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Tax Reform: Impact on REITs, Real Estate Businesses and Investors Pass-Through Business and Interest Deductions, Cost Recovery, Carried Interest, Sale of Partnership Interests, and More
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, FEBRUARY 27, 2018
Presenting a live 90-minute webinar with interactive Q&A
Steven R. Meier, Partner, Seyfarth Shaw, Chicago
John P. Napoli, Partner, Seyfarth Shaw, New York
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Seyfarth Shaw LLP “Seyfarth Shaw” refers to Seyfarth Shaw LLP (an Illinois limited liability partnership).
Tax Reform: Impact on REITs, Real Estate Businesses, and Investors
John Napoli and Steven Meier
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential
Agenda
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential
01 Background: Timing of tax law changes
02 Overview: What has changed/stayed the same
03 Pass-through business deduction
04 REIT dividends
05 Business interest deduction
06 Cost recovery
6
Agenda
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential
07 Like-kind exchanges
08 Carried interest holding period requirements
09 Sales of partnership interests by foreign partners
10 State and local tax deduction
11 Section 179 expensing
12 Historic preservation and rehabilitation tax credits
7
Agenda
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential
• How we’ll proceed:
• After a little background and an overview, we’ll cover
the major provisions that impact real estate and REITs
• We’ll discuss the provisions, work through an example
or two, discuss the implications of the provision for real
estate and REITs, and then point out some issues that
will require Treasury/IRS guidance
• We will answer questions at the end
8
Background: Timing of tax law changes
• November 2: House introduces “Tax Cuts & Jobs Act” (the
“Act”)
• November 3: House releases Chairman’s Mark of the Act
• November 9:
• House Ways and Means Committee approves of the Act
• Senate releases Chairman’s Mark of the Act
• November 16:
• House passes the Act
• Senate Finance Committee approves of the Act
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 10
Background: Timing of tax law changes
• November 28: Senate Budget Committee approves of the
Act
• December 2: Senate passes the Act
• December 15: Conferees appointed
• December 19: Senate passes modified Act
• December 20: House passes modified Act
• December 22: President Trump signs the Act into law
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 11
Overview: What has changed and what stayed the same
• Changed:
• Individual rates and corporate rates
• New deduction that will reduce tax on income from pass-
through businesses
• Business interest deduction has been limited (for non-
real estate; there is a special rule for real estate)
• Increased cost recovery/bonus depreciation (for non-real
estate and, in some circumstances, real estate)
• Sales of partnership interests by foreign partners (back
to normal)
• Historic preservation and rehabilitation tax credits
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 12
Overview: What has changed and what stayed the same
• Did not change:
• Business interest deduction (for real estate)
• Cost recovery/bonus depreciation (for real estate)
• 1031s survived! (for the most part)
• Most of the rules related to carried interests
• SALT deduction (for businesses)
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 13
Pass-through business deduction
• New Code Section 199A: 20% tax deduction for individuals for
“qualified business income” from “pass-through businesses”
• This deduction is scheduled to expire after 2025
• Pass-through businesses include domestic:
• Sole proprietorships
• Partnerships
• S corporations
• LLCs taxed as partnerships, S corporations, disregarded entities,
trusts, etc.
• REITs
• Publicly traded partnerships
• Cooperatives
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 14
Pass-through business deduction
• Qualified business income does not include:
• Income (received by taxpayers with income above $315,000 if filing
a joint return or $157,500 otherwise) from a “specified service trade
or business”
– Health, law, accounting, actuarial science, performing arts,
consulting, athletics, financial services, brokerage services,
investing or investment management, trading, or dealing in
securities, partnership interests, or commodities, 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
• Section 707(c) guaranteed payments for services
• Amounts paid that are treated as reasonable compensation paid to
a taxpayer
• Amounts paid or incurred for services by a partnership to a partner
who is acting other than in his or her capacity as a partner
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 15
Pass-through business deduction
• Deduction amount limitation:
– “Wage limitation” and “basis limitation”
– For taxpayers with incomes above certain thresholds
($315,000 joint return or $157,500 otherwise), the 20%
deduction is limited to the greater of:
50% of the W-2 wages paid by the business, or
25% of the W-2 wages paid by the business, plus
2.5% of the unadjusted basis, immediately after
acquisition, of depreciable property (which includes
structures, but not land)
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 16
Pass-through business deduction
• Deduction amount limitation:
– Real estate businesses need to look carefully at the
wage and basis limitations to be sure that they will
receive the full 20% deduction
The “plus 2.5% of the unadjusted basis, immediately
after acquisition, of depreciable property” is very
significant for real estate businesses
- For most real estate businesses the 2.5% will be
sufficient to allow the full 20% deduction
- If not, the business may need to consider
restructuring to shift around W-2 employees
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 17
Pass-through business deduction
• Example 1:
– Jim, an individual, is the sole owner of Jim’s Business, LLC
– In 2018, Jim receives $1,000,000 from Jim’s Business, LLC
– In 2018, Jim’s Business, LLC paid $100,000 in W-2 wages and
has $5,000,000 unadjusted basis in depreciable property
– Jim’s maximum deduction, before considering the limitations,
would be $200,000 (20% of 1,000,000)
– BUT: Jim’s limitation (the greater of 50% of W-2 wages or 25% of
W-2 wages + 2.5% of basis in depreciable property) is:
$150,000
- 50% of $100,000 = $50,000
- 25% of $100,000 + 2.5% of $5,000,000 = $25,000 + $125,000
= $150,000
– Jim can only deduct $150,000, the rest is taxed at individual rates
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 18
Pass-through business deduction
• Example 2:
– Same as Example 1, except Jim’s Business, LLC paid
$100,000 in W-2 wages and has $7,500,000 unadjusted
basis in depreciable property in 2018
– Jim’s maximum deduction, before considering the
limitations, would still be $200,000.
– Jim’s limitation is:
$212,500
- 50% of $100,000 = $50,000
- 25% of $100,000 + 2.5% of $7,500,000 = $25,000 +
$187,500 = $212,500
– Jim can deduct the full $200,000, the rest is taxed at
individual rates
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 19
Pass-through business deduction
• Example 3:
– Same as Example 1, except Jim’s Business, LLC is a pure
real estate business (non-S corporation) with no
employees, and so no W-2 wages, but has $10,000,000
unadjusted basis in depreciable property in 2018
– Jim’s maximum deduction, before considering the limitations,
would still be $200,000
– Jim’s limitation is:
$250,000
- 50% of $0 = $0
- 25% of $0 + 2.5% of $10,000,000 = $0 + $250,000 =
$250,000
– Jim can deduct the full $200,000, the rest is taxed at
individual rates ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 20
Pass-through business deduction
• Example 4:
– Same as Example 1, except Jim’s Business, LLC is a
“specified service trade or business” (here, say a
consulting business)
– Jim received $1,000,000 in 2018, so his income
exceeds the threshold ($315,000 if filing a joint return
or $157,500 otherwise) and the “specified service
trade or business” provision applies to him
– Jim’s income from Jim’s Business, LLC is not
“qualifying business income”
– Jim cannot deduct any of the $1,000,000 he received
from Jim’s Business, LLC, everything is taxed at
individual rates ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 21
REIT dividends
• REITs are considered a pass-through business for
purposes of this deduction
• As a result, REIT most dividends qualify for the deduction
• REIT qualified and capital gains dividends do not qualify
for the deduction
• REIT dividends are not subject to the wage and basis
limitations
• Effective maximum U.S. federal income tax rate on
qualified REIT dividends is 29.6% (plus additional 3.8%
Medicare tax on dividends)
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 22
REIT dividends
• Example 5:
• Same as Example 1, except Jim also owns stock in REIT
• In 2018, Jim receives $50,000 in ordinary dividends from
REIT
• Jim’s maximum deduction, before considering the limitations,
would be $210,000 (20% of 1,000,000 + 20% of $50,000)
• Jim’s deduction with respect to his income from Jim’s
Business, LLC is subject to the same limitation ($150,000)
• But: REIT dividends are not subject to the wage and basis
limitations
– Jim can take the full $10,000 deduction (20% of $50,000)
with respect to his REIT dividends
• Jim can deduct $160,000, the rest is taxed at individual rates
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 23
Implications: Pass-through business deduction & REIT Dividends
• The combination of the new deduction and the reduction of the
maximum individual tax bracket from 39.6% to 37% will result in
significant tax savings for real estate investors
• The carve out for “specified service trade or business” may mean
that service professionals should consider whether it makes sense
to run their business through a personal service corporation
• For REITs, the reduced corporate tax rate (now 21%) reduces, but
does not eliminate, the benefit to choosing REIT rather than
corporate form
• The Act reduces the favorable rate differential between qualified
REIT dividends and C corporation dividends from 8.4% to 7.2%
• However, C corporation tax rate does not expire, but the pass-
through deduction will expire, unless extended, after 2025
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 24
Issues: Pass-through business deduction & REIT Dividends
• Combination of qualified and nonqualified businesses
• What if a partnership has two different businesses, one qualified
and the other nonqualified? Do you need to bifurcate? On what
basis do you bifurcate? How do you bifurcate employees/assets?
• Consulting
• What if consulting is an ancillary part of the business? Does it taint
the qualifying business? How significant must it be before it taints?
• Doing business with a “specified service trade or business”
• If a business provides permissible services on an arm’s length basis
to a “specified service trade or business”, does the business qualify
for the 20% deductions?
• “Skill and reputation” as a “principle asset”
• What does this mean?
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 25
Issues: Pass-through business deduction & REIT Dividends
• “Reasonable compensation” exclusion from qualified income
• Does the “reasonable compensation” exclusion from qualified
income only apply to S corporations? Are partnerships and sole
proprietors required to designate a certain amount of net business
income as “reasonable compensation”?
• Aggregation of activities:
• Can businesses aggregate all of qualified trades or businesses at
the partner level for the purposes of the wage and basis limitations?
• 1031 exchange impact on deduction limitation
• Does exchanging property in a 1031 transaction reduce a business’
basis for purposes of the basis limitation?
• REIT interests through a mutual fund
• If an investor holds its REIT shares through a mutual fund (as is the
case for approximately half of all REIT shareholders) does the
investor get the benefit of the deduction? ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 26
Business interest deduction
• Business interest deduction (Generally):
• “Business interest” = any interest paid or accrued on
indebtedness properly allocable to a trade or business,
excluding “investment interest”
• New Code Section 163(j): for most taxpayers, the Act
disallows the deductibility of business interest to the
extent that net interest expense exceeds 30% of
EBITDA (2018 through 2022) or EBIT (beginning in
2022)
– EBITDA = taxpayer’s earnings before interest, taxes,
depreciation and amortization
– EBIT = taxpayer’s earnings before interest and taxes
– EBITDA is the bigger number ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 27
Business interest deduction
• Business interest deduction (Generally):
• The amount of any business interest not allowed as a
deduction for any taxable year may be carried forward
indefinitely
• This provision applies to existing debt and applies at the
entity level
• The limitation does not apply to taxpayers whose
average annual gross receipts for the three-tax-year
period ending with the prior tax period does not exceed
$25 million
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 28
Business interest deduction
• Business interest deduction (Real Estate):
• A real property trade or business can elect out of the
new business interest disallowance regime.
– Any business engaged in real property development,
redevelopment, construction, reconstruction,
acquisition, conversion, rental, operation,
management, leasing, or brokerage trade or business
• The real estate exception extends to
– (1) the activities of corporations and REITs, and
– (2) the operation or management of a hotel.
• The election out is irrevocable
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 29
Business interest deduction
• Business interest deduction (Partnerships):
• The limitation on the deduction is determined at the
partnership level, and any deduction available after
applying such limitation is included in the partners’
nonseparately stated taxable income or loss from the
partnership
• Any business interest that is not allowed as a deduction
to the partnership for the taxable year is not carried
forward by the partnership but, instead, is allocated to
each partner as "excess business interest" in the same
manner as nonseparately stated taxable income or loss
of the partnership
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 30
Business interest deduction
• Business interest deduction (Partnerships):
• The partner may deduct its share of the partnership’s
excess business interest in any future year, but only
against excess taxable income attributed to the partner
by such partnership
• A partner’s share of excess taxable income is
determined in the same manner as nonseparately stated
income and loss
• Any disallowed interest expense allocated to a partner
immediately reduces the unitholder’s basis in its
partnership interest, but any amounts that remain
unused upon disposition of the interest are restored to
basis immediately prior to disposition
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 31
Business interest deduction
• Example 6:
• In 2018, Jim’s Business, LLC paid $2,000,000 in net
interest expense that is properly allocable to its trade or
business to Lender
• In 2018, Jim’s Business, LLC’s earnings before interest,
taxes, depreciation and amortization is $5,000,000
• The business interest expense limitation is $1,500,000
(30% of $5,000,000)
• Jim’s Business, LLC can only deduct $1,500,000 in
business interest in 2018
• Jim’s Business, LLC can carry forward the $500,000 in
disallowed business interest indefinitely
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 32
Business interest deduction
• Example 7:
• Same as Example 6, except Jim’s Business, LLC is a
real property development business
• Jim’s Business, LLC can make an election out of the
business interest deduction
• Jim’s Business, LLC would then be able to deduct the
full $2,000,000 in net interest
• However, the election does have an impact on Jim’s
Business, LLC’s ability to take advantage of the new
cost recover provisions
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 33
Business interest deduction
• Example 8:
• Same as Example 6, except Jim’s Business, LLC is taxed as
a partnership and Jim owns 20% of Jim’s Business, LLC
• Jim is entitled to $300,000 of Jim’s Business, LLC’s
$1,500,000 allowed business interest deduction which the
partnership will include in Jim’s nonseparately stated taxable
income or loss from the partnership
• Jim will be allocated $100,000 of Jim’s Business, LLC’s
$500,000 disallowed business interest deduction as “excess
business interest” which he can deduct against Jim’s
Business, LLC’s excess taxable income in 2019 that is
attributed to him
• The $100,000 in disallowed business interest reduces Jim’s
basis in Jim’s Business, LLC
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 34
Cost recovery
• Cost recovery (Generally):
• “Bonus depreciation”
• The Act permits businesses an immediate write-off of the full
cost of qualified property
– After 2022, the bonus depreciation percentage is phased-
down to 80% for property placed in service in 2023, 60% for
property placed in service in 2024, 40% for property placed
in service in 2025, and 20% for property placed in service in
2026
• The Act removes the requirement in current law that the
original use of qualified property must commence with the
taxpayer
– Thus, immediate expensing applies to purchases of used
as well as new items ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 36
Cost recovery
• Cost recovery (Real Estate):
• Taxpayers that elect to use the business interest real estate
exception will be permitted to fully expense land improvements and
tangible, personal property used in their real property trade or
business from 2018 to 2023
• However, such taxpayers must depreciate real property using ADS
under slightly longer recovery periods: 40 years for nonresidential
property, 30 years for residential rental property, and 20 years for
qualified improvement property (interior)
• The switch to ADS applies to all nonresidential rental property,
residential rental property, and qualified improvement property, not
just property placed in service beginning in 2018
• The Act did not adopt the Senate proposal to reduce the MACRS
depreciable lives on residential and nonresidential depreciable
property
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 37
Cost recovery
• Example 9:
• In 2018, Jim’s Business, LLC purchase equipment
(either new or used) for $1,000,000 and places the
equipment into service the same year
• Jim’s Business, LLC can deduct its full $1,000,000 basis
in the equipment in 2018
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 38
Cost recovery
• Example 10:
• Same as Example 9, except Jim’s Business, LLC
elected out of the business interest deduction limitation
• Jim’s Business, LLC cannot fully expense its equipment
in 2018
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 39
Implications: Business interest deduction & cost recovery
• Real estate trades and businesses will need to decide which is
more important to their business
– Companies that rely heavily on leverage, may choose to elect
out of the business interest deduction limitation
– Companies that do not rely heavily on leverage may find that
the shorter depreciable lives of real property (and expensing
for qualified improvement property) may outweigh any
detriment from the limitation on interest deductions
– The interest limitation will be less onerous initially because
adjusted taxable income will not include deductions for
depreciation, amortization, or depletion until to 2022. This
may mean that the depreciation and expensing benefits could
justify deferring the election for exemption from the interest
limitation until 2022
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 40
Issues: Business interest deduction & cost recovery
• Debt incurred to capitalize an entity that engages in a real
property trade or business
– If a taxpayer borrows money and uses the money to capitalize
an entity that is engaged in a real property trade or business,
can that taxpayer elect out of the business interest deduction
limitation and deduct the interest?
– If the debt is used to capitalize several businesses, some of
which are real property trades or businesses and others are
not, does the taxpayer need to allocate debt/interest among
the businesses?
• Corporations borrowing to invest in REITs
– If a corporation incurs debt to purchase REIT shares, can the
corporation elect out of the business interest deduction
limitation and deduct the interest? ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 41
Like-kind exchanges
• The Act permits taxpayers to continue to defer gain on real
estate like-kind exchanges.
• Improved real estate and unimproved real estate will continue
to be considered property of a like kind.
• However, the portion of any exchange that includes personal
property will no longer qualify for tax deferred treatment under
Code Section 1031
• General Implications: This is very good for real estate
because it will continue to generate interest in real estate
investments
• Not a significant change from current law
• Cost Segregation Implications
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 42
Carried interest holding period requirements
• Holders of a carried interest in certain types of
partnerships, including hedge funds, private equity funds,
and real estate, must hold the interest for 3 years in order
to receive long-term capital gain treatment.
• The 3-year holding period applies to the partnership
interest and to the assets held by the partnership
• If the holder disposes of the interest before the 3 years,
they receive short-term capital gain treatment
• Implications: this is unlikely to have a significant impact
– Most carried interest holders hold their interest for
more than 3 years anyways
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 43
Sales of partnership interests by foreign partners
• The Act added a provision that treats gain or loss from the sale of a
partnership interest by a foreign partner as effectively connected
income (“ECI”) that is taxable in the U.S. if the gain or loss from the
sale of the underlying assets held by the partnership would be treated
as ECI
• This provision statutorily reverses the Tax Court’s recent decision
in Grecian Magnesite Mining, Industrial & Shipping Co., SA vs.
Commissioner, 149 T.C. No. 3 (Jul. 13, 2017) and returns to a rule
similar to Revenue Ruling 91-32 (1991-1 C.B. 107)
• The Act also requires the purchaser of a partnership interest from a
partner to withhold 10% of the amount realized on the sale or
exchange of the partnership interest unless the transferor certifies that
the transferor is not a nonresident alien individual or a foreign
corporation
• Implication: Return to status quo; must account for new withholding
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 44
State and local tax deduction
• The Act continues to permit pass-through entities the
ability to deduct state and local taxes paid or accrued in
carrying on a trade or business or in an activity related to
the production of income
• Implication: Status quo
• However, for individuals, the property and SALT tax
deduction is limited to a combined $10,000
• Implication: This may have an impact on residential
property values in high-tax states
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 45
Section 179 expensing
• The Act increases the maximum amount that a taxpayer
may expense under Code Section 179 to $1,000,000, and
increases the phase-out threshold amount to $2,500,000
• The provision also expands the definition of Code Section
179 property to include:
• Certain depreciable tangible personal property used
predominantly to furnish lodging or in connection with
furnishing lodging, and
• Any of the following improvements to nonresidential real
property placed in service after the date the real
property was first placed in service: roofs; heating,
ventilation, and air-conditioning property; fire protection
and alarm systems; and security systems
• Implications: Helpful for smaller real estate businesses ©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 46
Historic preservation and rehabilitation tax credits
• The Act preserves the 20% tax credit for the rehabilitation
of historically certified structures, but now requires that
taxpayers claim the credit ratably over a 5-year period.
• The Act repeals the 10% credit for the rehabilitation of pre-
1936 structures
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 47
Overall Impressions
• Benign to favorable for real estate
• New pass-through deduction is helpful for bringing in new
investors
• Real estate businesses will need to choose between
avoiding the new business interest deduction limitation or
enjoying the new full and immediate bonus depreciation
• May cause a shift away from debt financing towards
equity financing
• Retention of 1031s for real property is critical
• Carried interest left largely unharmed
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 48
Thank you
Steven R. Meier
John P. Napoli
©2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 50