FAQ: Real estate investors and tax reform
INSIGHT ARTICLE |
The tax law changes commonly referred to as the Tax Cuts and Jobs Act (TCJA), signed into law on Dec. 22, 2017, stands to be the most significant overhaul of U.S. tax policy since 1986. With most tax reform provisions already in effect as of the first of the year, it’s crucial that middle market real estate investors understand the key provisions that may affect their business operations. The following is a list of frequently asked questions and answers for real estate investors.
Q: Is it even worth planning anything or will the law be revised again in the near future?
A: Changes are always possible, but the core elements of the 2017 law are stable enough and significant enough to make it worthwhile to consider substantial efforts to maximize your benefits and minimize any detriments.
There are several planning opportunities that may be cost effective and provide significant savings:
- Cost segregation: As described below, 100 percent expensing of tangible personal property, for both new and previously owned assets, creates an immediate opportunity for tax savings. A cost segregation study involves an expert review of all features of the property, from what is on the floor to what is in the walls, to identify components of assets that can be eligible for faster depreciation. An objective report is provided upon completion of the study.
- Entity choice evaluation: The lower corporate tax rates are a “permanent” change to the tax law, meaning that there are no sunset provisions. Congress must affirmatively act to change the rates again. The rate has been slashed from 35 to 21 percent, although additional individual taxes are due upon a distribution of corporate earnings. If a company has not re-evaluated its entity choice recently, now is a good time to do so, as described more fully below. Note that for investors subject to the net investment income tax and/or self-employment taxes, those taxes remain in effect after tax reform. Consideration of those taxes could also affect the decision of which structure will achieve maximum tax efficiency. In particular, different types of pass-through entities are taxed differently under the self-employment and net investment income taxes.
Q: Will I still receive capital gains treatment for my carried interest or will that change?
A: Under the TCJA, there is a new requirement to hold a “capital asset” for three years before a promote partner can reap the benefit of capital gains tax rates. However, as with most of the new law, there is uncertainty as to how it will apply to certain transactions. As currently written, it appears that so-called “trade or business assets” that are not “capital assets” but enjoy capital gains treatment under section 1231 are exempt from the “three year hold” rule. Whether or not this remains an exception is unclear. While we await guidance, RSM’s leading experts have begun to analyze what they anticipate the final guidance will be.
Q: What part of the new tax legislation could have the most significant tax impact on real estate investment?
A: There are several items in the legislation that will impact real estate investors, such as broader bonus depreciation, the preservation of like-kind exchanges for real estate, and new opportunity zone gain deferrals.
For investments in real estate partnerships with operating income, the new 20% deduction on pass-through income may be a game changer. The provision provides that if you have an investment in an entity with $100 of qualified business income, you could end up only being subject to tax on $80. This brings the tax rate for an individual from 37 percent to about 29.6 percent.
However, many real estate investments generally operate at a taxable loss – in this case there will not be much of a difference from prior law, especially given the fact that capital gain rates did not change as a result of tax reform.
This new pass-through deduction was put in place to try to level the playing field between pass-through entities and corporations, given the new lower corporate tax rates.
Q: Is there anything I should be thinking about from a tax structuring perspective for a management company?
A: Depending on how much profit is distributed on an annual basis from a management company and the company’s ownership, it may be worthwhile to re-evaluate a management company’s choice of entity, given the new lower corporate tax rates. If the company retains most of the profits for reinvestment and is closely held, the after tax cash flow for a corporate entity may exceed that of a management company held via a pass-through structure.
How a company’s fees are defined in operating agreements becomes much more important under the new tax law. For a management company, some or all of the income earned may be considered to be from a “specified service trade or business.” This means that the income may not qualify for the 20 percent pass-through deduction.
A “specified service trade or business” is any trade or business involving the performance of services in the fields of health, law, accounting, consulting, 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 management, or trading or dealing in securities. It is thought that Congress intended engineering and architectural services not to be treated as a “specified trade or business.”
There is an important distinction when it comes to the source of a management company’s fees. If the fees are for real property management, as opposed to the management of a securities or investment portfolio, this income may be eligible for the 20 percent deduction.
Other management company tax issues that have changed as a result of tax reform include:
- The deductibility of meals and entertainment expenses
- Fringe benefits
- Immediate deductibility of capital improvements
Q: What are some potential planning opportunities to benefit from the new tax law when acquiring an asset?
A: The bill presents many new opportunities compared to prior law for those investing in real estate assets. Bonus depreciation was increased from 50 percent to 100 percent of the purchase price of assets with a shorter recovery life, and it is now extended to those buying assets previously used by other taxpayers, as opposed to including solely assets whose first use was by the taxpayer.
As described earlier, it is now more valuable than ever for investors purchasing real estate to consider cost segregation studies. A cost segregation study will help provide objective support to allocate a portion of the purchase otherwise allocated to real estate to land improvements and personal property, which may qualify for 100 percent bonus depreciation.
This write-off upon acquisition provides a significant tax deferral for investors.
A cost segregation study can be valuable for nearly every type of real estate asset. Other items for buyers of real estate assets to consider are purchase price allocations with the seller and appraisals to support a breakout between land and depreciable property. These items also have increased importance as a result of TCJA.
In certain acquisitions with related party implications, obtaining a transfer pricing study for cost-sharing may be important to properly report activity from a real estate investment for tax purposes. It is more important than ever to consult with your tax advisors when considering a real estate investment to look for planning opportunities based on the desired goals of the investors.
Q: What are some drawbacks of the bill from a real estate perspective?
A: One of the most significant changes in the new law is the new interest expense limitation imposed on most taxpayers, other than those who qualify for a small taxpayer exception. However, for certain real estate trades or businesses, the law allows for the continued deductibility of interest expense -- but for a price.
If a qualifying taxpayer makes an irrevocable election to be treated as a real estate trade or business, the depreciable recovery life on assets will increase (a requirement to use the Alternative Depreciation System, or ADS). As an example, a new residential rental building purchased by the taxpayer would be required to be depreciated over 30 years instead of 27.5 years, and a new non-residential rental building purchased by the taxpayer would be required to be depreciated over 40 years instead of 39.
While these changes do not appear to have a significant impact on any particular prospective asset purchase, the rules also require existing assets of an electing taxpayer to change to longer recovery periods, which can result in significantly less depreciation expense on the taxpayer’s overall portfolio of properties.
There are a couple of other drawbacks for real estate:
- Disallowance of portfolio deductions: For taxpayers that hold real estate for investment either directly or through a corporate entity such as a REIT, certain expenses that are paid, including management fees, could lose their deductibility compared to prior law with the suspension of portfolio deductions. For certain real estate investments it may be worth revisiting the structure to determine if expenses are being taken by the correct entities and if there is any flexibility to make adjustments to ameliorate these effects. As discussed earlier, a transfer pricing study could provide strong support for a cost-sharing arrangement.
- Cap on the deductibility of taxes for homeowners: In certain situations, the tax benefits of home ownership have been reduced as a result of the legislation. The deductibility of itemized deductions such as mortgage interest and real property taxes has survived, but new caps have been put in place that will limit the federal tax benefits for certain taxpayers. Additionally, the standard deduction that taxpayers can enjoy without itemizing deductions has increased substantially. In this way the relative benefits of homeownership, compared to renting have arguably been reduced.
Q: Are there any areas of real estate investment with greater opportunity compared to prior law?
A: While the tax benefits of personal home ownership may have decreased, the tax benefits of buying homes as rental properties have increased. Buyers of rental homes and apartments are able to fully deduct mortgage interest (subject to the aforementioned business interest limitations described earlier) and real estate taxes. Certain improvements made to the homes can now be immediately expensed, and all or a portion of the net rental income may be eligible for the 20 percent deduction from taxation.
For those looking to invest in real estate assets, REITs may be more attractive. An investor’s REIT income that would have previously been a dividend taxed at the highest marginal tax rate now is eligible for the 20 percent deduction in most situations, resulting in greater after tax returns for prospective investors.
Q: If I am a developer selling ‘inventory’ or ‘dealer property’, how does the bill impact me?
A: Depending on the investor mix and desired goals for the business, it may be worth revisiting choice of entity, as mentioned above. Real estate developers who would consider reinvesting profits in other properties may find a corporate structure more appealing as a result of the TCJA decreasing the corporate rate to 21 percent from the prior 35 percent rate, which could allow for increased after-tax cash invested in future assets in certain circumstances compared to a flow-through structure.
Investors in non-depreciable inventory property via a flow-through structure may be less likely to share the benefits of the 20 percent pass-through deduction than other real estate owners. Income earned from the sale of inventory property is earned at ordinary tax rates (currently 37 percent + 3.8 percent net investment income tax as applicable) for a total effective federal tax rate of 40.8 percent prior to the application of state taxes.
Q: How did REITs come out in the new tax bill compared to prior law?
A: REITs appear to be a big winner of the bill compared to prior law. While rental income earned directly or via a flow through structure must meet certain qualifications related to levels of income, wages, and depreciable property to be eligible for the 20 percent deduction, ordinary dividend income earned directly through REITs automatically qualifies as eligible for the deduction as long as it otherwise meets the REIT tests.
This favorable provision towards REITs appears to also apply to mortgage REITs that generate interest income from real property loans. This interest income earned by a mortgage REIT would be converted to a dividend subject to the 20 percent deduction for the investor. Lenders with a diversified ownership structure may be more likely to consider having a REIT in their structure compared to prior law.