The Tax Cuts and Jobs Act (the “Act”) that generally is effective for tax years beginning after Dec. 31, 2017, will affect the tax treatment of real estate businesses in various ways. Below are some of the more significant changes likely to affect the real estate industry:
- Availability of reduced tax rate on ordinary income from pass-through businesses. Under the Act, “qualified business income” (generally ordinary income from a trade or business) that a pass-through business generates is eligible for a 20% deduction. In a late change, the new 20% deduction became more available to income from real estate operations by expansion of the limitation on the deduction for income above threshold levels (beginning at $157,500 for single filers and $315,000 for joint filers) beyond the original proposed limitation of 50% of the wages the business pays to employees. Instead, in a benefit to capital intensive businesses, such as real estate, the Conference Committee expanded the amount eligible for the 20% deduction to the greater of (i) 50% of wages paid, or (ii) the sum of 25% of wages paid plus 2.5% of the acquisition costs of tangible depreciable property (during the longer of 10 years or the property’s depreciable life). Furthermore, 20% of any qualified REIT dividends, qualified co-operative dividends and qualified publicly traded partnership income qualify for the deduction.
- Limitation on interest expense deductions can be avoided. The Act imposes on certain businesses (generally any entity with average gross receipts of more than $25,000,000) a limitation on interest expense deductions equal to the sum of business interest income and 30% of adjusted taxable income (excluding deductions for depreciation, amortization or depletion prior to 2022). However, real estate businesses can avoid this limitation by depreciating residential rental property over 30 years under the ADS system instead of the customary 27.5 years and depreciating commercial real property under the ADS system over 40 years instead of the customary 39 years. Thus, real estate businesses can avoid the interest expense limitations by electing slightly longer depreciation periods for real property.
- Retention of like-kind exchanges. Although the Act eliminates like-kind exchanges for personal property, the Act continues to permit like-kind exchanges for real property that is not held primarily for sale.
- Certain carried interests are subject to a new three-year holding period. In the case of real estate equity funds and sponsors that generally raise capital from investors, any carried interest received in a partnership (or LLC taxed as a partnership) engaged in the activity must be held for more than three years (rather than the typical one-year holding period) to obtain capital gain treatment on sales of those interests or on any gain allocated to the sale of the underlying real estate assets.
- New limitations on losses. If net losses from all trades and businesses of a taxpayer filing jointly are greater than $500,000 ($250,000 for other filers), the excess loss cannot be used to offset other income but instead must be carried over to future years. Note, the Act further limits the NOL deduction in any future year to 80% of taxable income in that future year.
- Historic tax credit retained, but in slightly less favorable form. The 20% rehabilitation tax credit for certified historic structures is retained but now must be taken ratably over five years (instead of immediately upon the year placed in service). The Act repeals the 10% credit for non-certified structures.
- New 15-year recovery period for qualified improvement property. The Act adopts a 15-year recovery period for “qualified improvement property,” which essentially combines and expands the 15-year recovery period that previous law provided for “qualified leasehold improvement property,” “qualified restaurant property” and “qualified retail improvement property.” Qualified improvement property generally is any improvement to the interior of non-residential real property.
- New market tax credits are not affected by the Act.
- Favorable tax treatment for investments in qualified opportunity funds. The Act provides temporary deferral in certain cases of capital gains that are reinvested in a qualified opportunity fund (investment vehicle for the purpose of investing in property located in certain state-designated low-income areas) A permanent exclusion of capital gains from investing in such a fund is also available in certain cases.
- More government subsidies are likely to be taxable. As discussed in more detail in a separate alert, the Act generally repeals the nontaxable treatment of contributions to capital that government entities make to corporations for development purposes.
Members of Taft’s Tax practice are available to discuss in more detail planning opportunities and issues arising from the Act affecting real estate operations.