Speakers: TCJA Has Created New World for Real Estate Industry

Chris Gaetano
Published Date:
Nov 15, 2018

The Tax Cuts and Jobs Act has carved out a new landscape for the real estate industry, full of both risks and opportunities, according to a panel of speakers at the Foundation for Accounting Education's Real Estate Conference on Nov. 15.

Especially prominent was the creation of the new Opportunity Zone program, which was designed to spur investment in distressed communities throughout the country through tax benefits—for example being able to defer certain gains from inclusion in gross income, to the extent that corresponding amounts are reinvested in a Qualified Opportunity Fund, and being able to exclude from gross income the post-acquisition gains on investments in Qualified Opportunity Funds that are held for at least 10 years.

One of the panelists, Attorney Mark A. Goldsmith, a partner at Troutman Sanders LLP, said that while the Opportunity Zone program can apply to any type of business within a designated zone, real estate investors have been particularly interested in benefiting from it. In the case of real estate, though, potential investors will need to be mindful of some industry-specific rules. First, real estate investments qualify only if they involve the first use of the property, and the investing entity must be the first to put that property into service. This is to prevent people from gaming the incentive system by continually buying and selling the same property over and over. However, an exception exists if an entity acquires a property already in service but then makes substantial improvements, defined as an amount equal to the cost of the property itself. 

"On its face, that seems to be insurmountable in many instances," Goldsmith said. "If you buy a two-story building and add 10 stories, that would be easy, but if you buy an existing multifamily property and just renovate the apartments, you're probably not going to spend equal to your investment."

However, he noted that proposed IRS guidance on the provision suggests that entities need only consider the cost of the building itself, not the cost of the land, and so if there's an existing property in use worth $20 million, but the building on the land is worth $10 million, real estate investors will need to exceed only $10 million in substantial improvements. 

Goldsmith also said that the creation of Qualified Opportunity Funds has the potential to change the timing of deals in favor of real estate investors. Up to now, he said, most real estate investment companies would consider a property first and then raise capital to buy it. However, with the creation of these new funds, which must be composed of at least 90 percent Opportunity Zone investment assets, groups can now do the opposite: raise the capital first, then decide what they want to buy with it. 

"What the IRS came out with in the proposed regulations was, 'We will treat reasonable working capital that comes in order to acquire Opportunity Zone property as qualifying as long as you have a written plan of what you'll spend it on, how you will spend it, and actually spend that money within a 31-month period.' So it allows funds to raise the $100 million [given as an example] and look for properties to buy, versus having to first find the property, then seek investors, then bring in the money shortly before closing," he said. 

Another provision with major impacts on the real estate industry is the 20 percent deduction for pass-through entities outlined in code section 199A (for more information see our recent Trusted Professional story covering a discussion on the provision at a recent conference). Jonah Gruda, a partner at Mazars USA, said that even with proposed IRS guidance now out, 199A's impact on the real estate industry is still "vague," at least partially due to what does and does not give rise to the level of a trade or business. While before there had always been a tension in the tax code regarding active or passive income from real estate, the 199A deduction does not seem to make this distinction, and so planners cannot assume a dividing line between them when making the calculation. 

For example, he said, a triple net lease (a passive vehicle where a tenant is responsible for all taxes, insurance and maintenance) does not qualify for the deduction, but dividends from Real Estate Investment Trusts, which are also passive, do. Similarly, while investment management fees do not qualify, property management fees do. And this is before even getting into more complicated types of income, such as if a property management company invests in triple net lease properties. 

Gruda noted that real estate firms would likely not have been able to take advantage of the deduction at all were it not for a last-minute addition to the calculations. The general formula for the deduction is 20 percent of qualified business income or the greater of either 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of qualified business property, whichever is less. He said the W-2 wages plus 2.5 percent of qualified business property is what allows real estate companies, which don't always have W-2 wage employees, to take advantage of the deduction.

Attorney Robert A. Friedman, another partner at Troutman Sanders, said that the business interest deduction limit is "less exciting" but "a little more clear" in terms of its impacts on Section 163-J of the Tax Code. Prior to the change, interest could not be deducted if the debt-to-equity ratio was more than 1.5 to 1 or if the net interest expense exceeded 50 percent of adjusted taxable income. This, he said, still allowed a "fair amount of room" for people to get plenty of interest deductions. No more. Under the new rules, the business interest expense deduction is limited to the sum of business interest income, 30 percent of adjusted taxable income, and floor plan financing interest. However, he said, those in the real estate industry can take advantage of an election that lets them get around the 30 percent limit. They can decide, instead, to use the alternative depreciation system (ADS) to depreciate property with a recovery period of 10 years or more. But there is a complication. 

"At the moment, we've no rules on when and how to make the election,"he said. "So you can do the math this year and wait and see what happens. 2021, most people think, will be a big factor for determining whether you are hurt by the new 30 percent limit or not and, at the moment, [you] can wait until that point in time to make the election."

Friedman also pointed out that there is an exception for entities with gross receipts under $25 million as well. This means that real estate businesses might wish to consider starting separate partnerships for their properties, making each their own taxpayer with less than $25 million in receipts. Goldsmith noted that this could mean that partnerships could form a separate entity inside the consolidated group, thereby circumventing the limit without the need to spin out a completely separate entity. Friedman said that an entity could realize great savings by doing this, but  he said savings should not be the only factor. 

"Now, it make make more sense not to have them disregarded. ... It might create additional legal fees, accounting fees. But overall it could create significant tax savings without having to do the math on whether you make the election," he said. 

The TCJA also significantly affected the treatment of like-kind exchanges, a staple of the real estate world. Barry L. Sunshine, a partner with Janover LLC, said the law now effectively says "like-kind exchanges are no good, are no longer valid, except if it's real estate for real estate, and it has to be U.S. property." While this is certainly good for the real estate market, he said it's disastrous for others. 

"I had a client who had a plane, and used to swap the plane for another plane, and it was a used plane he acquired. So now there's a phantom income he has to pick up on the trade in allowance for the plane he traded in, [which] we always ignored," he said. While paired with the new 100 percent bonus depreciation rules, this means there's an offset. "You've got to report the income and the loss," he said. "If it's a car, the same thing: When I traded in my car to get a new car, now I've got to pick up a gain on my return." 

But Sunshine said that even in the case of real estate, there can be complicating factors. The industry, he said, tends to do a lot of cost segregation studies to separate out, say, one part of a building with a 39-year depreciation and another part with a 5-7 year depreciation. 

"If [the exchange is] 39-year for 39-year, if you did a cost segregation on a property, it may prohibit your ability to do [a  Section] 1031 [exchange] on the entire property. ... I have a few clients selling a piece of property and don't know whether they'll be doing a 1031 or not, and that's a real big area [of concern] because they want to sell but they're waiting," he said. 

Along similar lines, Sunshine mentioned that a major change that has not gotten a lot of attention is the Section 461L provision, a limitation on excess business losses for noncorporate taxpayers, such as a real estate partnership. He said this is "a big trap for the unwary," and he was "shocked on what this means." Previously, he said, there was a $3,000 limit on capital losses in excess of capital gains. This has been the case since 1916. But now, in 2018, "you're only allowed to deduct business losses over business income to the extent of [a flat] $250,000 for a single taxpayer and $500,000 for married filing jointly." This has effectively wiped out a large area of tax planning. He said for years he'd worked with a sub S entity owned by a father and son. The father owned 100 percent of the entity and drew a $2.5 million W-2 wage from the company, with a corresponding reported loss on the company itself. For years, Sunshine said, they had been able to net out this loss. This can't happen anymore, though. 

"What the law is doing is saying you take all of your schedule C income, all of your trust income, the state income, the active business income, partnership income, your K-1 income, after applying the at-risk rules, after applying the 469 rules, all these rules, and to the extent you have a loss of, say, more than $500,000 you can't deduct it currently," he said. 

He said it was "mind boggling" that someone with $1 million of interest investment income but $1 million in business losses, would not be able to net out and avoid paying any income tax. Now, however, the loss is treated as a net operating loss in the subsequent year. 

"If you have a client with $1 million interest income and $1 million in business losses and every year not paying tax, suddenly you'll find they are paying tax this year and next year, even though they never had a net operating loss [before], because ...  that excess business loss will be net operating loss, subject to [a taxable income limit] an 80 percent," he said.  He did note, however, that, because of the carry-forward, "it's only a one-year tax implication, and then [the client will] pay very little tax," but "I think that's one big surprise on folks." 

Gruda said that the TCJA has completely changed fundamental assumptions on how tax policy fits into business planning, and he noted that much of the confusion came from the nature of how the bill was created. 

"This was supposed to be tax simplification, right? Everything we're talking about today is meant to be simplified," he said. "But we get ink to paper in November, a law in December and proposed regulations in August. I think in 1986, we had two years to go through public policy, but this was really rushed through, so there's a lot of statutory language ambiguity and not a lot of commentary. Interestingly enough, never before has discussion around deal-structuring provisions, reviews of provisions, operating agreements and investment decisions been driven by tax policy. Now, there's a lot of opportunities."

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