Impact of 2017 Tax Act on Real Estate Activities

Sullivan & Worcester

The first, global observation to share is that the real estate industry dodged a lot of potential bullets during the tax reform process and came out smelling like roses – indeed, actually came out ahead, overall, under the 2017 Tax Act (the “Act”).

At the outset, the real estate industry was targeted by a variety of potentially adverse changes, including various proposals to eliminate Code §1031 exchanges, to eliminate favorable treatment of carried interests, to impose limitations on interest deductions, and a variety of other proposals that where discussed by Congress and eventually, for the most part, dropped from the final legislation.

The real estate lobby is really good. Now for the good news.

First of all, the real estate industry will benefit from the lowering of individual income tax rates. (Not too many real estate businesses operate as C corporations, and so the dramatic drop in C corporation tax rates is mostly irrelevant.).

In addition to lower individual tax rates, it appears that real estate businesses will benefit from the 20% Qualified Business Income exclusion deduction under new Code §199A. All in all, real estate owners and real estate businesses should enjoy favorable tax results in 2018.

Individual income tax rates are down and that is a big plus.

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. The real estate industry also tends to make a little bit of money in the activities, and so real estate professionals are generally impacted favorably by reductions in the highest tax rates. The reduction of the maximum individual tax bracket from 39.6% to 37% is a direct savings, but also note that the expansion of the lower tax brackets. For example, the 39.6% bracket was going to apply at $480,050 for married persons filing jointly, but now the maximum 37% bracket does not kick in until $600,000 of income. Between lower rates and higher bracket steps, the savings will be significant.

Code §199A.

Individuals, estates and trusts that have “Qualified Business Income” or “QBI,” including from pass-through entities and disregarded entities, are eligible for a new deduction equal to 20% of the qualified business income.

This flat 20% deduction, which is subtracted from taxable income (i.e. at the middle of page 2 of the Form 1040), is calculated the lesser of 20% of taxable income (minus net capital gains and qualified dividends) or 20% of QBI income, and is further restricted at the individual level. Generally, for individual taxpayers above certain thresholds ($207,500 of taxable income for single individuals, and $415,000 taxable income for married filing jointly), the QBI deduction is further limited to an amount that is equal to the greater of (1) 50% W-2 wages paid by the qualified business; or (2) 25% of W-2 wages, plus 2.5% of the depreciable property in service in the qualified business.

Note: This second factor, which includes 2.5% of the depreciable property, is thought to have been added specifically to benefit the real estate industry -- and that is a pretty big win for real estate businesses.

There is a fairly interesting and complicated question about whether triple net leasing of real estate is actually a “trade or business” for purposes of this QBI 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. However, the IRS was surprisingly restrictive in how it treated leasing income for purposes of the net investment income tax (the dreaded “NIIT”), and so this issue may need further elaboration by the IRS through regulations or other announcements.

Another interesting part of the QBI deduction – and another big win for the real estate industry is dividends (other than qualified or capital dividends) distributed by a Real Estate Investment Trust (“REIT”), or qualified income of a publicly traded partnership is also eligible for the 20% QBI deduction, and in the case of REITs and publicly traded partnership the QBI deduction is not subject to the phase-out or limitation for high-end income.

The QBI deduction overall looks like a pretty attractive benefit for the real estate industry, but it may be complicated by current structuring issues. The eligibility for the full 20% benefit is restricted by W-2 wages paid and/or depreciable property, and thus, for example, real estate companies have funds who have employees providing services under separately foreign corporate entities may have a disconnect between the real estate income and the W-2 wages necessary to take full advantage of the deduction. Real estate industries may well need to reorganize their operations in order to move employees around the business structure. Another obvious incentive is to restructure compensatory arrangements so that service providers are paid W-2 compensation rather than “profits interest” if the extra payments are needed to increase the wage limitation.

Carried Interest.

There was a lot of discussion about eliminating entirely the favorable treatment of Carried Interests, but the Act ended up delivering a slap on the wrist. The Act imposes a three-year holding requirement for Carried Interests, which are defined as “Applicable Partnership Interests,” in order to be eligible for long-term capital gain treatment. If the three-year holding requirement is not satisfied, the holder receives short-term capital gain treatment.

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 by certain related persons in an “applicable trade or business.”

Covered trades or businesses are activities that are conducted on a regular, continuous, and substantial basis and that consist, in whole or in part, of (1) raising or returning capital; and (2) either developing, or investing in or disposing of (or identifying for investing and disposition) “Specified Assets” such as securities, commodities, real estate held for rental investment, or cash or cash equivalents. There is a carve-out for partnership interests held by a corporation.

Also, there is a carve-out for “Capital Partnership Interest” that gives the partner the right to share in partnership capital commensurate with the amount of capital contributed, or the partnership interest was included in income under §83 on receipt or vesting of the interest.

Note that the Act does not provide any grandfathering applicable to Partnership Interest held as of the effective date of the new law, so it can have a retroactive impact.

Business Interest Expense.

The new Act puts a cap on the deductibility of interest expenses incurred in a business activity to 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 business can 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 expenses 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 disallowed interest 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 30 limitation rules, real estate businesses are required to use a less favorable depreciation schedule, e.g. the so-called “Alternative Depreciation System for nonresidential depreciable real property,” for residential depreciable real property, and for qualified improvements, which are respectively 40 years, 30 years and 20 years.

Bonus Depreciation.

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 property. Bonus depreciation is not available for purchases of real estate, but would apply to many of the tangible assets purchased and installed in a real estate business or used in a real estate business. A very important further aspect of this new provision is that it no longer requires that the purchased property be new in order to be eligible for bonus depreciation.

Like‑Kind Exchanges.

The 2017 Tax Act eliminated like-kind exchanges for everything except real estate (which must still be held for use in a trade or business or for investment; real estate held as inventory is not included).

Partnership taxable terminations are eliminated.

The 2017 Act modifies the rules under Code §708(b)(1)(B), such that the technical termination under 708(b)(1)(B) has been eliminated. Formerly, a “technical termination” occurred when 50% or more of the partnership interests in both profits and capital were transferred in any twelve-month period.

When there was a technical termination, there was a deemed transfer of assets to a new partnership and a distribution of the new partnership interests to the existing partners. The drawback was that depreciation schedules had to be restarted in the new partnership and certain new elections were required or permitted to the new partnership.

The elimination of the technical termination provision means that partners can transfer interests more freely and flexibly and that partnerships do not need to police the transfers. Many partnership agreements contain indemnification obligations that apply if the transferring partner triggers a technical termination, and obviously those kind of concerns are no longer relevant.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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