The Impact of Recent Tax Legislation on the Real Estate Business

The Tax Reform Act of 2017 (the Act) includes several benefits for the real estate industry.

The Act provides for new tax deductions to partners, S corporation shareholders and sole proprietors investing in real estate (among other industries). In addition, provisions that aid the real estate investor were also included to eliminate the impact of new limitations on deductibility of business interest expense.

Further, although carried interest rules are modified to provide for a three-year holding period to get long-term capital gain treatment, such change likely will not impact those granted carries in many real estate partnerships. Like-kind exchanges also are still allowed for real estate and rehabilitation tax credits remain for historic properties and the low-income housing credit survives. Finally, the changes under the Act will also favorably affect foreign investors in U.S. real estate.  With respect to real estate, possibly the only negative impact of the Act for taxpayers result from changes that dampen the tax benefit of home ownership.

Favorable Qualified Business Income Deduction

For partners, S corporation shareholders and sole proprietors in certain industries (for example professional service and financial service businesses are largely excluded), the Act adds a new deduction equal to 20% of qualified business income (QBI). While the deduction is subject to a wage and property limitation, that limitation has been drafted in such a way as to not negatively impact the real estate industry. The wage and property limitation provides that the 20% deduction cannot exceed the greater of: (1) 50% of the wages paid by the partnership or (2), 25% of the wages paid by the partnership plus 2.5% of the original cost basis of depreciable tangible property placed in service in the last 10 years. A partnership’s investment in depreciable real estate (but not land) can now help increase this new deduction.

Limits on Interest Deduction

The Act provides that a taxpayer’s net business interest expense deduction cannot exceed 30% of its adjusted taxable income. Any interest disallowed under this rule is carried forward indefinitely, but still subject to this rule in those subsequent years. This limitation does not apply if the gross receipts from all business activities do not exceed $25 million.

However, an election can be made to eliminate application of this new limit if the taxpayer agrees to depreciate its assets under the Alternative Depreciation System (ADS). The regular recovery period for commercial real estate (e.g., an office building) is 39 years while the ADS period is a mere one year longer, 40 years. The recovery period for residential real estate is 27.5 years while the ADS period is now 30 years. The modest loss of current depreciation deductions may be worth taking if interest can then be fully deducted.

Other Changes

The Act’s elimination of tax-free like-kind exchanges does not apply to real estate, leaving a major benefit for those buying and selling real property.  In addition, the Act did not alter the recovery period for commercial or residential real estate. However, in what appears to be a technical error in the legislation drafting, the 15-year recovery period for leasehold improvements was inadvertently changed to 39 years.

The low-income housing tax credit remains as a valuable tool to assist construction of affordable housing. However, community development was likely hindered by elimination of the new markets tax credit. The Act allows the rehabilitation tax credit to remain, but only for historic buildings.

The grant of carried interests in a partnership has been a long-standing tax-favored way to reward sponsors, managers and other service providers by allowing some income that otherwise might be treated as ordinary income to be taxed as capital gain. The Act changes the treatment of carried interests, but in a very limited manner. With respect to a carried interest, the holding period for long-term capital gain treatment for underlying assets held by the partnership would be increased from more than one year to more than three years.  However, given that real estate tends to be held for longer periods of time than financial assets, this change likely has limited impact on the real estate industry. 

In years before January 1, 2018, if within a 12-month period there were sales or exchanges of a partnership interest that equal or exceed 50% of the total partnership interest in profits and capital, the partnership was deemed terminated for tax purposes. This hyper-technical rule can serve to reset the clock for depreciating the partnership’s assets, which can lower the annual depreciation deduction and increase a partner’s tax bill. The Act eliminates this rule.

Not all the changes under the Act positively impact real estate. Net operating losses (NOLs) can be valuable in the real estate world since depreciation and other expenses often create NOLs. The Act allows NOL carryovers to offset only 80% of a taxpayer’s taxable income for taxable years beginning after December 31, 2017. While all carrybacks would generally be repealed, carryforwards would now be allowed indefinitely, with the 20-year limit under prior law repealed.

Foreign Investment in U.S. Real Estate

For many wealthy foreigners, U.S. real estate is an attractive investment. To avoid exposure to elements of the U.S. taxing system, that real estate investment is typically made through a U.S. blocker corporation. These corporate blockers can now benefit from the new 21% corporate tax rate, which slashes their tax bills nearly in half. Foreign investors who want to lend to real estate projects are still aided by the portfolio interest exemption, which allows interest paid to many foreign investors to be paid free of any U.S. tax. The Act leaves the exemption untouched.

Reduced Tax Assistance for Single Family Home Ownership

Historically, the tax law has been very supportive of single-family home purchases, with the tax deduction for real property taxes and home mortgage interest incentivizing home ownership. The Act reduces some of this incentive. The deduction for real property taxes and state and local income and sales taxes cannot exceed $10,000. In addition, the Act retains the deduction for interest on acquisition indebtedness, but only for interest on up to $750,000 of acquisition indebtedness ($375,000 for a married person filing a separate return). A grandfather rule is provided for mortgages with respect to homes that a taxpayer already owns. The Act also repeals the mortgage interest deduction on home equity loans. The impact of these changes is that home ownership is not as tax beneficial, which may make home ownership less affordable. 

The Takeaway

The Act includes many potentially positive provisions for the real estate industry.  However, exactly how these provisions impact individuals and their businesses must be carefully considered.  For taxpayers who own and invest in real estate businesses, a detailed review of the tax impacts of the Act should be done.