including unadjusted tax basis in determining the cap on the pass-through income deduction, the Act is significantly more favorable to capital intensive operations that have few employees such as real estate partnerships.
This pass-through income deduction also applies to ordinary REIT dividends and distributions by publicly traded partnerships. REIT capital gains dividends will continue to be taxable at a lower capital gains rate. This 20% deduction is available for tax years beginning after December 31, 2017, but will expire in 2025.
The 20% deduction does not apply to certain service businesses including services in the fields of healthcare; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees; and any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests or commodities. Although engineering and architectural services had been included as exceptions in prior versions of the bill, these activities were removed from the conference report.
However, there is significant uncertainty as to the scope of businesses that rely on the reputation of an employee (including, perhaps, engineering and architecture businesses). Moreover, the scope of investment management, which does not qualify, and asset management, which may qualify, remain unclear.
Corporate Tax Rate. The Act lowers the tax rate for corporations to 21%. This reduction will apply for taxable REIT subsidiaries and to REITs to the extent that a REIT is subject to tax.
Proposed and Adopted Changes for Recovery Periods Under MACRS and ADS. The Senate proposed that the recovery period for both residential rental property and non-residential real property be reduced to 25 years under MACRS. This provision was not adopted in the Act. The recovery period for rental real property remains at 27.5 years under MACRS and the recovery period for non-residential real property remains at 39 years under MACRS.
The Act does, however, shorten the ADS recovery period for residential real property from 40 years to 30 years.
Interest Expense Limitation; Real Property Trade or Business Election Out. The Act limits the deduction for net interest expense for tax years beginning after 2017 and before 2022 to 30% of an amount that generally reflects EBITDA. Beginning in 2022, the deduction for net interest expense is limited to 30% of EBIT resulting in a potentially significant reduction in the limit. As this limitation is based on net interest expense, many mortgage REITs will not be impacted by this change.
Real property trades or businesses, including most REITs, can elect out of the interest expense limitation. However, an electing-out business is required to use the alternative depreciation system to depreciate residential rental property, non-residential real property, and “qualified improvement property” (which is discussed in “Bonus Depreciation for Equipment” below), and such business may be required to change its depreciation method for existing properties. That would require that residential rental property be depreciated over 30 years (as opposed to 27.5 years under MACRS) and non-residential real property would be required to be depreciated over 40 years (as opposed to 39 years under MACRS). Therefore, real property trades or businesses will need to determine whether a slightly longer depreciation period is worth avoiding the interest expense limitation.
In addition, an electing-out business cannot expense qualified improvement property which includes any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building was first placed in service except for any improvement for which the expenditure is attributable to (a) enlargement of the building, (b) any elevator or escalator, or (c) the internal structural framework of the building.
Elimination of Itemized Deductions. Under pre-Act law, certain itemized deductions, including investment expenses, were allowed to the extent that they exceeded 2% of the taxpayer’s adjusted gross income. Investment expenses were also limited to offsetting investment income. The Act generally eliminates the ability to deduct itemized deductions subject to the 2% floor. The Act eliminates the investment expense deduction, so such deduction will no longer be available, even to the extent that the taxpayer has investment income. The elimination of the investment expense deduction may also impact the computation of net investment income for purposes of the net investment income tax.
Active Loss Limitations. The Act prohibits individuals from deducting losses incurred in an active trade or business from other sources of income, including passive and portfolio income and perhaps wage income, in excess of certain limits ($500,000 for married individuals filing jointly or $250,000 for other individuals). Any disallowed losses can be carried forward as a net operating loss and are available in subsequent years to offset up to 80% of any income earned by the taxpayer. This limitation can create a deduction timing impact to individual owners of a new business with significant up-front expenses.
Bonus Depreciation for Equipment. The Act provides for 100% bonus depreciation of certain tangible personal property and equipment that is placed in service by 2022. A reduced percentage applies for the five years thereafter.
Qualified leasehold improvements (as well as qualified restaurant property and qualified retail improvement property) will also be eligible for 100% bonus depreciation as part of a new category of property known as “qualified improvement property,” except in connection with a real property trade or business that elects out of the interest expense limitation rule discussed above. Qualified improvement property will otherwise have a 15-year recovery period under MACRS and 20 years under the alternative depreciation system.
Like-Kind Exchanges. Tax-free like-kind exchanges for real property are still possible under the Act, but like-kind exchanges will no longer be available for personal property.
International Provisions. The Act moves the United States from a worldwide tax system towards a territorial tax system. As a result, accumulated overseas earnings and profits are deemed repatriated to the U.S. starting in 2017.
For REITs, any income deemed repatriated is excluded from the REIT gross income tests. However, income that is deemed repatriated will need to be taken into account for REIT distribution requirements. REITs will have the option to make an irrevocable election to defer the inclusion of repatriated income over an eight-year period.
FIRPTA. The Act generally retains FIRPTA in its pre-Act form, but FIRPTA withholding on REIT capital gains dividends is reduced from 35% to the highest applicable corporate tax rate (21% in 2018) starting in 2018.
Alternative Minimum Tax. The Act repealed the alternative minimum tax on corporations.
Tax-Exempt Investors. The House proposal had included a provision that would have subjected state pension plans to tax on their unrelated trade or business income. However, the Act does not include a similar provision, so state pension plans will still not be subject to tax on their UBTI.
Sale of Partnership Interest By Foreign Partner. The Act provides that the sale of an interest in a partnership by a foreign individual or corporation is treated as effectively connected income to the extent that a hypothetical sale of a partnership’s assets would give rise to effectively connected income. The provision overrides the recent tax court decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner. Therefore, partnerships must identify which assets give rise to effectively connected income to the extent that the partnership has a non-U.S. partner that is an individual or corporation.
The Act also requires that the purchaser of a partnership interest from a foreign person withhold 10% of the purchase price and pay that amount to the IRS. This regime is similar to the FIRPTA regime in that a certificate of non-foreign status would relieve the purchaser of their withholding obligation. The Treasury recently announced that this withholding obligation has been delayed for the time being.
Carried Interest. Long-term capital gain treatment with respect to carried interest will be available only if the underlying asset has been held by the issuer of the carried interest for at least three years. If the underlying asset is held for less than three years, the income will be short-term capital gain. This provision applies to carried interest payable after December 31, 2017. As a result, the three-year holding period applies to assets purchased prior to 2018 even if such assets had met the prior one-year holding period test on the effective date.
In general, the foregoing provisions provide the real estate industry with some favorable tax planning opportunities. If you have any questions or concerns on how the above will impact your business, please do not hesitate to contact us.