On December 22, 2017, H.R.1, commonly referred to as the Tax Cuts and Jobs Act ("Tax Act") was signed into law. The Tax Act made the most significant changes to the U.S. tax code since 1986, and will have an effect on taxpayers engaged in the real estate business, including real estate investment trusts (REITs). For additional background and a more detailed discussion of the Tax Act, please see https://www.shearman.com/perspectives/2017/12/tax-cuts-and-jobs-act-passed.
Pass-through Business Income Deduction
The Tax Act Provides a New 20 Percent Deduction for Pass-through Entities, such as Partnerships and Limited Liability Companies Taxed as Partnerships
The Tax Act reduces the income tax imposed on qualified business income (QBI) derived by a non-corporate taxpayer (i.e., an individual, estate or trust) from a partnership, limited liability company taxed as a partnership, S corporation or sole proprietorship by creating a new deduction of up to 20 percent of the QBI of each such taxpayer, regardless of such taxpayer's tax bracket. Thus, the top marginal tax rate on QBI that qualifies for the 20 percent deduction under the Tax Act is 29.6 percent. Under prior law, no such deduction existed, and taxpayers were generally subject to tax on flow-through business income at the individual tax rate (up to 39.6%, the highest marginal tax rate under prior law).
QBI for a taxable year is defined as the net amount of domestic qualified items of income, gain, deduction and loss with respect to the taxpayer's qualified trades and businesses, which generally means any trades or businesses (including real estate businesses) other than specified service businesses. "Specified service businesses" are professions in the fields of health, law, consulting, athletics, financial services, brokerage services, or 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 or owners, or which involves the performance of services that consist of investing and investment in management trading, or dealing in securities, partnership interests, or commodities (excluding engineering and architecture). The Tax Act allows individuals that derive business income from specified service businesses to treat such income as QBI if their taxable income is less than $315,000 (for married taxpayers filing a joint return) or $157,500 (for individuals). In addition, the Tax Act excludes from QBI:
- any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer and
- any amount that is a guaranteed payment for services actually rendered to or on behalf of a partnership.
The Tax Act limits the deduction for an individual's QBI to the greater of:
- 50 percent of the individual's "W-2 wages" paid with respect to the qualified trade or business, or
- the sum of:
- 25 percent of such W-2 wages, and
- 2.5 percent of the unadjusted basis of all "qualified property" immediately after its acquisition.
For this purpose, "qualified property" includes property of a character subject to depreciation and used in production of QBI. The W-2 wage limit does not apply for taxpayers with taxable income not exceeding $315,000 (for married taxpayers filing a joint return) or $157,500 (for individuals).
QBI does not include certain investment-related income, gains, deductions or losses. However, qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income give rise to a 20 percent deduction that is not subject to the limitations described above.
Because QBI includes qualified REIT dividends, and qualified REIT dividends are not subject to the wage/capital limitation described above, individuals that own interests in non-REIT real estate ventures should evaluate whether to structure such investments using a REIT to qualify for this additional benefit. Please see "Changes that affect REITs" immediately below for more detail.
These provisions will expire on December 31, 2025.
Exclusion of Real Estate from Interest Deduction Limitation
Electing Real Property Trades and Businesses are Not Subject to the Limitation on Deduction of Business Interest, and the "Earnings Stripping" Rules No Longer Apply
For most companies, the Tax Act limits the deduction for net business interest expense to 30 percent of the "adjusted taxable income" for the taxpayer's taxable year. For this purpose, adjusted taxable income is roughly similar to EBITDA for taxable years before January 1, 2022 and roughly similar to EBIT for years thereafter.
However, this limitation does not apply to an electing real property trade or business (including the businesses of real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage). Such election must be made at a time and in a manner prescribed by the IRS, which, at this time, is not known because the IRS has not yet provided guidance in this regard. If the real property trade or business exemption does not apply, there is also an exemption provided for taxpayers that (together with certain related parties) have average annual gross receipts of $25 million or less over the three-year period ending with the most recent taxable year.
A real estate trade or business that elects to be excluded from the limitation on deductibility of business interest will be required to use the "Alternative Depreciation System," which requires that longer recovery periods be used for its commercial real property, residential rental property and qualified improvement property. Generally, qualified improvement property means any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service, subject to certain exceptions, such as the enlargement of a building, any elevator or escalator, or the internal structural framework of the building. This means that depreciation deductions for such items of property would be spread out over a recovery period of 40 years for commercial real property, 30 years for residential rental property and 20 years for qualified improvement property. However, an electing real property trade or business will be able to immediately expense its cost of acquiring certain qualified property under the Tax Act. In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business. Qualifying property includes qualified real property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property). The Tax Act further expanded qualified real property to include qualified energy efficient heating and air-conditioning property acquired and placed in service after November 2, 2017.
The Tax Act eliminates the "earnings stripping" rules under prior law, which applied only to deductions for interest paid by U.S. corporations to, or guaranteed by, related foreign parties and only if certain other conditions were met; real estate companies were not permitted to elect out of the earnings stripping rules under prior law.
Since real estate companies can elect out of the business interest limitation, the after-tax cost of capital of U.S. real estate companies will likely be lower as compared to other similarly situated companies. And non-U.S. investors that invest in U.S. real estate companies using a mix of debt and equity will generally be able to both:
- achieve greater tax efficiency by investing in real estate rather than other U.S. asset classes and
- achieve greater tax efficiency with respect to U.S. real estate investments than under prior law.
Changes that Affect REITs
The Tax Act Reduces the Tax on Ordinary REIT Dividends by Providing a 20 Percent Deduction for Non-Corporate Taxpayers
U.S. taxpayers (other than corporations) may now deduct 20 percent of the amount of ordinary REIT dividends (generally speaking, dividends that are not capital gain dividends) they receive, subject to the limitation that the combined deduction for QBI and ordinary REIT dividends cannot exceed 20 percent of the taxpayer's income and gain for the year that is taxable at ordinary income rates. Thus, the top marginal tax rate on ordinary REIT dividends that qualify for the 20 percent deduction under the Tax Act is 29.6 percent (or 33.4 percent including the 3.8 percent Medicare tax on net investment income).
As noted earlier, the 20 percent deduction for ordinary REIT dividends is not subject to the wage/capital limitation described above, while the deduction for QBI derived through a partnership, limited liability company taxed as a partnership or S corporation is subject to this limitation. Consequently, an investor that would otherwise be subject to the wage/capital limitation might be better off making the same investment through a REIT. In the case of an investment in real estate mortgage debt, if the investment is held through a partnership, and the partnership is an investor rather than being in the business of lending, the interest income will not be QBI, and no deduction will be available; in contrast, if the investment is held through a REIT, ordinary dividends from the REIT will be eligible for the 20 percent deduction. Thus, the use of a REIT structure may significantly reduce the federal income tax on certain investments in real estate mortgage debt. We note, however, that the 20 percent deduction for ordinary REIT dividends currently does not apply if the interest in a REIT is held through a regulated investment company (i.e., a mutual fund).
These provisions will also expire on December 31, 2025.
REITs (Other than Mortgage REITs) Generally May Elect out of the Limitation on Deduction of Business Interest, Which Replaced the Earnings Stripping Rules
Because real estate businesses can elect out of the limitation on deduction of business interest, and the Tax Act eliminates the "earnings stripping" rules under prior law, foreign related-party investors may now find REITs more attractive. Previously, the use of shareholder debt to structure an investment by a foreign investor that owned 50 percent or more of a REIT potentially had both advantages and drawbacks. The interest payments received by the investor may have been exempt from tax (under a treaty or otherwise), while the leverage resulted in a corresponding reduction in the amount of taxable dividends paid to the investor, resulting in an overall reduction of tax leakage. But because of the prior earnings stripping rules, the REIT was limited in the amount of interest it could deduct with respect to the interest paid to the foreign investor.
Under the Tax Act, however, if a REIT's business is an electing real property trade or business, the interest the REIT pays to its foreign shareholders will generally be deductible. Further, REITs will not be subject to the Base Erosion and Anti-Avoidance Tax (or BEAT) with respect to the interest payments because REITs are not subject to the BEAT. As a result, in certain circumstances, foreign investors can use leverage to invest in REITs more tax-efficiently than was the case under prior law. For example, any foreign investor that either (1) is eligible for treaty benefits with respect to interest payments, or (2) owns less than 10 percent of the voting stock of the REIT, may receive interest payments from the REIT that are exempt from U.S. tax under a treaty or the "portfolio interest exemption," while the REIT deducts such interest payments as freely as it would deduct dividends paid to shareholders.
Reduction of Withholding Tax Rates to Conform With Reduction in the Corporate Tax Rate
Capital gain dividends and liquidating distributions paid by REITs to non-U.S. shareholders are generally treated as gain from the sale of U.S. real property interests, which is subject to withholding at the REIT level. The Tax Act reduced the FIRPTA withholding rate on these types of distributions to 21 percent. Under prior law, such withholding rate was 35 percent.
Corporate Tax Rate Lowered to 21 Percent
Corporate Alternative Minimum Tax Repealed
The Tax Act replaces the graduated tax rates for corporations with a 21 percent corporate tax rate (prior maximum rate of 35 percent). In addition, the Tax Act eliminates the corporate alternative minimum tax (or AMT).
The reduction in the corporate tax rate will significantly reduce the effective tax rate for investments in U.S. real estate by non-U.S. investors that are held through a non-REIT domestic corporation or "blocker," and the exemption for electing real property trades and businesses from the limitation on deduction of business interest expense may further improve the after-tax returns from such investments.
Depreciation Periods for Real Property
Modest Shortening of Cost Recovery Period for Real Estate Depreciated Under the Alternative Depreciation System (ADS)
The Tax Act shortens the cost recovery period for real estate depreciated under ADS, by providing recovery periods of 40, 30 and 20 years for depreciable commercial real property, depreciable rental residential real property and qualified improvement property (as described above), respectively. As noted above, real property businesses that elect out of the interest deduction limitation will be required to use ADS to depreciate such properties. Real estate businesses should consider the impact of switching from their current depreciation method to ADS before electing to be an "electing real property trade or business" that is exempt from the business interest limitation. However, an electing real property trade or business will be able to immediately expense its cost of acquiring certain qualified property under the Tax Act (as described above).
Section 1031 Like-Kind Exchanges
Tax-Free Exchange Treatment Retained for Real Property, Eliminated for Personal Property
Under prior law, Section 1031 provided taxpayers with nonrecognition treatment on the exchange of real estate, tangible personal property, and certain types of intangible property (other than goodwill) held for productive use in a trade or business or for investment for property of like kind that is also held for productive use in a trade or business or for investment. The Tax Act eliminated nonrecognition treatment for like-kind exchanges of assets other than real property. Because tax-free like-kind exchange treatment for real property has been retained, real property will remain a tax efficient asset class for families looking to preserve and accumulate wealth over multiple generations without the need to pay income tax on gains, because of the ability to engage in tax-free like-kind exchanges. When real property is passed to the next generation, the tax basis of the real property is adjusted to equal its fair market value (regardless of whether it was acquired through a string of tax-free like-kind exchanges), and the family may choose to sell the real property for cash after the basis step-up in order to diversify the family's assets.
Treatment of Carried Interest
Three-Year Holding Period Applies for Determining Character of Carried Interest Income
The Tax Act provides that capital gain allocated by a partnership to an individual partner as carried interest is characterized as short-term capital gain to the extent the gain is from the disposition of property in which the partnership's holding period was not more than three years in such property. The three-year holding period requirement also applies to gain from the disposition of carried interest partnership interests. The longer holding period applies to "applicable partnership interests," which are those that are acquired or held by an individual, a trust or an estate in connection with a trade or business that consists of the raising or returning of capital and either investment in or development of "specified assets." Specified assets include commodities, real estate held for rental or investment, cash and options, among others. This provision is effective for gain recognized in taxable years beginning after December 31, 2017, regardless of when the underlying asset-level gain accrued or was realized for financial or other purposes and regardless of when the applicable partnership interest was issued or acquired.
Only property that is not "dealer property" (i.e., is not held primarily for sale to customers in the ordinary course of a trade or business) produces long-term capital gain. Real property that is not dealer property is often held for longer than three years, regardless of tax considerations. As a result, the new holding period rule may not be a significant factor for many general partners that receive carried interests in connection with a real property business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.