United States: The Effects Of The Tax Cuts And Jobs Act On Real Estate

On Friday December 22, 2017, President Trump signed into law H.R.1, commonly referred to as the Tax Cuts and Jobs Act (TCJA). This is the most sweeping change to the U.S. federal income tax laws in over three decades, and it will have an effect on every U.S. taxpayer, including real estate investment trusts (REITs) and taxpayers engaged in the real estate business. The purpose of this blog is to focus on some of the provisions of the TCJA that we believe will significantly impact the real estate industry. For background and a more detailed discussion of the TCJA provisions generally, please see, House of Representatives and Senate Conferees Reach Agreement on the Tax Cuts and Jobs Act (H.R. 1).

Corporate tax rate lowered to 21 percent; corporate alternative minimum tax repealed

The TCJA changes the corporate tax rate from a graduated scale with a 35% maximum rate to a flat 21% corporate rate and repeals the corporate alternative minimum tax (AMT), effective for tax years beginning on January 1, 2018. Although many real estate businesses are organized as pass-throughs, large corporate real estate operating companies will benefit greatly from this provision alone. Unlike many of the provisions discussed below, this rate reduction is permanent.

Individual tax rates and state and local income tax deduction limited; individual AMT retained

The TCJA reduces the top individual tax rate from 39.6% to 37%, effective January 1, 2018 (there are some adjustments to the brackets as well). There are no changes to the current 20% maximum rate for net long-term capital gains (including qualified dividend income) and the 25% rate applicable to unrecaptured gain under Section 1250 of the Internal Revenue Code of 1986, as amended (Code), as well as the 28% rate on 28%-rate gain. The 3.8% surtax on net investment income is also retained under the TCJA.

The reduction in rates comes at the cost of eliminating or limiting certain deductions. In states that impose a high income tax rate, one of the most costly limitations is the $10,000 cap on the itemized deduction of state and local income and property taxes. It is important to realize however that property taxes that are incurred in the operation of a real estate business are not affected by this limitation.

The reduction in individual tax rates and the cap on the state and local tax deduction expire after December 31, 2025.

The TCJA retains the individual AMT, but increases the individual AMT exemption amount to $109,400 for married taxpayers ($70,300 for single taxpayers) from $84,500/$54,300 under prior law, and increases the AMT exemption phase-out to $1,000,000 (joint filers) and $500,000 (all other taxpayers) from $160,900 and $120,700, respectively.

Pass-through business deduction

Subject to limitations discussed below, the TCJA provides for a maximum effective tax rate of 29.6% on an individual's domestic "qualified business income" from a partnership, S corporation, or sole proprietorship. The reduced maximum rate arises from a 20% deduction ([100% – 20%] x 37% top individual marginal rate = 29.6%). Qualified business losses carry forward to the next tax year and reduce the amount of qualified business income included in determining the amount of the deduction for that year.

Qualified business income is net income and gain arising from a "qualified trade or business." A qualified trade or business is generally any business other than certain service businesses, referred to as "specified service trades or businesses." Importantly, since most "specified service trades or businesses" do not include traditional real estate businesses, a qualified business should include a trade or business of the renting of real property and real estate development. Accordingly rental income and ordinary income from real estate development should now be subject to the new maximum 29.6% rate. However, rental income from the triple-net leasing of real estate is not generally considered a trade or business and would not be entitled to the 29.6% pass-through rate, unless the real estate is held through a REIT, as described below.

"Qualified business income" must be income that would be treated as effectively connected with a U.S. trade or business if earned by a non-U.S. person, and does not include certain forms of "investment" income (e.g., capital gain, most dividends, and interest that is not allocable to a qualified trade or business). Thus, real estate rental income will qualify for the 29.6% rate; long-term capital gain income will continue to be taxable at 20%, and short-term capital gain will now be taxable at the maximum 37% individual rate.

The deduction for qualified business income is effective for taxable years beginning after December 31, 2017 and sunsets after December 31, 2025.

The amount of the deduction available to a taxpayer from a partnership, S corporation or sole proprietorship cannot exceed the greater of (a) 50% of the taxpayer's share of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all "qualified property." "Qualified property" is defined as depreciable tangible property that is held by and available for use in a qualified trade or business at the close of the taxable year and is used in the production of qualified business income for the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date or (b) the last day of the last full year of the applicable recovery period that will apply to the property under Code Section 168 (without regard to Code Section 168(g)). This period is the "depreciable period."

As a result of the new test, the owners of a pass-through business with no employees that is engaged in a qualified trade or business can benefit from the deduction (and the 29.6% effective rate) with respect to a return of up to 12.5% per year on its investment in depreciable tangible property. To illustrate, a taxpayer with a $10,000x qualified property investment will be eligible for a deduction of up to $250x (2.5% of $10,000x). If the taxpayer earned a 12.5% return on its capital investment, resulting in qualified business income of $1250x (12.5% x $10,000x), the taxpayer could deduct 20% of the entire return (20% x $1250x = $250x) without exceeding the cap, thereby being taxed at a maximum effective rate of 29.6% on the $1250x.

The W-2 wage/qualified property limitation will not apply to individuals with taxable incomes at or below $315,000 for married individuals filing jointly or $157,000 for single individuals, but will phase-in completely over the next $100,000 or $50,000, as applicable, of taxable income. Qualified business income earned through a publicly traded partnership and otherwise eligible for the deduction, as well as REIT dividends (discussed below) also will not be subject to the limitation.

Business interest expense limitation – exception for real estate business

Under the TCJA net business interest deductions are generally limited under Code Section 163(j) to 30% of a taxpayer's adjusted taxable income, which before January 1, 2022 is calculated under a formula similar to earnings before interest, taxes, depreciation, and amortization ("EBITDA"), and on after January 1, 2022 under a formula similar to earnings before interest and taxes ("EBIT"). "Business interest" includes any interest paid or accrued on indebtedness "properly allocable to a trade or business" but does not include "investment interest" (as defined in Code Section 163(d)). To the extent a business is subject to the interest deductibility limits, the TCJA allows the disallowed interest to be carried forward indefinitely. The changes are effective for taxable years beginning after December 31, 2017 through taxable years ending on December 31, 2025.

Most importantly for the real estate industry, real property development, construction, rental property, or similar businesses (including REITs), may elect out of this limitation (although making such an election will impact depreciation and the applicability of the new expensing provisions described below). The limitation also does not apply to taxpayers with average annual gross receipts of $25 million or less for the three-taxable year period ending with the prior tax year.

Depreciable lives of real property modified

Under the TCJA, the recovery period for all "qualified improvement property" (which now includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) is standardized at 15 years. The TCJA preserves cost recovery periods under MACRS for residential rental and nonresidential real property at 27.5 years and 39 years, respectively. The "alternative depreciation system" ("ADS") recovery period for qualified improvement property is 20 years. The ADS recovery period for nonresidential real property remains at 40 years, but the ADS recovery period for residential rental property is shortened to 30 years.

The TCJA requires a real estate business that elects to be excluded from the interest deductibility limitations described above to utilize the ADS recovery periods with respect to its depreciable real property. As modified under the TCJA, this would mean that a real estate business electing out of the interest deductibility limitations would be required to use a recovery period of 40 years for nonresidential real property, 30 years for residential rental property and 20 years for qualified improvement property.

Expensing of business assets; other cost recovery changes

The TCJA expands and extends the additional first year depreciation provision under Code Section 168(k) to allow for 100% immediate expensing of the cost of certain business property placed into service after September 27, 2017 and before January 1, 2023. Code Section 168(k) continues to apply only to MACRS property with a depreciable life of 20 years or less, water utility property, computer software and qualified improvement property. Beginning in 2023, the immediate first-year expensing will be reduced to 80%, followed by 60% in 2024, 40% in 2025, 20% in 2026, and reduced to 0% thereafter. A transition rule in the TCJA allows taxpayers to elect to expense 50% of the cost of eligible business property rather than the full 100% for their first tax year beginning after September 27, 2017.

Immediate expensing will be available only to taxpayers subject to the net interest deduction limitation in Code Section 163(j) (described above). Therefore, real estate-related businesses electing out of Code Section 163(j) will not be entitled to immediate expensing under this provision.

Under amended Code Section 179, the TCJA allows immediate expensing for up to $1,000,000 of the cost of qualifying tangible personal property placed into service after December 31, 2017, an increase from the $500,000 cap under current law, and expands the definition of qualified real property eligible for Code Section 179 expensing to include certain improvements (e.g., roofs, heating, and alarms systems) made to nonresidential real property after the property is first placed in service. This benefit is reduced (but not below zero) to the extent the value of qualifying property placed into service during a taxable year exceeds $2,500,000 for the tax year (compared to $2 million under current law). These changes take effect for tax years beginning after December 31, 2017 and will be permanent. Unlike Code Section 168(k) described in the paragraph above, real property businesses can use this provision for immediate expensing even if they elect out of the net interest deduction limitation in new Code Section 163(j) (described above).

Limitation on losses for taxpayers other than C corporations

For taxable years beginning after December 13, 2017 and before January 1, 2026, "excess business losses" will not be allowed for a taxable year but must be carried over as part of that taxpayer's net operating loss. "Excess business losses" are defined as losses attributable to the taxpayer's trades or businesses in excess of $500,000 for married individuals filing jointly or $250,000 for other individuals. The provision is applied at the partner or shareholder level for partnerships and S corporations. This provision applies after the application of the passive loss rules.

The effect of this provision is to limit a taxpayer's ability to use losses from a non-passive business activity to offset other sources of income. This will directly affect any real estate professional who used more than $500,000/$250,000 of real estate losses to offset unrelated income.

Extended 3-year holding period required for partnership interests transferred for services

Under the TCJA, individual holders of partnership interests transferred to, or held by, a taxpayer in connection with the performance by that taxpayer (or a related party) of substantial services for an any "applicable trade or business," commonly referred to as "carried interests," must satisfy a 3-year holding period to qualify for long-term capital gains rates. An "applicable trade or business" is one that is conducted on a regular, continuous, and substantial basis (and may include activity by multiple entities) and consists of the development of real estate held for rental or investment or certain other specified assets or the investment in and/or disposition of real estate held for rental or investment or other specified assets (including identification of specified assets for investment and/or disposition).

The 3-year holding period will apply to allocations of income relating to the sale or other disposition of assets held by the partnership as well as transfers of partnership interest itself. The provision does not apply to profits interests held directly or indirectly through a corporation, apparently including S corporations. Thus, this carried interest provision seems to be avoidable by holding the carried interest through an S corporation. However, a technical correction (or possibly regulations) could change this result retroactively.

Like-kind exchange treatment of real property preserved

The TCJA limits non-recognition treatment under Code Section 1031 only to like-kind exchanges of real property. However, the TCJA repeals the deferral of gain for all other types of property. Because personal property is now excluded from Section 1031 exchanges, there could be gain recognition in Section 1031 exchanges of real property that include a significant personal property component, such as restaurants and hotels.

Changes to rehabilitation credit

The TCJA limits the rehabilitation tax credit to certified historic structures for amounts paid or incurred after 2017. Although the credit for certified historic structures remains at 20%, it must be claimed ratably over a five-year period beginning in the taxable year in which the qualified rehabilitated structure is placed in service. The TCJA includes a transition rule that applies to all properties (whether historic or not) owned or leased by the taxpayer as of December 31, 2017 if the 24 month period selected by the taxpayer to cover expenses by the credit (or the 60 month period if applicable under the statute) begins no later than 180 days after date of enactment of the TCJA.

Net operating Loss deductions limited

The TCJA limits deductions for net operating losses ("NOLs") to 80% of taxable income for any taxable year (90% in connection with NOLs related to excess business losses discussed above). NOLs will no longer expire after 20 years but will be carried forward indefinitely to future tax years. However, the current two-year carryback of NOLs will no longer be available to most taxpayers.

Reduced FIRPTA withholding tax rate applicable to REIT capital gain distributions

Under the TCJA, transactions that were subject to a 35% withholding tax rate under the Foreign Investment in Real Property Tax Act (FIRPTA), including capital gain dividends and liquidating distributions paid by REITs, are now subject to FIRPTA withholding at the highest corporate tax rate in effect for the taxable year, which is 21% effective January 1, 2018.

REITs

REITs are treated quite favorably under the TCJA. The most important changes that affect REITs specifically are:

  • Ordinary REIT dividends (i.e., dividends that are not declared as capital gain dividends or qualified dividend income) are entitled to the 20% pass-through deduction discussed above. However, these REIT dividends are not subject to the wage/capital limitation. Accordingly, noncorporate taxpayers would be subject to a maximum effective tax rate on ordinary REIT dividends of 29.6% (or 33.4% including the 3.8% surtax on net investment income). However, it is possible that noncorporate investors in UPREITs and DownREITs who are invested in the operating partnership rather than the REIT itself would be subject to the wage/capital limitation on the pass-through deduction and may be subject to tax at a higher rate on ordinary income allocated to them by the operating partnership than investors in the REIT who would receive the same income in the form of an ordinary REIT dividend. The pass-through deduction is also available for REIT dividends received from mortgage REITs, but is not available for interest on a mortgage held directly. Therefore, mortgage REITs should become the preferred vehicle for investing in real estate mortgages. The taxation of capital gain dividends and qualified dividend income from REITs has not changed. Finally, the benefit of the reduced tax rate on ordinary REIT dividends will sunset for tax years beginning after December 31, 2025.
  • Hard asset REITs generally would be entitled to elect out of the interest expense limitation discussed above. Mortgage REITs generally would not be subject to the interest expense limitation because they do not have net interest expense. If a REIT elects out of the interest expense limitation, it will not be able to benefit from the immediate first-year expensing discussed above, and it will be required to use the revised ADS recovery periods for depreciation discussed above. However, because residential rental property and nonresidential real property are not eligible for immediate expensing in any case, the main impact of electing out of the interest expense limitation, other than having to use the ADS recovery periods, would seem to be the loss of the ability to immediately expense qualified improvement property.
  • REITs, as corporate taxpayers, are subject to tax at corporate rates on any income they do not distribute in a tax year to their shareholders. Accordingly, REITs that do not distribute 100% of their taxable income in any year will be taxed as the new lower corporate tax rate of 21% on any undistributed income.
  • REITs are subject to the changes to NOLs discussed above and benefit from the repeal of the corporate AMT. However, in order to determine the 80% annual limit for a REIT, the TCJA reorders the application of the dividends paid deduction ("DPD") in determining the REIT's "REIT taxable income." Accordingly, a REIT's taxable income for this purpose is its "REIT taxable income" prior to the application of the DPD. Absent this change, REITs would have calculated the limitation after the DPD, which would have had the effect of even further reducing the utilization of NOL carryforwards.
  • Capital gain dividends and liquidating distributions paid by REITs to non-U.S. shareholders generally are treated as the sale of U.S. real property interests, and therefore, as effectively connected income under FIRPTA. As discussed above, the TCJA reduced the FIRPTA withholding rate on these types of distributions from 35% to the highest corporate tax rate in effect for the taxable year, which is now 21%.

The Effects Of The Tax Cuts And Jobs Act On Real Estate

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions