Beyond the Elephant, Which Tax Issues May Affect CRE?

SAN FRANCISCO—The tax reform act, commonly referred to as the Tax Cuts and Jobs Act of December 2017 has been largely incorporated into the Internal Revenue Code though some provisions still face interpretation and fine tuning. This includes the elephant in the room for many investors, carried interest, which has been much discussed but still has key components to be sorted out by the IRS, according to Chris Paris, partner, Moss Adams. So, what are the other changes affecting the real estate industry/?

In recent months, states have been rolling out 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, says Paris. Owners and investors can defer and reduce capital gains from the sale or exchange of property by investing the proceeds into Qualified Opportunity Funds within 180 days. These funds must be invested, directly or indirectly, into property located in designated Qualified Opportunity Zones.

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

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 non-corporate businesses can’t deduct interest expenses in excess of 30% of adjusted taxable income starting with tax years in 2018, according to Paris. 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, Paris points out.

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 phase-out 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,” Paris tells GlobeSt.com. “However, in an apparent drafting error, the statute retains QIP’s 39-year recovery period and eliminates its eligibility for bonus deprecation. However, QIP is now eligible for Section 179 expensing.”

Paris says tax treatment of asset management fees can be significant and relies on essential questions: 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 a deduction equal to 20% of the 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, says Paris. 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.

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 is 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 interest is obtained through an allocation of such gains,” Paris tells GlobeSt.com. “Many real estate firms are moving cautiously.”

Qualified owners and investors are changing real estate strategies based on the TCJA tax laws, particularly those who face tax-year deadlines, sale/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, concludes Paris.