The text of the Senate Finance Committee’s proposed tax reform bill has not yet been released, but the Senate Finance Committee Chairman’s Mark released in summary form (“Senate Mark”) suggests that it will differ from the House bill as reported to the House floor on November 9 in several material respects. Below, we highlight several of the proposals mentioned in the Joint Committee’s summary that are of interest to the real estate industry.
17.4% Deduction for Certain Pass-Through Income (including REIT dividends). Subject to the wage limitation mentioned below, the Senate Mark generally allows an individual to deduct 17.4% of its “domestic qualified business income” from a partnership, S corporation, or sole proprietorship.
- Qualified business income for a taxable year means the net amount of domestic qualified items of income, gain, deduction, and loss with respect to the taxpayer’s qualified businesses.
- A qualified business is a trade or business other than certain service trades or businesses.
The Senate Mark provides that qualified business income or loss does not include certain investment-related income, gain, deductions, or loss, but it does not specify what types of investment-related income, gain, deductions, or loss are covered by this exception from the definition of qualified business income. Ordinary dividends from REITs are qualified business income eligible for the deduction.
Overall, this is less favorable to the real estate industry (particularly for REITs) than the House bill.
- Under the House bill, real estate rental income and dividends from REITs were generally taxed at a maximum rate of 25%.
- Subject to the wage limitation mentioned below, under the Senate Mark, it appears that real estate rental income and dividends from REITs will be taxed at a maximum effective rate of 31.8%.
Given the reduction of the corporate tax rate to 20% in both House and Senate proposals, the effect of this provision is to reduce the spread between tax on regular corporations and REITS, unlike the House proposal, which increases the spread.
- Under the Senate Mark, $100 of income earned by a REIT and distributed to its shareholders could be reduced to as little as $68.20 after federal income taxes (excluding Medicare investment taxes). Under the same proposal, $100 of income earned by a regular corporation and distributed to its shareholders could be reduced to as little as $64 after federal income taxes (excluding Medicare investment taxes).
- A $4.20 spread on the difference between $100 earned by a REIT and a regular corporation after taxes is significantly lower than the $8.40 spread under current law and the $11 spread proposed by the House.
Wage Limitation. Without providing much additional detail, the summary states that, in the case of a taxpayer who has qualified business income from a partnership or S corporation, the amount of the deduction discussed above is limited to 50% of the W-2 wages of the taxpayer. Only those wages that are properly allocable to qualified business income are taken into account.
- The Senate Mark does not provide much detail on this limitation and the language is unclear, but it may be hinting at a pro-jobs incentive that will cap the amount of partnership or S corporation income eligible for the 17.4% deduction at 50% of the wages paid by the partnership or S corporation. In any event, more will be known when the bill’s text is released.
ECI Tax on Sales of Partnership Interests. The summary states that gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business (and thus, for foreign sellers, subject to U.S. tax on a net basis) to the extent that the seller would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange.
The proposal requires that any gain or loss from the hypothetical asset sale by the partnership be allocated to interests in the partnership in the same manner as nonseparately stated income and loss, though it is not clear how this requirement would apply in all situations. This change would reverse the effect of a recent court decision and subject foreign partners to U.S. tax on sales of partnership interests to the extent the partnership has assets that give rise to effectively connected income, even if current law FIRPTA provisions do not apply.
- Under current law, gains and losses from the disposition of ”U.S. real property interests” are generally treated as effectively connected with the conduct of a U.S. trade or business. The Code currently requires that, as provided for in regulations, a foreign seller must treat the amount realized from sale of a partnership interest as an amount received from the sale of United States real property interests to the extent that the amount realized is attributable to United States real property interests held by the partnership. Current regulations provide guidance only with respect to partnerships in which, directly or indirectly, 50% or more of the value of the gross assets consist of U.S. real property interests and 90% or more of the value of the gross assets consist of U.S. real property interests plus any cash or cash equivalents.
The proposal also requires the buyer of a partnership interest to withhold 10% of the amount realized on the sale of the partnership interest unless the seller certifies that the seller is not a nonresident alien individual or foreign corporation. If the buyer fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the buyer an amount equal to the amount the buyer failed to withhold.
- Under current law, buyers of partnership interests are required to withhold only if the partnership holds U.S. real property interests representing 50% or more of the value of its gross assets, as well as a combination of U.S. real property interests and cash representing 90% or more of the value of its gross assets.
Increased Annual Real Estate Depreciation Deductions. Unlike the House bill, which does not propose to change current law regarding the depreciation of real property, the Senate Mark shortens the recovery period for depreciating residential rental real property and nonresidential real property from 27.5 years for residential rental real property and 39 years for nonresidential real property to 25 years for both.
- This will result in significantly increased annual depreciation deductions for commercial real estate in particular.
The proposal also provides a general 10-year recovery period for qualified improvement property (generally, improvements to interior portions of nonresidential real property), and a 20-year alternative depreciation system (“ADS”) recovery period for such property. Thus, for example, qualified improvement property placed in service after December 31, 2017, would be generally depreciable over 10 years using the straight line method and half-year convention, without regard to whether the improvements are property subject to a lease, placed in service more than three years after the date the building was first placed in service, or made to a restaurant building.
Real Estate Business Personal Property Not Excluded from 100% Expensing. The Senate Mark allows for 100% expensing (i.e., a deduction equal to cost) of qualified property (which generally does not include real property but does include qualified improvement property) placed in service after September 27, 2017. Unlike the House bill, the Senate Mark does not state that qualified property used in a real estate trade or business is ineligible for 100% expensing.
Interest Limitation Election and Effect on Depreciation. Similar to the House bill, the Senate Mark generally limits business interest deductions to 30% of the adjusted taxable income of the taxpayer for the taxable year. However, the House bill entirely exempts taxpayers in the real estate industry from the business interest deduction limitation. Under the Senate Mark, the business interest limitation will apply to taxpayers in the real estate industry unless the taxpayer makes an election for the limitation not to apply. If the taxpayer makes this election, the Senate Mark requires the taxpayer to use ADS to depreciate its nonresidential real property, residential rental property and qualified improvement property (which would require stretching depreciation deductions for real property over 40 years).
In a departure from the House bill, the Senate Mark does not add back depreciation and amortization in determining the taxpayer’s adjusted taxable income on which the interest limitation is applied. (In essence, the House bill’s limit is based on a definition of “adjusted taxable income” that is similar to EBITDA, while the Senate proposal is based on a definition that is similar to EBIT). This change will result in a more onerous limitation for many real estate businesses.
- If these rules become law, real estate investors should compare the amount of their interest deductions that would be limited if they do not elect out of the limitation to the amount of annual depreciation they would forego if, as a result of their election, they will be required to use ADS rather than the new 25 year depreciation schedule.
1031 Preserved for Real Estate. Like the House bill, the Senate proposal will eliminate Section 1031 non-recognition of gain or loss except in the case of real property that is not held primarily for sale.
Rules Impacting Residential Market: The following changes to current law mentioned in the Senate Mark could impact the residential real estate market:
- For individuals, the Senate Mark would repeal the deduction for state, local and foreign property taxes not incurred in a trade or business wholesale.
- The House bill allows a deduction of up to $10,000 and current law allows an uncapped deduction.
- Under both House and Senate proposals, real estate investors will still be able to deduct property taxes imposed on their investment properties.
- The deduction for interest paid on up to $100,000 in home equity indebtedness is repealed, but, unlike the House bill, the Senate Mark does not propose changing the current law deduction for qualified residence acquisition indebtedness.
- As in the House bill, the Senate Mark modifies the exclusion of gain from the sale of a principal residence by requiring that the taxpayer must own and use the residence as a principal residence for at least five of the eight years ending on the date of the sale. In addition, the taxpayer can benefit from the exclusion only once every five years. However, unlike the House bill, the Senate Mark contains no mention of a phaseout of this exclusion for high income earners.