Beyond the Elephant, Which Tax Issues May Affect Real Estate?

A version of this article was previously published in September 2018 in GlobeSt.

The tax reform act of December 2017, commonly referred to as the Tax Cuts and Jobs Act (TCJA), has been largely incorporated into the Internal Revenue Code though some provisions still face interpretation and fine-tuning—including the elephant in the room for many investors, carried interest, which has been much discussed but still has key provisions to be sorted out by the IRS. What are the other key changes affecting the real estate industry?

Following are some of the most notable changes.

Opportunity Zones: Key Provisions, Tips, and Tactics

In recent months, states have been rolling out their lists of designated Opportunity Zones under the new federal tax program, and real estate investors and developers are starting to act on them. The significant financial incentives are aimed to boost economic impact where it’s needed most.

Owners and investors can defer and reduce capital gains from the sale or exchange of property by investing the proceeds into Qualified Opportunity Funds (QO Funds) within 180 days. These funds must be invested, directly or indirectly, into property located in designated Qualified Opportunity Zones (QOZs).

If you already have material gains from the sale or exchange of property in 2018, or anticipate material gains in the future, investing in QO Funds may be a strategic tool to lower your overall tax burden. More details of the program are expected from the IRS.

Shifts on Leverage Make Some Deals Less of a Deal

Use of leverage in real estate is changing dramatically, with the limit of 30% of adjusted taxable income (generally speaking, NOI) for acquisitions.

Whereas interest paid or accrued by a business generally was fully deductible, under the TCJA, affected corporate and noncorporate businesses can’t deduct interest expenses in excess of 30% of adjusted taxable income (ATI) starting with tax years in 2018. For S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes, this limit is applied at the entity level rather than at the owner level.

Commencing in 2022, the NOI will have to be reduced by depreciation and amortization expense in calculating the interest expense limitation. Real estate businesses are able to elect out of this limitation, but with that will come decelerated depreciation expense deductions. This election can be made on an entity by entity basis and only affects real property and not personal property which is still eligible for accelerated depreciation.   

Lease Deductions Are Simpler, Better—with Caveats

Changes for leased property deductions under bonus depreciation and Section 179 are also affecting real estate strategy.

Under TCJA, the benefit of Section 179 expensing is somewhat reduced due to the enhanced bonus depreciation provisions; however, the maximum amount a taxpayer can expense under Section 179 is increased to $1 million and the phaseout threshold is increased to $2.5 million.

The TCJA eliminates the asset classifications for qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, but retains the classification for qualified improvement property (QIP). It appears that the intent of Congress was to reduce the QIP recovery period to 15 years from 39 years and have it retain its bonus eligibility. However, in an apparent drafting error, the statute retains QIP’s 39-year recovery period and eliminates its eligibility for bonus depreciation. However, QIP is now eligible for Section 179 expensing.

When Asset Management Is an Operating Business—or Not

Tax treatment of asset management fees can be significant, and relies on an essential question, ‘What is the applicable definition of an ‘operating business?’ Will asset management fees qualify for the 20% deduction under the new Section 199A on Qualified Business Income (QBI)?

The new TCJA deduction under Section 199A reduces tax liabilities for certain partnerships, S corporations, and sole proprietorships allowing them a deduction equal to 20% of their QBI. In some cases, it’s a significant decrease in taxes.

For example, if the TCJA’s top individual income tax rate of 37% otherwise applies, the QBI deduction lowers the individual’s effective tax rate on his or her QBI to 29.6%. However, computing the deduction under the new rules can be complex.

The five-step analysis involves determining whether the entity qualifies, calculating the QBI scenarios including that of taxpayers with multiple businesses, applying the W-2 and qualified property limitations, determining the QBI amount and applying the taxable income limitation. 

Carried Interest, Three Years and Holding

As noted, carried interest is the elephant in the room for many investors. The TCJA added a holding period requirement of three years for gains on carried interest (Section 1061) in investment or development of specified assets, and it’s motivating many investors to establish holding periods post-haste, or at least be ready as more IRS guidance is issued.

A related, notable question involves application to Section 1231 gains if the carried is interest is obtained through an allocation of such gains. Many real estate firms are moving cautiously.

Summary

Qualified owners and investors are changing their real estate strategies based on the TCJA tax laws, particularly those who face tax-year deadlines, sale and acquisition strategies, or other business considerations. For provisions still awaiting further IRS guidance, it’s important to monitor potential changes in order to best benefit.

We’re Here to Help

For questions about what these topics mean for your real estate business, please contact your Moss Adams professional.