United States

Key tax issues for real estate investors under new tax legislation

INSIGHT ARTICLE  | 

The final tax bill agreed to by the House and Senate conferees makes several significant changes for real estate investors. Assuming an individual taxpayer in the highest marginal rates, here is a summary of the key provisions.

Tax rates may come down for top bracket investors

Today, net income from rents is taxed at 39.6 percent, plus a 3.8 percent Affordable Care Act (ACA) tax for passive investors. All in that is 43.4 percent for passive investors, 39.6 percent for active investors.

Under the final bill, investors qualifying for the new 20 percent deduction, net income from rents would effectively be taxed at 29.6 percent, plus the 3.8 percent ACA tax for passive investors. All in, that is 33.4 percent for a passive investor and 29.6 percent for an active investor–approximately a 10 percentage point reduction.

Many real estate investors should qualify for the 20 percent deduction. But income that does not qualify–such as rental income on land in many cases–would be taxed at the top marginal income tax rate of 37 percent, plus the 3.8 percent ACA tax for passive investors for a top, all-in tax rate of 40.8 percent.

In order to qualify for the full 20 percent deduction, the business must either pay a minimum amount of wages–generally twice the desired deduction–or have a minimum investment in tangible, depreciable property used in the trade or business–such as a building–but not including such items as land or inventory property. The rules can best be understood with several examples:

  1. Assume that a nondepreciable, equity-financed parking lot purchased for $1,000 generates $140 of gross income before paying its employees $40 for net income of $100–a return of 10 percent. The 20 percent deduction would be $20 and would be fully allowable because it was no more than 50 percent of the company’s wages of $40. Thus, only $80 of the $100 would be taxable at whatever rate was applicable.
  2. If the same investment were debt financed, of course, there would be interest expenses and the amount of net income would be reduced, along with a reduction in the 20 percent deduction. That smaller deduction would clearly meet the wage test in this case.
  3. If the same $40 were paid to independent contractors, no benefits would be available because payments to independent contractors do not count as wages. In that case, the full $100 of net income would be taxable.
  4. However, if the endeavor purported to pay wages of $30 to the owner, the net income remaining would be $70 and a 20 percent deduction of $14 would appear to meet the wage test, because it was less than 50 percent of total wages paid. The owner’s income would be the sum of $30 of wages and $56 of qualified business income. In effect, there would be a 14 percent deduction instead of a 20 percent deduction. It is not entirely clear if this approach will pass muster, however.
  5. Even if no wages were paid, if the facility was not a parking lot but was a fully automated depreciable parking structure (on leased land) originally purchased for $1,000, and it generated the same $140 of gross income and $100 of net income after paying $40 to independent contractors to maintain the facility, the 20 percent deduction would be the same $20. It would be fully allowable, exposing only $80 to tax. This is because $20 did not exceed 2.5 percent of the $1,000 original purchase price (unadjusted basis) of the structure–which in this case would be $25.
  6. Again, if the investment was debt financed and incurred interest deductions, the amount of net income would be reduced, as would the 20 percent deduction. It appears that the 2.5 percent of purchase price allowance would not be reduced, even if the property was purchased with debt, including nonrecourse debt. Thus, there would appear to be even more leeway to enjoy the deduction of 20 percent of net income.
  7. Even if the structure was in the process of being depreciated, the $1,000 “base” on which the 2.5 percent allowance is calculated would not be reduced by any depreciation deductions (the base is the property’s “unadjusted” basis) until the expiration of the useful life of the property (e.g., 39.5 years) or 10 years, whichever is longer. The property would need to continue to be used in the taxpayer’s trade or business.

As can be seen, a real estate investment would have to be very profitable before 20 percent of its net income was more than 2.5 percent of the original, unadjusted cost basis of the underlying tangible property. The 2.5 percent rule is tantamount to viewing a “normal” return on invested capital to be 12.5 percent. That is, if 20 percent of net income is supposed to approximate 2.5 percent multiplied by the asset’s original cost, the ostensible “normal” return on the asset’s original cost would appear to be 12.5 percent. Note also that the taxpayer is allowed to use, as a limit, the sum of 2.5 percent of assets and 25 percent of wages.

Finally, note also that for investors with joint incomes below $315,000 or single filers below $157,500, the wage or asset requirements would not apply. That benefit is phased out quickly, however, as income increases to $415,000/$207,500.

Based on the examples described below and the potential for 'grouping' as described in the Section 199A regulations, the costs to comply with these rules will likely increase at the entity and individual level to provide investors with information needed to be eligible for the deduction described above.

REITs are big winners under tax reform

The wage or asset requirements described above would not apply to shareholders receiving a share of real estate rental income through real estate investment trusts (REIT) as ordinary REIT dividends. Assuming that the REIT meets the same income and asset test requirements as in place today, those ordinary dividends would automatically qualify for a 20 percent rate reduction in the hands of the shareholder. All in, REIT ordinary dividends would be taxed at an all-in rate of 33.4 percent. This is significantly better than the 43.4 percent maximum tax rate on ordinary REIT dividends under current law.

In addition, this treatment appears to apply to mortgage REITs that pool and collect interest income from real estate mortgages.

Thus, for example, a REIT owning parking lots operated by independent contractors, and accordingly not paying any wages, could pass through its net income to REIT investors, who would be eligible for a 20 percent of income deduction, even though the REIT did not have any investments in depreciable property and did not pay any wages.

In addition, a restriction in the bill on getting the benefits for businesses that provide services in certain professional fields–such as health–would not apply to REITs–and thus could not cause a health-care REIT to be disqualified.

Active losses limited

Under a set of provisions that are still quite unclear in scope and meaning, active losses would be subject to new limitations, limiting their ability to be used against wage or fee income or portfolio income.

Interest expense still deductible, but depreciation may change

Most real estate investments are heavily debt financed. Under current law, business interest is fully deductible. Under the final bill, new limits are imposed on business interest deductions of corporations and pass-through businesses that do not qualify for a small taxpayer exception.  However, real estate trades or businesses can irrevocably elect to be exempt from those rules. In exchange, more restrictive depreciation rules will apply. In general, the owners must use 30-year straight line depreciation (not the otherwise applicable 27.5-year rule) for residential real property and 40-year straight line (not the otherwise applicable 39-year rule) for nonresidential real property, with other rules for specific items.

For real estate trades or businesses that do not elect out of the business interest limitations, the rules will generally limit net interest deductions to 30 percent of earnings before interest. For the first four years after enactment (tax years after Dec. 31, 2017, and before Jan. 1, 2022) that rule will be applied also adding back amortization and depreciation to make it equivalent to a 30 percent of EBITDA rule, not 30 percent of EBIT. After that period going forward, the EBIT rule will apply. Interest that is disallowed will generally be carried forward indefinitely and may be used in later years if it satisfies the applicable standard for that year. However, there is an exemption from the limitation for taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million.

Like-kind exchanges preserved for real estate and opportunity zone language added

The allowance of tax-free “like-kind” exchanges of rental real estate is preserved under section 1031 of the tax code.   

The TCJA also enacted additional legislation for investors looking to defer and exclude certain items of capital gains with the introduction of Qualified Opportunity Zones

Changes to carried interest

Under current law, capital gains passed through to holders of profits interests received for the provision of services (so-called “carried interests”) are treated like all other capital gains.

Under the final bill, carried interests in certain activities–general, private equity, real estate private equity, hedge funds and similar enterprises–would only get capital gains treatment if the assets generating the gain were held for a 3-year holding period, longer than the 1-year holding period of current law. It appears that this rule applies to the asset generating the gain, whether it be a partnership interest or the underlying assets.

It may be appropriate to consider possible structural or deal modifications to maximize after-tax benefits under this rule.

Please see the chart below for details of how tax treatment under current law differs from the conference report for several key areas impacting real estate investment.

Issue

Previous law (2017)

Tax Cuts and Jobs Act

A business where the pass-through deduction would apply

39.6 percent + 3.8 percent net investment income tax

29.6 percent (37 percent marginal rate with 20 percent reduction of pass-through income*) + 3.8 percent net investment income tax

A business where the pass-through deduction would not apply (excluding self-employment tax)

39.6 percent + 3.8 percent net investment income tax

37 percent + 3.8 percent net investment income tax

Interest expense

Fully deductible

Can elect out of 30 percent of EBITDA/EBIT interest limitations and fully deduct. Limited interest expense deductions can be generally carried forward indefinitely

Depreciation expense

27.5 years for residential real property, 39 years for nonresidential real property

Same as current law unless electing out of 30 percent interest limitation–depreciable lives would then be 30 years for residential and 40 years for nonresidential real property  

Bonus depreciation

50 percent deduction allowed for most original use assets besides buildings

100 percent for certain assets

Highest marginal capital gain tax rate on real estate sale income

20 percent + 3.8 percent net investment income tax

20 percent + 3.8 percent net investment income tax

Carried interest (for distributive items of long-term capital gain)

20 percent + 3.8 percent net investment income tax (1-year hold required)

20 percent + 3.8 percent net investment income tax (potential 3-year hold would be required)

Corporate tax rate on all real estate related income

35 percent

21 percent (starting in 2018)

REIT ordinary dividend income

39.6 percent + 3.8 percent net investment income tax

29.6 percent (37 percent marginal rate with 20 percent reduction of pass-through REIT income) + 3.8 percent net investment income tax

REIT and corporate net operating losses (NOL) carryforwards

100 percent (90 percent for AMT)

80 percent and indefinite carryforward (no carrybacks allowed); corporate AMT repealed

Active loss limitations offsetting other income items

No limitations

Single taxpayers limited to $250,000, married filing joint taxpayers limited to $500,000 and carried forward

1031 exchanges

Real and personal property allowed for like kind exchanges

Only real property allowed for like kind exchanges

*Note: The highest marginal tax rate on pass-through rental income is subject to two tests (the greater of a 50 percent of W-2 wages test or a 25 percent of W-2 wages + 2.5 percent of unadjusted basis in qualified property). This analysis assumes that the taxpayer would have a large enough share of allocated basis in qualified property to be eligible for the full 20 percent pass-through rate reduction. Neither of the above two tests apply to REITs that otherwise meet the REIT requirements.


additional insights

FAQ: Real estate investors and tax reform

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The following is a list of frequently asked questions and answers about how the new tax law will impact real estate investors.

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Tax reform and your business

How might the Tax Cuts and Jobs Act affect your business and tax planning? Follow our insights on the sweeping changes to tax legislation.

Understanding the benefits of opportunity zones

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The TCJA established Opportunity Zones for taxpayers to invest proceeds from property sales in a fund to defer capital gains tax.

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