Authored by Randy Barrus and James Munuhe
The Tax Cuts and Jobs Act (TCJA) is now law and will impact how real estate investment trusts (REITs) will make future business decisions. Below are some of the primary considerations REITs should keep in mind as they navigate the new tax rules.
In general, under the TCJA, REITs will not be able to deduct interest expense in excess of 30 percent of adjusted taxable income. Adjusted taxable income is the REIT’s taxable income computed without regard to business interest expense, business interest income, net operating losses, depreciation, amortization and, presumably, the dividends paid deduction (although additional guidance is needed to confirm the dividends paid deduction is in fact a deduction for purposes of this calculation). REITs can elect out of this limitation; however, the trade-off is that they must use the Alternative Depreciation System (ADS) which has a longer depreciable life compared to regular Modified Accelerated Cost Recovery System (MACRS) depreciation. Additionally, REITs would not be eligible for bonus depreciation for qualified improvement property (QIP).
Planning tip: Determine if the REIT will be subject to the 30 percent limitation. Many REITs have low leverage so the limitation will not be a problem. Keep in mind that REITs must already use the longer-life ADS depreciation and cannot use bonus depreciation for calculating dividend income reported to shareholders. Therefore, if the REIT does not need accelerated MACRS or bonus depreciation to meet its 90 percent distribution requirement, there should be little to no impact to a REIT by electing out of the 30 percent limitation.
The TCJA eliminates the separate definitions of qualified leasehold improvement and qualified retail improvement property. Instead, it provides a general 15-year MACRS recovery period for QIP with a 20-year ADS recovery period. The new law attempted to simplify the bonus depreciation rules for QIP; although, due to a drafting error, the final statutory language does not reflect congressional intent. The TCJA removed QIP from the definition of qualified property for bonus depreciation purposes, but the intent was to make QIP bonus-eligible by virtue of a 15-year recovery period. In the end, the 15-year recovery period for QIP (as well as the 20-year ADS recovery period) was omitted from the final legislation. It is our understanding that the Committee on Ways and Means will address this error in a technical corrections bill; however, it is uncertain if a technical corrections bill can pass Congress.
The TCJA retains the MACRS depreciable lives of 39 and 27.5 years for nonresidential and residential rental property, respectively. However, it reduces the ADS life for residential rental property to 30 years from 40 years.
For REITs that do not elect out of the 30 percent limitation discussed above, they would be able to fully expense qualified property (tangible personal property with a recovery period of 20 years or less) acquired after Sept. 27, 2017, and before Jan. 1, 2023. The percentage that can be expensed is reduced each year after 2022. This provision is applicable for the acquisition of new and used property. The inclusion of used property is a significant change from previous bonus depreciation rules.
The TCJA increases the maximum amount a taxpayer may expense under section 179 to $1 million and increases the phase-out threshold amount to $2.5 million. The $1 million limitation is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2.5 million. The $1 million and $2.5 million amounts are indexed for inflation for taxable years beginning after 2018. The Act also expands the definition of qualified real property eligible for section 179 expensing to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems.
Planning tip: Although REITs may elect out of the 30 percent limitation, and therefore not be eligible for MACRS and bonus depreciation, the REIT may still be able to expense new additions under section 179 and 100 percent expensing in 2017 for any qualified property placed in service between Sept. 27, 2017, and Dec. 31, 2017.
Corporate tax rate
The TCJA provides for a flat 21 percent corporate rate. Furthermore, corporate alternative minimum tax (AMT) is repealed. Prior-year minimum tax credits may offset a taxpayer’s regular tax liability for tax years beginning after 2017, subject to a formula. This reduced rate will benefit REITs that only distribute 90 percent of taxable income annually or have taxable REIT subsidiaries.
Planning tip: REITs should only consider distributing 90 percent of taxable income to retain more cash for operations and development. The remaining 10 percent will be taxable to the REIT, but now at lower tax rates. Additionally, REITs may want to consider converting to a fully taxable C corporation, often referred to a real estate operating company (REOC). Generally, the tax burden will be greater for a REOC, but a REOC is not subject to the limitations (i.e., distribution requirements, holding periods, prohibition on offering certain services and amenities) and additional administrative costs of a REIT.
The net operating loss (NOL) rules have been modified so a REIT’s NOL carryover can only offset 80 percent of taxable income for losses arising in years beginning after Dec. 31, 2017. The 80 percent limitation is calculated by multiplying current-year REIT taxable income before the dividends paid deduction by 80 percent. Although there is now an annual NOL limitation, the new rules allow post-2017 NOLs to be carried forward indefinitely. Under the former rules, a REIT NOL could only be carried forward 20 years.
Planning tip: The TCJA applies to losses arising in taxable years beginning after Dec. 31, 2017. Therefore, if a REIT now needs to use an NOL carryover from a prior year (for example, if the REIT did not distribute capital gain dividends), any pre-2018 NOLs will not be subject to the new 80 percent limitation. This will require careful tracking of all NOL carryforwards.
20 percent REIT dividend deduction
Individual REIT shareholders are now able to deduct 20 percent of REIT dividend income. Dividends that qualify for capital gain rates do not qualify for the new 20 percent deduction. The 20 percent deduction is not limited by the amount of wages or net invested capital like other qualifying business income.
Planning tip: The TCJA effectively reduces the federal tax rate (not including the net investment income tax) on ordinary REIT dividends to 29.6 percent from 37 percent for individual taxpayers. Unfortunately, the tax rate reduction does not apply to C corporations. Although the rate is not as low as the qualified dividend rate for individuals of 20 percent, it still directionally provides a benefit compared to the old rules. Therefore, the TCJA should be an opportunity for REITs to attract new capital by potentially increasing the after-tax return to individual shareholders.
Impact on UPREIT partnerships
REITs often hold property through umbrella partnership real estate investment trust (UPREIT) partnerships. The TCJA has several partnership provisions that could impact UPREIT unit holders. The new provisions include:
- Long-term capital gains from carried interests held less than three years will be treated as short-term capital gains (i.e., taxed at ordinary individual rates). A conversion of UPREIT units to REIT shares is generally a taxable event that will result in short-term capital gain to the holder if done prior to the three-year holding mark.
- The partnership “technical termination” rules have been repealed, so a 50 percent or greater change in ownership will no longer require the partnership to restart depreciation and make new elections.
- Non-REIT unit holders may be able to offset rental income with a 20 percent deduction (similar to the 20 percent REIT dividend deduction discussed above); however, this deduction has wage and invested capital limitations.
Planning tip: The above tax law changes are generally favorable, with the exception of the three-year holding period requirement for carried interests. Partnership and employment agreements may need to be updated so long term incentive plan (LTIP) units are held for at least three years before sale (or ensure holders are aware of the tax impact of disposition prior to the three-year mark). Because rental income is eligible for 20 percent deduction, unit holders may need additional information such as asset acquisition and wage information to determine if there are any limitations. REITs may want to be proactive and provide this information as a footnote or statement on the partnership’s Schedule K-1s issued to the unit holders.
In summary, the TCJA should generally impact REITs and their investors in a favorable manner and provide for additional tax planning opportunities. Nevertheless, as with most major tax law changes, there are potential traps that will need to be navigated and the need for future guidance from the IRS and U.S. Treasury to fully understand the long-term impact of the TCJA on REITs and the real estate industry.
For more information on this topic, or to learn how Baker Tilly real estate specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.