A Review of the Tax Cuts and Jobs Act — Commercial Real Estate

The Act lowers some individual income tax rates beginning in 2018 and expiring after 2025, temporarily reducing the highest marginal income tax rate applicable to ordinary income of individuals from 39.6% to 37%.  However, the tax rates for capital gains and qualified dividends are left unchanged at 20%.  Net investment income tax also remains unchanged at 3.8%.

For tax years beginning after December 31, 2017, the Act permanently sets the corporate income tax rate to a flat 21%.  Accordingly, the aggregate maximum federal income tax rate on the income of a C corporation distributed to its shareholders as a qualified dividend will be 36.8% of pre-tax corporate income.  The net investment income tax (3.8%) may also apply to dividend income received by an individual.

Important Note for the Real Estate Industry:

The choice of entity through which to conduct commercial real estate activities again becomes an important decision. Among other things, key considerations include whether: (a) the asset base includes real estate or other assets (like intangibles) likely to appreciate over time; (b) the need to retain capital to grow the business; and (c) the likelihood of attracting capital from foreign or tax-exempt investors.

The Act adds Code Section 199A, effective for tax years beginning after December 31, 2017 and before January 1, 2026, that provides for a potential deduction/exclusion of up to 20% of qualified business income (QBI) earned by an individual, trust, or an estate from a partnership, S corporation, or sole proprietorship.  QBI generally includes income from operating any trade or business, except for certain “specified service businesses” that may be limited by other wage and capital-based measures, discussed further below.  QBI does not include any wages earned by an employee of any business.  Interestingly, ordinary dividends from REITs are eligible for the 20% deduction and are not subject to any further limitations. 

• There are no limitations for deducting 20% of trade or business income earned directly or from a pass-through entity for married filing jointly taxpayers with taxable income less than $315,000 and $157,500 for individuals filing single. However, the 20% deduction, without further limitation, is phased out ratably on taxable income above $315,000 and completely at taxable income of $415,000 for married filing jointly taxpayers, and on taxable income above $157,500 and up to $207,500 for single filers.
• For taxpayers with taxable income above the phase out threshold amounts discussed above, the following additional requirements apply to qualify for the 20% deduction: 
  • The business must not be a “specified service business” -  generally defined as any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, or dealing in securities, partnership interests or commodities, and more broadly 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. Engineering and architectural service do qualify.
  • The amount of the potential deduction for QBI cannot exceed the greater of 50% of W-2 wages paid by the qualified business; or the sum of 25% of W-2 wages paid by the qualifying business, and 2.5% of the unadjusted basis of tangible, depreciable property.  

Important Note for the Real Estate Industry:

Given that many real estate businesses are structured using pass-through entities, the analysis of this potential benefit will have broad application.  When it comes to applying the limitations applicable to higher earning income taxpayers, a challenge is that the real estate industry typically has relatively low amounts of W-2 employees in comparison with other industries.  On the other hand, the wage-based limitation may be counterbalanced by the capital-intensive nature of the real estate business.  Lastly, the nature of the real estate business must be considered when connecting these dots. 

It will be also important to consider the nature of the income generated by the different sectors within real estate business.  On its face, the income from traditional real estate rental and operating businesses would seem to have more potential benefit in comparison with real estate fund managers and other investors that pursue capital appreciation.  Fortunately, the long-term capital gains rates are unchanged under the Act and remain at preferential rates in comparison with ordinary/operating income even after the application of the Code Section 199A deduction.  Finally, the major challenge, and some of the uncertainty in analyzing and applying these provisions as currently drafted, pertain to applying the qualification standards in relation to specified service business definitions, and the quantification issues associated with allocating and matching employee wage payment arrangements with income streams, and unadjusted basis measures for capital investments.

The Act amended Code Section 163(j) for tax years beginning after December 31, 2017 to disallow deductions for net business interest expense that exceeds 30% of adjusted taxable income (ATI).  ATI for taxable years beginning after December 31, 2017 and before January 1, 2022 is taxable income other than items not applicable to a trade or business, business interest income and expense, depreciation, amortization, and depletion, the amount of any 20% deduction for qualified business income, and NOLs.  ATI can be thought of simply as an EBITDA-type measure until tax years beginning after December 31, 2021, at which point depreciation, amortization, and depletion would be deducted in the calculation of ATI, changing it into an EBIT-type measure.  

Disallowed interest expense deductions will be treated as net operating losses (NOLs) and carried forward indefinitely and can be potentially utilized in subsequent years.  Interest expense on existing debt instruments is not “grandfathered.”  Special rules apply for partnerships and S corporations in computing the partner’s or shareholder’s business interest limitation.  This limitation does not apply to “small business” taxpayers (other than tax shelters) having no more than $25 million in gross receipts.  

Important Note for the Real Estate Industry:

A “real property trade or business” can elect to be exempt from the interest expense limitation regime and continue deducting 100% of business interest expense.  For this purpose, a real property trade or business is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”  Real property trades or businesses making this permanent election will be required to use the Alternative Depreciation System (ADS) to depreciate residential rental property, nonresidential real property, and qualified improvement property.  The requirement to use longer-life ADS depreciation (see discussion below) will also eliminate the ability to deduct bonus depreciation on certain otherwise eligible improvements.  

Careful analysis and tax planning should be performed to determine whether it is more beneficial for a real estate business to elect out of the 30% interest limitation (and deduct 100% of business interest) or continue depreciating real estate assets under normal, more favorable, cost recovery rules.  The timing of making this irrevocable election should be considered further in relation to any imminent capital improvement plans, which may yield significant accelerated/immediate expensing opportunities under normal cost recovery rules, and the upcoming changes to the ATI computations beginning after December 21, 2021 which will reduce the 30% ATI computation by the amounts of depreciation, amortization, and depletion expense.  In general, for real estate investments with relatively high leverage levels and insignificant short-term capital improvement plans, the relatively marginal changes to residential and nonresidential property mentioned above under ADS will likely not be a significant cost in comparison with the 100% business interest deductions available for electing taxpayers. 

The Act increases the “bonus depreciation” deductibility percentage from 50% to 100% for property acquired and placed in service after September 27, 2017, and before 2023.  Thereafter, gradually until 2026, the rate will drop back down to 20%.  The Alternative Depreciation System (ADS) recovery period for residential rental property will be shortened from 40 years to 30 years.  The Act will, in the future, also provide a single 15-year recovery period (20 years for ADS) for qualified improvement property, although a technical correction will be required to properly state this rule. 

Qualified improvement property will include certain property placed in service after a building’s initial placed in service date, including qualified leasehold improvement property, most of what is currently defined as qualified restaurant property, qualified retail improvement property, and interior building improvements - other than building expansions, internal structural framework, and elevators/escalators.  

Important Note for the Real Estate Industry:

As mentioned above, real property trades or businesses that elect to be exempt from the business interest limitations must use ADS depreciation for all nonresidential real property, residential rental property, and qualified improvement property, not just property that’s placed in service in 2018 and future years.  Bonus depreciation will still be available for eligible property other than real property and qualified improvement property, with 100% expensing available for property that currently qualifies for bonus depreciation for property that’s acquired and placed in service after September 27, 2017 and before January 1, 2023. 

Because of the requirement to use ADS, comparing the benefits of depreciating real estate assets under normal, shorter recovery periods and the eligibility for bonus depreciation on qualified improvement property may outweigh the benefit of electing out of the business interest limitations for real estate owners that use relatively lower leverage amounts (e.g., certain REITs).

Code Section 179 was modified, increasing the maximum amount of “eligible property” that can be deducted to $1 million, from $500,000, and the phase-out amount was increased from $2 million to $2.5 million.  In addition, the Act expanded the definition of Section 179 “eligible property” by: (1) removing the limitation related to lodging property; and (2) adding the following nonresidential rental (i.e., commercial real property) components: roofs, HVAC property, fire protection, alarm systems, and security systems.

Important Note for the Real Estate Industry:

The increases to the amounts of deduction and phase-out, and the expansion of the definition of “eligible property” to Code Section 179 under the Act generally improves the opportunity for additional current deductions, and specifically for certain real estate related improvements.  These additional benefits can be used to mitigate the depreciation limitations under ADS discussed above for real estate trades or businesses that elect to be exempt from the business interest deduction limitations.

Opportunities for deferral of gain under Code Section 1031 are now limited to like-kind exchanges of real property only, but gains arising from the sale or exchange of real property held primarily for sale are not eligible for deferral.  While tangible personal property is no longer eligible for deferral, the potential for full expensing of replacement tangible personal property may offset the negative impact of eliminating gain deferral under Code Section 1031.

Important Note for the Real Estate Industry:

Preserving the ability to defer tax on gains under Code Section 1031 is significant to the real estate industry in general, and real estate is now the only remaining industry that has this important tax planning tool available.  Under other recent tax proposals, there was concern that Code Section 1031 transactions would be eliminated for real estate transactions as well.  With renewed confidence that gains can be continue to be deferred under Code Section 1031, there may be an uptick in market transactions.

A taxpayer’s NOL deduction arising in 2018 or later is now limited to 80% of the taxpayer’s taxable income.  In addition to this limitation, the Act generally eliminates the ability to carryback NOLs to prior tax years.  However, the Act now allows NOLs to be carried forward indefinitely, in comparison to the general 20-year carry forward limit under prior law.  

Important Note for the Real Estate Industry:

Analyzing the timing of deductions will be important to determine whether deductions that may go unused and create an NOL in one year, may then be limited in future years with significant projected income.  For example, it may be less beneficial to take accelerated depreciation for a value-add real estate investment with a significant projected gain on disposition if there is relatively low net operating income before depreciation projected during the holding period. 

Interest and depreciation deductions are two of the more significant real estate related deductions that should be analyzed in relation to the NOL limitation.  Further, the relationship between the business interest deduction and ADS depreciation limitations discussed above are interactive variables in regards to this analysis.  Once again, potentially unused accelerated depreciation deductions may be less beneficial than preserving tax basis which would not be subject to the NOL limitation.  Note that there is flexibility in the tax planning associated with asset classification and choice of depreciation method that impacts the timing and amount of depreciation deductions.  Individual real estate investments held in separate corporate form will be particularly important to analyze (including the typical “leveraged blocker structure” that many offshore investors in US real estate utilize) to avoid the risk of having NOLs go permanently unutilized. 

The “excess business loss” limitation is a new provision introduced by the Act which applies to taxpayers, other than C corporations, whereby the amount of business losses which are deductible in any tax given year are limited to $500,000 for married individuals filing jointly or $250,000 for other individuals.  A taxpayer’s excess business loss will be treated as part of an NOL, and will be carried forward to subsequent tax years.  Such NOL carryforwards will be allowed in a tax year – up to an amount equal to 80% of the taxpayer’s taxable income.  Effectively, the new loss limitation will limit the ability of non-C corporations to deduct active business losses to the amounts listed above against wages, investment, and other income.  

Important Note for the Real Estate Industry:

The new excess business loss limitation applies after the limitations from prior law, such as basis, at-risk, and passive activity losses. 

Individuals that qualified as “real estate professionals” and netted losses from real estate investment partnerships against their wages, investment, and other income will now be limited to a maximum annual deduction of $500,000 for married individuals, or $250,000 for other individuals.  Wages, investment and other income more than the business loss limitation will be subject to applicable individual tax rates and any disallowed loss will be carried forward as an NOL and subject to the 80% annual limitation discussed above. 

Partnership technical terminations for partnership tax years beginning after December 31, 2017 are eliminated.  Under current law, a sale or exchange of 50% or more of partnership capital or profits within a 12-month period causes the partnership to “technically terminate.”

Important Note for the Real Estate Industry:

Elimination of the technical termination provision will generally make reorganizations, restructurings, and other transactions that are treated as a sale or exchange of 50% or more of partnership capital or profits less administratively cumbersome from an accounting and tax compliance perspective.  A technical termination under current law created two stub tax years within a 12-month period and required two income tax returns to be filed within a 12-month period.  Additionally, the requirement to re-start depreciation using the adjusted tax basis of the assets over a new, full recovery period will no longer be applicable. 

A new three-year asset-holding period is required to qualify for long-term capital gain treatment with respect to a carried interest allocation.  If the asset-holding period does not meet the three-year holding period test, the allocation will be treated as short-term capital gain. 

Important Note for the Real Estate Industry:

Value-add real estate investments in many cases are held by funds for three years or more, and accordingly, the changes to the carried interest allocation rules should not have a material impact on the after-tax results for fund managers.

Ordinary REIT dividends qualify for the same 20% deduction that applies to QBI mentioned above.  Unlike other QBI deductions, the REIT dividends are not subject to the W-2 wages and depreciable basis limitations.  These provisions are effective beginning after December 31, 2017, and they are set to sunset for taxable years beginning after December 31, 2025.

Important Note for the Real Estate Industry:

For individual investors, REITs provide more certainty and no other wage and capital limitations for purposes of QBI and the 20% deduction discussed above.  Accordingly, additional consideration should be given, beginning in 2018, to structuring REIT qualifying debt and equity using REITs in comparison with other more traditional pass-through entities that will have more complexities associated with the QBI analysis.

Among other things, the Act eliminates the ability for tax-exempt organizations to offset unrelated business taxable income (UBTI) losses from one unrelated trade or business against UBTI income from another unrelated trade or business.  UBTI losses can be carried forward and utilized against future UBTI income from the same unrelated trade or business. 

Important Note for the Real Estate Industry:

Reduced corporate income tax rates that apply to UBTI will somewhat mitigate the impact of the inability to net income and losses from separate unrelated trades or businesses.  Additional consideration may need to be given to structuring UBTI income producing activities in corporate blocker form or other alternative structures. 

Here is the short list of items that we feel are most advantageous to analyze quickly:  

• Eligibility for a 20% deduction for pass-through QBI earned by real estate principals, factoring in structurally how and where employees’ W-2 wages as well as quantifying how much, and structurally where and quantifying how much capital investment exists within a real estate business platform
• Benefits of making a permanent election to deduct 100% of business interest for a real property trade or business; and verifying that the benefit of making the permanent election outweighs the projected cost of using the longer life (ADS) cost recovery methods required for certain real estate assets

Given that the commercial real estate industry has comparably low W-2 wage employees and relatively high capital investment in comparison with other industries, the interplay within the above two issues will prove to be a dynamic analysis.  A fresh analysis of the existing structure of a multi-strategy real estate platform will undoubtedly highlight benefits and burdens under the Act because of the income and deduction quantification and qualification criteria contained in two of the most significant provisions, arguably, that impact the commercial real estate industry. 

Next, we look collectively at the real estate investment continuum.  We begin by carefully considering the fundraising stage, and U.S. tax issues faced by investors, investment sponsors, and the typical structures interposed between the capital and the ultimate real estate investment.  Our initial view is that many of the tax strategies and structures implemented to manage tax liabilities for investors in U.S. real estate will remain intact, and in many cases, will be positively impacted by the Act’s tax rate reductions.  For example, the reduction of the corporate tax rate to 21% results in less tax burden for those offshore investors in U.S. real estate that have traditionally invested through corporate structures.  Additionally, tax-exempt investors paying UBTI at corporate rates will suffer less tax from “unblocked” real estate investments generating UBTI.  Ordinary REIT dividends eligible for the 20% QBI deduction are not subject to wages and capital limits.  

With the corporate tax rate reduced to 21%, establishing C corporations as tax structuring entities may now become more of a consideration for real estate businesses and ordinary income-producing real estate investments.  However, the attractiveness of the comparatively low corporate tax rate must be balanced with the double taxation that applies when corporate dividends are taxed in the hands of the shareholders.  For example, capital preservation and reinvestment strategies (e.g., using Code Section 1031 like-kind exchanges for the deferral of gain recognition) will be more of a consideration as opposed to opportunistic value-creation and exit strategies.  Additionally, real estate service, operational, and management oriented businesses may be worth considering using corporate structures, whereas in the examples above, flow-through LLCs and S corporations were traditionally considered the primary choice entity-types. 

During the value-creation period of the real estate investment continuum, we will continue to advise clients to analyze opportunities to maximize depreciation deductions using accelerated cost-recovery methods and 100% bonus-depreciation.  In our view, cost segregation studies will continue to be the best path to analyze and properly document fixed asset classification, and maximize depreciation deductions under the most beneficial cost recovery rules.  Under revised Code Section 1031 like-kind exchange provisions, tangible personal property assets exchanged are not eligible for deferral.  This limitation can be mitigated by analyzing replacement property, particularly in situations where the replacement property’s value is more than the relinquished property, and utilizing the 100% expensing provisions provided for under the Act.  Lastly, cost segregation studies may be effective to offset the opportunity cost of using ADS depreciation for certain real estate assets when a real property trade or business elects to opt out of the business interest limitations. 

Entering the disposition phase of the real estate investment continuum, reduced individual tax rates on ordinary income-producing real estate investment and reduced corporate tax rates will improve after tax internal rate on existing real estate investments that were underwritten using higher tax rates under prior law.  For example, reduced corporate rate will significantly benefit non-U.S. investors who hold U.S. real property investments in U.S. corporate structures.  Accordingly, reduced income tax rates, preservation of long-term capital gains rates, and Code Section 1031 may prompt certain U.S. real property owners to reconsider their portfolio disposition strategies.  

Finally, it is difficult to talk about tax reform in the private alternative investment community without discussing the issue of “carried-interest.”  As mentioned above, provided the underlying real estate investment generating long-term capital gain was held for more than three years, the carried interest allocation of the capital gain will retain its long-term capital gain character in the hands of the fund sponsor.  Fortunately, in most cases, the value created by fund managers during the typical real estate investment continuum occurs over an investment holding period of three years or more. 

The commercial real estate industry, on a standalone basis, has fared well under the Act and remains comparably tax advantageous in comparison with many other investment sectors.  Aside from certain ancillary changes to the deductibility of state and local taxes and tax incentives for homeownership, we believe there are substantial benefits that were either retained or created by the Act for real estate investors, owners, and operators.  In our view, the most significant real estate related items that the Act provides are the:

• Deduction of up to 20% of qualifying pass-through business income that may apply to certain real estate related income 
• Potential for full deductibility of business interest that is available to an electing “real property trade or business”
• Continued ability to defer the recognition of gain in a like-kind exchange of real property
• Retention, and in some cases, improvements to the property cost recovery rules, contrasted with the requirement for real property businesses that elect out of the business interest limitation rules to use ADS depreciation for real property assets

Taxpayers owning or operating commercial real estate should analyze the impact of the Act in relation to existing and pending investments, business strategies, and entity structures.  As we move into 2018, the effective dates of these provisions become immediately relevant, requiring quick analysis to evaluate the tax issues and opportunities that may require the execution of structural changes.