On December 22, 2017, President Trump signed into law tax reform legislation known as the Tax Cuts and Jobs Act (the “Act”). The Act provides the real estate industry 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 from pass-through entities, commonly referred to as Qualified Business Income (“QBI”). The Act is significantly more favorable to real estate partnerships that have capital intensive operations. In general, for a capital intensive real estate operation, this new deduction normally should equal 25% of wages paid, plus 2.5% of cost of capital assets owned. In addition, the Act imposes an overall limitation equal to 20% of QBI.
Example – A business purchases an office building for $10 million ($7 million attributable to the structure, $3 million attributable to the land). The building generates annual rental income of $500,000 — an approximate 5% return on assets. The maximum allowable pass-through deduction would be $100,000 (20% of $500K). Even if the business paid no wages, the business would qualify for the full deduction because 2.5% of $7 million is $175,000.
QBI for a rental real estate operation generally is equal to taxable income, reduced by certain investment income such as short and long-term capital gains, dividends, interest. The 20% deduction is applied at the investor level, and if QBI is a loss it is carried forward to the succeeding year. Thus, any entity level taxes, nonresident withholding, or composite state taxes generally are not affected. This 20% deduction is available for tax years beginning after December 31, 2017, but will expire in 2025.
Technically speaking, the QBI deduction is equal to the lesser of (a) 20% of the taxpayer’s QBI 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.
Thus, if all of the income from a business qualified for the deduction, a taxpayer in the top 37% tax bracket would pay an effective rate of 29.6% on that income. A taxpayer in the 35% bracket would pay an effective rate of 28%, etc. Example – a high-income taxpayer with $100 of qualifying income would get a deduction of $20. The remaining $80 of income (after the deduction) would be taxed at 37%. The taxpayer would owe $29.60. Thus, the taxpayer would have an effective tax rate of 29.6%.
Notably, the QBI deduction does not distinguish between active or passive owners, although passive investors remain subject to the 3.8% ACA tax with a total tax rate of 33.4% (29.6% + 3.8%). All in, this 33.4% top tax rate represents a full 10 percentage point reduction.
This 20% deduction does not apply to certain service businesses 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.
For businesses providing services to the real estate industry, there is uncertainty as to the scope surrounding the reputation of employees (including, perhaps, engineering and architecture businesses). Moreover, the scope of investment management, which does not qualify, and asset management, which may qualify, remain unclear. In addition, it is also unclear whether there will be grouping rules similar to IRC §469 or §446.
Carried Interest. Generally, a service provider can receive a profits interest tax-free in exchange for services. The economic benefit of the profits interests often comes in the form of capital gain allocations from the partnership recognized on the sale of the underlying partnership property.
Real estate developers often receive carried interests in exchange for managing a real estate project or fund. A carried interest is an ownership interest in a partnership entitling the holder to receive future profits and appreciation of the partnership, but not the right to receive money or other property if the partnership were liquidated immediately after grant. Typically, a carried interest allows the manager/developer to share in a pro rata amount of income from operations, then share in a portion of the proceeds from the disposition of the underlying property after the other partners have received a return of their capital contributions.
Going forward, long-term capital gain treatment with respect to a 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 (taxed at the highest marginal rate). 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 of the Act.
Thus, the Act changes the holding period required to receive long-term capital gain treatment with respect to a carried interest from one year to three years. Specifically, in order to receive long-term capital gain treatment any gain allocable to the carried interest must be attributable to assets held for more than three years.
This new provision covers partnership interests when the partnership conducts its business activities on a regular, continuous and substantial basis, and those activities consist of: raising or returning capital, and either developing, or investing in or disposing of (or identifying for investing or disposition) “specified assets,” a term which includes securities, commodities, real estate held for rental or investment, or cash or cash equivalents. An exception is provided for a capital interest which provides the taxpayer the right to share in the partnership’s capital that is commensurate with the amount of capital contributed by the partner or with the amount taxed to the partner under §83. It is uncertain whether the holding period applies only to the partnership interest, to assets of the partnership generating capital gain, or to both.
Like-Kind Exchanges. Tax-free like-kind exchanges for real property not held as inventory is still possible under the Act, but like-kind exchanges will no longer be available for personal or intangible property. However, the acquisition of the personal property may qualify for full expensing or accelerated depreciation (see below), which could offset the gain from the sale of the personal property.
Bonus Depreciation for Equipment. The Act provides for 100% bonus depreciation of certain tangible personal property and equipment that is placed in service after September 27, 2017 and before January 1, 2023. Bonus depreciation will be phased out evenly over five years starting January 1, 2023, resulting in a 20% reduction in the amount that can be expensed each year. In addition, the former “original use” requirement has been removed. Thus, both new and used personal property and equipment is now eligible for bonus depreciation in the year acquired. Lastly, qualified leasehold improvements (as well as qualified restaurant property and qualified retail improvement property) is now eligible for 100% bonus depreciation.
Other Changes Involving Tax Depreciation. The recovery period for rental real property remains at 27.5 years and the recovery period for non-residential real property remains at 39 years under MACRS.
However, there is a trade-off that may apply if the election to deduct all business interest expense is made (see below). If applicable, this election requires the entity to use the alternative depreciation system (ADS) on all non-residential real property, residential real property and qualified improvement property. 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). Furthermore, an electing-out business cannot expense qualified improvement property (described above).
Under old law, businesses could deduct up to $500,000 of qualifying property under §179. The Act increases this deduction to $1.0 million. The Act also expands the property eligible for expensing to include all improvements to the interior of non-residential real property such as roofs, heating, ventilation, air-conditioning, fire protection, and alarm/security systems.
Interest Expense Limitation; Election Out. Under the Act, the deduction for business interest is now limited to a percentage of the company’s earnings before interest, tax, depreciation and amortization (“EBITDA”). Prior law allowed for full deductibility. For tax years beginning after 2017 and before 2022, the interest deduction is limited to 30% of EBITDA. After 2021, the limitation expands to 30% of the taxpayer’s earnings before interest and tax (“EBIT”).
However, a small business exception to this limitation applies when the taxpayer’s average annual gross receipts for the current and two prior taxable years is less than $25 million. The interest expense deduction limitation is calculated at the entity level and applied at the partner level. Further consideration should be given to the fact that gross receipts of certain related taxpayers will be combined for purposes of this $25 million threshold.
Real estate companies can elect out of the interest limitation rules so long as the interest is incurred in real property development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing or brokerage trades or businesses. Interestingly, this election out is also available to entities operating or managing lodging facilities (e.g., hotels, motels and similar properties where more than one-half of the units are used on a transient basis). Once elected, such election is irrevocable. Furthermore, any disallowed interest carries forward indefinitely.
The IRS plans to issue guidance on the process of electing out of the interest limitation. The trade-off is whether a slightly longer depreciation period is worth avoiding the interest expense limitation. See our discussion above for the impact that this election may have on depreciation.
Technical Terminations of Partnerships. The rule providing that a technical termination of a partnership occurs whenever 50% or more of the interests in both profits and capital are transferred during any 12 month period is repealed. With the elimination of technical terminations, partnerships and LLCs whose agreements prohibit transfers that could result in a technical termination likely should review whether prohibiting such transfers still makes business sense.
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.
Alternative Minimum Tax. The Act repealed the Alternative Minimum Tax (AMT) on corporations. Unfortunately for individuals, including those owners and investors in real estate companies structured as S corporations, partnerships, or LLC’s, the AMT calculation remains, but with an increased exemption amount of $109,400 for married couples filing jointly. The exemption phases out when an individual taxpayer’s alternative minimum tax income exceeds $1 million for married couples filing jointly. Trusts and estates are also subject to the AMT.
Impact on Your Estate Plan. For the estates of persons dying, and gifts made, after December 31, 2017, and before January 1, 2026, the gift and estate tax exemption and the GST tax exemption amounts increase to an inflation-adjusted $10 million, or $20 million for married couples with proper planning (expected to be $11.2 million and $22.4 million, respectively, for 2018). Absent further congressional action, the exemptions will revert to their 2017 levels (adjusted for inflation) beginning January 1, 2026. The marginal tax rate for all three taxes remains at 40%.
State and Local Tax Deductions (SALT). (SALT) deductions will remain in place, but will be capped at $10,000 for any combination of state and local income and property taxes. That means homeowners living in high-tax states like California, New Jersey and New York could see an increase in federal tax payments in coming years. This provision expires after 2025.
Mortgage Interest Deduction. Under existing law, taxpayers may claim an itemized deduction for mortgage interest paid with respect to one’s principal residence and a second qualifying residence. Itemizers may deduct interest payments on up to $1 million in acquisition indebtedness (for acquiring, constructing or substantially improving both residences). Under the Act, mortgage interest on up to two personal residences can still be deducted for mortgage debt originating after Dec. 15, 2017, but only up to $750,000 in acquisition indebtedness for tax years 2018–2025.
Individuals who take out home equity (HELOC) loans, however, will no longer be able to deduct that interest which is suspended under the ACT. The same is true for second mortgages and vacation homes, which may impact the vacation home market.
Capital Gains Exclusion on Sale of Primary Residence. No changes here. Taxpayers will still be able to exclude up to $500,000 (or $250,000 for single filers) from capital gains taxation when they sell their primary home, as long as they have lived there for at least two of the past five years.
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
Changes in Tax Credits. The initial tax reform bill passed by the House of Representatives would have significantly altered many project-based tax credits including the Low-Income Housing Tax Credit, the New Markets Tax Credit, the Historic Tax Credit and Production Tax Credit and Investment Tax Credit for renewable energy projects. The Act largely leaves these credits in place, although the Historic Tax Credit is limited for certain projects and the timing of receipt of the benefit of the credit has been lengthened. Further, the credits may be more difficult to monetize due to other changes made by the Act.
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.
FIRPTA. The Act generally retains FIRPTA in its pre-Act form. Non-US real estate investors would see a significant rate reduction under the Act on sales of US real property interest since the lower rates under the Act also apply to US nonresidents.
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 (“ECI”) 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. he Treasury recently announced that this withholding obligation has been delayed for the time being.
Other Important Changes. Corporate Net Operating Losses (“NOLs”). The ACT limits the deduction for NOLs to 80% of the corporation’s taxable income while generally disallowing the ability to carryback NOLs. However, NOLs can be carried-forward indefinitely.
Below is a recap of the previous tax law and changes under the ACT. Furthermore, consideration should be given to whether the states will adopt some or all of the changes, since the Act will put pressure on the states to keep certain popular deductions, particularly depreciation.
Previous law (2017)
The Act (2018)
|A business where the pass-through deduction would apply||39.6 percent + 3.8 percent net investment income tax||29.6 percent (37 percent marginal rate with 20 percent reduction of pass-through income*) + 3.8 percent net investment income tax|
|A business where the pass- through deduction would not apply (excluding self-employment tax)||39.6 percent + 3.8 percent net investment income tax||37 percent + 3.8 percent net investment income tax|
|Interest expense||Fully deductible||Can elect out of 30 percent of EBITDA/EBIT interest limitations and fully deduct. Limited interest expense deductions can be generally carried forward indefinitely|
|Depreciation expense||27.5 years for residential real property, 39 years for nonresidential real property||Same as current law unless electing out of 30 percent interest limitation – depreciable lives would then be 30 years for residential and 40 years for nonresidential real property|
|Bonus depreciation||50 percent deduction allowed for most original use assets besides building||100 percent for certain assets|
|Highest marginal capital gain tax rate on real estate sale income||20 percent + 3.8 percent net investment income tax||20 percent + 3.8 percent net investment income tax|
|Carried interest (for distributive items of long term capital gain)||20 percent + 3.8 percent net investment income tax (1 year hold required)||20 percent + 3.8 percent net investment income tax (potential 3 year hold would be required)|
|Corporate tax rate on all real estate related income||35 percent||21 percent (starting in 2018)|
|REIT/Corporate net operating losses (NOL) carryforwards||100 percent (90 percent for AMT)||80 percent and indefinite carryforward (no carrybacks allowed); corporate AMT repealed|
|Active loss limitations offsetting other income items||No limitations||Single taxpayers limited to $250,000, married filing joint taxpayers limited to $500,000 and carried forward|
|1031 Exchanges||Real and personal property allowed for like kind exchanges||Only real property allowed for like kind exchanges|