Impact of 2017 Tax Act on Real Estate Activities
The real estate industry was initially a major target during the 2017 tax reform process but managed to dodge most of the bullets and came out smelling like roses – indeed, overall, the industry actually comes out ahead under the 2017 Tax Act (the “Act”).
At the outset of tax reform, the real estate industry was the focus of a variety of potentially adverse changes, including proposals to eliminate Code § 1031 exchanges, eliminate favorable treatment of carried interests, and impose limitations on interest deductions, as well as various other adverse proposals that were discussed seriously by Congress and eventually, for the most part, dropped from the final legislation.
The real estate lobby is really good. Now for the details.
Tax Rates and Brackets
First of all, real estate investors will benefit significantly from the reduction in individual income tax rates. The real estate industry almost always operates on a pass-through tax basis, with income from real estate activities passing out to individual taxpayers, whether through REITs, partnerships, or other pass-through entities. (Relatively few real estate businesses operate as C corporations, so the dramatic reduction in C corporation tax rates, from 35% to 21%, is mostly irrelevant.)
On a pass-through basis, individual real estate owners are likely to benefit from the decrease in the maximum individual tax rate from 39.6% to 37% as well as from the expansion of the lower tax brackets. For example, the 39.6% bracket would have applied at $480,050 for married couples filing jointly, but under the Act, the same couple needs $600,000 of income to reach the maximum 37% rate. For many taxpayers, the lower headline rates and revised brackets will yield significant savings.
In addition to lower individual tax rates, it appears that pass-through real estate businesses will also benefit significantly from the 20% qualified business income deduction under new Code § 199A (discussed below). All in all, real estate owners and real estate businesses should enjoy favorable tax results under the Act.
Code § 199A
Individuals, estates and trusts (but not C corporations) that have “qualified business income” or “QBI,” including from pass-through entities and disregarded entities engaged in the business of real estate, should be eligible for a new deduction of up to 20% of QBI.
This deduction, which is subtracted from taxable income (i.e., after taxable income is determined on the middle of page 2 of the Form 1040), is an astonishingly complicated calculation. Basically, QBI is the active income derived from conducting a trade or business, which should include a real estate “business.”
There is a fairly interesting and complicated question about whether triple-net leasing of real estate rises to the level of a “trade or business” for purposes of the deduction. The good news is that, when it comes to renting real estate, there is a fairly low standard under applicable case law for qualifying as a trade or business for federal income tax purposes. However, in some circumstances the IRS may challenge the characterization of triple-net leases as trades or businesses, and so this issue will probably need to be addressed by the IRS through regulations or other guidance.
Another interesting feature of the QBI deduction – and another big win for the real estate industry – is that dividends from a real estate investment trust (a “REIT”) (other than capital gain dividends and qualified dividends), and qualified income of a publicly traded partnership, are eligible for the full 20% QBI deduction without further limitation.
The QBI deduction is likely to be an attractive benefit for the real estate industry, but – depending on how the IRS interprets this new law – enjoying the full benefit may require attention and changes to a firm’s organizational structure. Eligibility for the full 20% deduction is limited by wages paid and properly reported on Form W-2 and/or the original tax basis in certain depreciable property, and this may impact some real estate businesses.
These limitations apply on a business-by-business basis, but the exact meaning of the term “business” is uncertain. Depending on how the IRS interprets the law, some real estate businesses may need to reorganize their operations in order to take full advantage of the deduction by aligning their wages and real estate income. Real estate businesses may also find it is beneficial in some circumstances to pay W-2 wages rather than issue “profits interests” or make partnership guaranteed payments for services provided to a partnership.
There was a lot of discussion about eliminating entirely the favorable federal income tax treatment of carried interests, but for most ventures, the Act ended up delivering a slap on the wrist. The Act imposes a three-year holding requirement for carried interests (so-called “applicable partnership interests”) in order to qualify for long-term capital gain treatment. If the requirement is not satisfied, the holder recognizes short-term gain upon sale.
An applicable partnership interest is a partnership interest transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer or a related person in an “applicable trade or business.”
The trades or businesses subject to this new rule include activities conducted on a regular, continuous and substantial basis, consisting in whole or in part of (i) raising or returning capital, and (ii) either developing, investing in or disposing of (or identifying for investing and disposition) “specified assets,” which includes real estate held for rent or investment, as well as securities, commodities, and cash or cash equivalents.
Also, there is a carve-out for partnership “capital interests” that give partners the right to share in partnership capital commensurate either with the amount of capital contributed, or with the value of the capital interest subject to tax under Code § 83 upon receipt or vesting of the interest. The provision is inapplicable to partnership interests held by corporations.
Note that the Act does not “grandfather” partnership interests issued on or before its effective date, so the rule can have retroactive effect.
Business Interest Expense
The Act caps the deductibility of interest expenses incurred in a business activity at an amount equal to business interest income earned by the business (often negligible) plus 30% of the taxpayer’s “earnings.” From 2018 through 2021, the taxpayer’s earnings are measured as earnings before interest, taxes, depreciation and amortization (i.e., EBITDA). After 2021, the deduction is limited to 30% of the taxpayer’s earnings before interest and taxes (EBIT).
Fortunately, a taxpayer engaged in a real property trade or business may elect out of this provision in exchange for a relatively modest extension in the depreciation schedule. An eligible real property business is any business engaged in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Interest expense deductions disallowed under this provision are carried forward indefinitely. Note that the business interest expense limitation is applied at the partnership level for businesses that operate through a partnership. Any interest expense deduction disallowed under these rules is allocated to the partners in the same ratio as net income and loss and can be used in future years.
In exchange for making the favorable election not to be governed by these new business interest limitation rules, real estate businesses are required to use a less favorable depreciation schedule, namely, the alternative depreciation system (“ADS”).
This “penalty” may be barely noticeable – for example, non-residential property currently depreciated over 39 years will now be depreciated over 40 years under ADS, and residential rental property currently depreciated over 27.5 years will be depreciated over 30 years under ADS. Note also that there are some glitches in the law that need to be fixed.
Bonus depreciation is available for property placed in service after September 27, 2017, and before January 1, 2023. The Act allows bonus depreciation equal to 100% of the purchase price for tangible personal property. Bonus depreciation is not available for purchases of real estate but is available for many of the tangible assets purchased and installed in a real estate business or used in a real estate business. An extremely important further aspect of this new provision is that it now extends to both new and used property.
Real estate businesses are used to doing “cost segregation studies,” and the ability to carve out tangible property within a larger real estate activity just became even more important.
Limitation on Excess Business Losses
For taxpayers other than C corporations, the Act disallows “excess business losses” in excess of $500,000 for married couples filing jointly, or $250,000 for other taxpayers, and requires that the excess losses be treated as a net operating loss (NOL) carryforward to the subsequent tax year.
For this purpose, an excess business loss is the excess of deductions attributable to a taxpayer’s trades or businesses, over the aggregate gross income from such trades or businesses. For partnerships and S corporations, the limitation applies at the partner or shareholder level after application of the passive loss rules.
This new rule will limit real estate professionals who materially participate in real estate businesses from using net real estate losses to offset non-business income (e.g., compensation or portfolio income) in excess of the limits noted above. For example, the new rule will prevent real estate professionals from netting excess business losses against REIT dividends or against salary income from the same real estate business that generated those losses.
The Act eliminated like-kind exchanges for all property other than real estate. Tangible property used in a trade or business can enjoy the bonus depreciation deduction for the next few years, so the impact on that category of property is minimal, but property held for investment other than real estate is no longer eligible. Real estate must still meet all the usual requirements for like-kind exchange treatment – the real estate must still be held for use in a trade or business or for investment to qualify for exchange treatment, and inventory does not qualify.
Elimination of Partnership Technical Terminations
The Act repeals the rule under Code § 708(b)(1)(B) that treated a partnership as terminated where there was a sale or exchange of 50% or more of the total interest in partnership capital and profits within any 12-month period.
In the past, a “technical” termination resulted in the deemed transfer of assets to a new partnership, and a deemed distribution of new partnership interests to the existing partners. Technical terminations created a mess: depreciation schedules had to be restarted in the new partnership, new tax elections were required by the new partnership, and other tax attributes terminated.
Elimination of technical terminations means that partners may transfer interests more freely and flexibly. Many partnership agreements contain indemnification obligations that apply if the transferring partner triggers a technical termination, so that headache is now eliminated. There are still reasons for partnerships to police transfers by their partners, but happily technical terminations are no longer one of them.
The Act includes a range of favorable provisions for the real estate industry, as well as some significant limitations. Please contact your Sullivan & Worcester real estate advisor, or a member of our tax team, with any questions you may have about how the Act affects your particular circumstances.