On Dec. 22, President Donald Trump signed into law the 2017 Tax Act, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (H.R. 1). This legislation is considered the most significant overhaul of the U.S. tax code since 1986. Generally applying to taxable years beginning on and after Jan. 1, 2018, the changes will have a profound impact on real estate companies and their owners.
Individual Income Tax Rates
For tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, the 2017 Tax Act modifies the tax brackets for individual income tax, with the highest bracket being a marginal rate of 37 percent. (Prior to the new law, the highest bracket was 39.6 percent.) The reduced tax rates may not produce a lower tax liability, as the new law also eliminates personal exemptions, suspends or limits many itemized deductions and increases the standard deduction.
Taxation on U.S. Businesses
Corporate Income Tax and Corporate AMT: The 2017 Tax Act provides for a permanent 21 percent flat corporate income tax rate and repeals corporate alternative minimum tax (AMT) for taxable years beginning after Dec. 31, 2017. The new law also reduces the 80 percent dividends-received deduction to 65 percent and the 70 percent dividends-received deduction to 50 percent.
Corporate Net Operating Losses: The 2017 Tax Act limits the deduction for net operating loss carryovers to 80 percent of taxable income, eliminates the carryback of such losses for most companies and provides for an indefinite carryforward. This provision is generally effective for losses arising in tax years beginning after 2017.
Deduction for Qualified Business Income of Pass-Through Entities: A new deduction will be available to individuals, trusts and estates for qualified business income from pass-through and disregarded entities. Importantly, the deduction against qualifying income would expire for tax years beginning after Dec. 31, 2025.
During the covered years, individuals, estates and trusts may deduct from their taxable income 20 percent of qualified business income from a partnership, S corporation or sole proprietorship, including a disregarded entity treated as a sole proprietorship, subject to certain limitations.
Generally, a taxpayer’s qualified business income is derived from an active trade or business. It excludes any amounts paid by an S corporation treated as reasonable compensation, guaranteed payments to a partner in a partnership, and amounts paid to a partner acting in a capacity other than as a partner. The new law excludes income generated from certain specified service businesses (such as law, health, accounting and financial services) from qualified business income status if the taxpayer’s taxable income exceeds certain thresholds. Dividends (other than capital dividends) from real estate investment trusts (REITs) and earnings from publicly traded partnerships are eligible for the 20 percent deduction.
The pass-through deduction is limited to the greater of: 50 percent of the W-2 wages paid by the qualified business, or 25 percent of the W-2 wages plus 2.5 percent of the depreciable property in service in the qualified business.
This new deduction could mean significant income tax savings for many real estate business owners. However, real estate companies and funds whose employees are “housed” in separate related party entities may be limited in taking advantage of this deduction due to the wage limitation. For this reason, certain real estate companies may look to reorganize their operations to move employees around in the structure and to pay compensation to employees rather than issue “profits interests” in order to boost the wage limitation base.
Carried Interest: The 2017 Tax Act institutes a three-year holding requirement for carried interests (defined as “applicable partnership interests”) to be eligible for long-term capital gain treatment. If such holding requirement is not satisfied, any capital gain recognized by the holder of “applicable partnership interests” will receive 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 certain related persons in an “applicable trade or business.” Covered trades or business 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 or disposition) “specified assets,” such as securities, commodities, real estate held for rental or investment, or cash or cash equivalent.
There are two notable carve-outs from the definition of applicable partnership interests. First, a partnership interest held by a corporation is excluded. Second, applicable partnership interests do not include capital partnership interests that provide the partner with the right to share in partnership capital commensurate with the amount of capital contributed or the value of such interest included in income under Section 83 of the Internal Revenue Code upon the receipt or vesting of the interest.
The new rules apply notwithstanding the application of Section 83 to the interest or whether the holder made a Section 83(b) election with respect to the interest. Interestingly, the 2017 Tax Act does not include rules “grandfathering” applicable partnership interests held as of the effective date of the new law.
The new provision could impact many real estate owners (such as real estate developers and sponsors) since numerous real estate deals provide for carried interest to such persons. The three-year holding requirement will be the primary hurdle for owners of carried interests.
There will likely be future guidance in this area as the 2017 Tax Act authorizes the U.S. Department of Treasury to promulgate regulations necessary to carry out the purposes of the provision. Also, portions of the technical language of the provision are ambiguous, so clarifying authority will be necessary.
Business Interest Expenses: Business interest expenses once deductible under Section 163 of the Internal Revenue Code now may be limited to 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortization (EBITDA) for taxable years beginning after 2017 and before 2022, and limited to 30 percent of a taxpayer’s earnings before interest and tax (EBIT) for taxable years beginning after 2021. The limitation does not apply to regulated public utilities, certain electric cooperatives and taxpayers with average annual gross receipts for the current and prior two taxable years that do not exceed $25 million. Further, at the taxpayer’s election, the limitation does not apply to interest incurred by the taxpayer in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Disallowed interest expenses can be carried forward indefinitely. Also, the business expense limitation is applied at the partnership level for businesses operated in a partnership. Any interest that cannot be deducted by the partnership because of the limit would be allocated to the partners in the same ratio as net income and loss, and could be used in future years to offset any excess income allocations.
The exclusion of interest deductions will impact businesses with business interest expenses, particularly taxpayers with large annual revenues beginning in 2021 when the 30 percent limit is applied to a much smaller earnings base. However, the carve-out for certain real estate activity described above should allow most real estate companies to continue to deduct their business interest expenses.
Bonus Depreciation: The 2017 Tax Act modifies bonus depreciation under Section 168(k) of the Internal Revenue Code to allow 100 percent expensing for property placed in service after Sept. 27, 2017, and before Jan. 1, 2023, and then phases out bonus depreciation with 20 percent reductions each year. Property “acquired” before Sept. 28, 2017, including under a binding written contract, will be subject to the old bonus depreciation rules, which is 50 percent through 2017, 40 percent in 2018, and 30 percent in 2019 with no bonus depreciation thereafter. The new law removed the “original use” requirement for bonus depreciation. This means property previously placed in service will qualify for 100 percent bonus depreciation when acquired by another party before Jan. 1, 2023.
Depreciable Lives for Certain Depreciable Real Property: The 2017 Tax Act requires any taxpayer engaged in specified real property activity that elects to be excluded from the business interest expense deductibility limitations described above to utilize the alternative depreciation system with respect to its depreciable real property. Pursuant to the new rules, the recovery periods under the alternative depreciation system for nonresidential depreciable real property, residential depreciable real property and qualified improvements are 40 years, 30 years and 20 years, respectively.
Like-Kind Exchanges of Real Property: The 2017 Tax Act limits the like-kind exchange rules to exchanges of real property that is not held primarily for sale. Thus, personal property (tangible or intangible) is no longer eligible for like-kind exchange treatment. This new provision applies to exchanges completed after Dec. 31, 2017.
Partnership Technical Terminations: The 2017 Tax Act eliminates the current rules regarding partnership technical terminations under Section 708(b)(1)(B). Technical terminations occur when 50 percent or more of interests in both profits and capital are transferred in any rolling 12-month period. This results in the technical termination of the current partnership and the formation of a new partnership for federal tax purposes, with depreciation schedules restarted in the new partnership and certain new elections being required or permitted by the new partnership. The 2017 Tax Act allows partnerships to continue without these effects, despite transfers of partnership interests that previously resulted in a partnership technical termination. Further, many partnership agreements have prohibitions on transfers that could result in a technical termination, including upstream transfers. The removal of the partnership technical termination rules will allow partners to more easily make transfers of their partnership interests, and even avoid indemnification if the partnership documents required indemnification by the transferring partner for technical terminations.
The 2017 Tax Act’s changes could have a significant impact on the structure and operation of real estate companies. Real estate companies may view themselves as “winners,” for the most part, under the 2017 Tax Act. However, the new lower corporate income tax rate and the wage limitation on the 20 percent deduction for qualified business income from pass-through and disregarded entities may cause real estate companies to re-evaluate the most tax-efficient structure for their operations.