Presenting a live 90-minute webinar with interactive Q&A. Today s faculty features:

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1 Presenting a live 90-minute webinar with interactive Q&A Tax Reform: Impact on REITs, Real Estate Businesses and Investors Pass-Through Business and Interest Deductions, Cost Recovery, Carried Interest, Sale of Partnership Interests, and More TUESDAY, FEBRUARY 27, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Steven R. Meier, Partner, Seyfarth Shaw, Chicago John P. Napoli, Partner, Seyfarth Shaw, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Tax Reform: Impact on REITs, Real Estate Businesses, and Investors John Napoli and Steven Meier Seyfarth Shaw LLP Seyfarth Shaw refers to Seyfarth Shaw LLP (an Illinois limited liability partnership) Seyfarth Shaw LLP. All rights reserved. Private and Confidential

6 Agenda 01 Background: Timing of tax law changes 02 Overview: What has changed/stayed the same 03 Pass-through business deduction 04 REIT dividends 05 Business interest deduction 06 Cost recovery 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 6

7 Agenda 07 Like-kind exchanges 08 Carried interest holding period requirements 09 Sales of partnership interests by foreign partners 10 State and local tax deduction 11 Section 179 expensing 12 Historic preservation and rehabilitation tax credits 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 7

8 Agenda How we ll proceed: After a little background and an overview, we ll cover the major provisions that impact real estate and REITs We ll discuss the provisions, work through an example or two, discuss the implications of the provision for real estate and REITs, and then point out some issues that will require Treasury/IRS guidance We will answer questions at the end 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 8

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10 Background: Timing of tax law changes November 2: House introduces Tax Cuts & Jobs Act (the Act ) November 3: House releases Chairman s Mark of the Act November 9: House Ways and Means Committee approves of the Act Senate releases Chairman s Mark of the Act November 16: House passes the Act Senate Finance Committee approves of the Act 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 10

11 Background: Timing of tax law changes November 28: Senate Budget Committee approves of the Act December 2: Senate passes the Act December 15: Conferees appointed December 19: Senate passes modified Act December 20: House passes modified Act December 22: President Trump signs the Act into law 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 11

12 Overview: What has changed and what stayed the same Changed: Individual rates and corporate rates New deduction that will reduce tax on income from passthrough businesses Business interest deduction has been limited (for nonreal estate; there is a special rule for real estate) Increased cost recovery/bonus depreciation (for non-real estate and, in some circumstances, real estate) Sales of partnership interests by foreign partners (back to normal) Historic preservation and rehabilitation tax credits 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 12

13 Overview: What has changed and what stayed the same Did not change: Business interest deduction (for real estate) Cost recovery/bonus depreciation (for real estate) 1031s survived! (for the most part) Most of the rules related to carried interests SALT deduction (for businesses) 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 13

14 Pass-through business deduction New Code Section 199A: 20% tax deduction for individuals for qualified business income from pass-through businesses This deduction is scheduled to expire after 2025 Pass-through businesses include domestic: Sole proprietorships Partnerships S corporations LLCs taxed as partnerships, S corporations, disregarded entities, trusts, etc. REITs Publicly traded partnerships Cooperatives 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 14

15 Pass-through business deduction Qualified business income does not include: Income (received by taxpayers with income above $315,000 if filing a joint return or $157,500 otherwise) from a specified service trade or business Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing or investment management, trading, or dealing in securities, partnership interests, or commodities, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners Section 707(c) guaranteed payments for services Amounts paid that are treated as reasonable compensation paid to a taxpayer Amounts paid or incurred for services by a partnership to a partner who is acting other than in his or her capacity as a partner 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 15

16 Pass-through business deduction Deduction amount limitation: Wage limitation and basis limitation For taxpayers with incomes above certain thresholds ($315,000 joint return or $157,500 otherwise), the 20% deduction is limited to the greater of: 50% of the W-2 wages paid by the business, or 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable property (which includes structures, but not land) 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 16

17 Pass-through business deduction Deduction amount limitation: Real estate businesses need to look carefully at the wage and basis limitations to be sure that they will receive the full 20% deduction The plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable property is very significant for real estate businesses - For most real estate businesses the 2.5% will be sufficient to allow the full 20% deduction - If not, the business may need to consider restructuring to shift around W-2 employees 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 17

18 Example 1: Pass-through business deduction Jim, an individual, is the sole owner of Jim s Business, LLC In 2018, Jim receives $1,000,000 from Jim s Business, LLC In 2018, Jim s Business, LLC paid $100,000 in W-2 wages and has $5,000,000 unadjusted basis in depreciable property Jim s maximum deduction, before considering the limitations, would be $200,000 (20% of 1,000,000) BUT: Jim s limitation (the greater of 50% of W-2 wages or 25% of W-2 wages + 2.5% of basis in depreciable property) is: $150,000-50% of $100,000 = $50,000-25% of $100, % of $5,000,000 = $25,000 + $125,000 = $150,000 Jim can only deduct $150,000, the rest is taxed at individual rates 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 18

19 Pass-through business deduction Example 2: Same as Example 1, except Jim s Business, LLC paid $100,000 in W-2 wages and has $7,500,000 unadjusted basis in depreciable property in 2018 Jim s maximum deduction, before considering the limitations, would still be $200,000. Jim s limitation is: $212,500-50% of $100,000 = $50,000-25% of $100, % of $7,500,000 = $25,000 + $187,500 = $212,500 Jim can deduct the full $200,000, the rest is taxed at individual rates 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 19

20 Pass-through business deduction Example 3: Same as Example 1, except Jim s Business, LLC is a pure real estate business (non-s corporation) with no employees, and so no W-2 wages, but has $10,000,000 unadjusted basis in depreciable property in 2018 Jim s maximum deduction, before considering the limitations, would still be $200,000 Jim s limitation is: $250,000-50% of $0 = $0-25% of $ % of $10,000,000 = $0 + $250,000 = $250,000 Jim can deduct the full $200,000, the rest is taxed at individual rates 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 20

21 Pass-through business deduction Example 4: Same as Example 1, except Jim s Business, LLC is a specified service trade or business (here, say a consulting business) Jim received $1,000,000 in 2018, so his income exceeds the threshold ($315,000 if filing a joint return or $157,500 otherwise) and the specified service trade or business provision applies to him Jim s income from Jim s Business, LLC is not qualifying business income Jim cannot deduct any of the $1,000,000 he received from Jim s Business, LLC, everything is taxed at individual rates 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 21

22 REIT dividends REITs are considered a pass-through business for purposes of this deduction As a result, REIT most dividends qualify for the deduction REIT qualified and capital gains dividends do not qualify for the deduction REIT dividends are not subject to the wage and basis limitations Effective maximum U.S. federal income tax rate on qualified REIT dividends is 29.6% (plus additional 3.8% Medicare tax on dividends) 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 22

23 Example 5: REIT dividends Same as Example 1, except Jim also owns stock in REIT In 2018, Jim receives $50,000 in ordinary dividends from REIT Jim s maximum deduction, before considering the limitations, would be $210,000 (20% of 1,000, % of $50,000) Jim s deduction with respect to his income from Jim s Business, LLC is subject to the same limitation ($150,000) But: REIT dividends are not subject to the wage and basis limitations Jim can take the full $10,000 deduction (20% of $50,000) with respect to his REIT dividends Jim can deduct $160,000, the rest is taxed at individual rates 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 23

24 Implications: Pass-through business deduction & REIT Dividends The combination of the new deduction and the reduction of the maximum individual tax bracket from 39.6% to 37% will result in significant tax savings for real estate investors The carve out for specified service trade or business may mean that service professionals should consider whether it makes sense to run their business through a personal service corporation For REITs, the reduced corporate tax rate (now 21%) reduces, but does not eliminate, the benefit to choosing REIT rather than corporate form The Act reduces the favorable rate differential between qualified REIT dividends and C corporation dividends from 8.4% to 7.2% However, C corporation tax rate does not expire, but the passthrough deduction will expire, unless extended, after Seyfarth Shaw LLP. All rights reserved. Private and Confidential 24

25 Issues: Pass-through business deduction & REIT Dividends Combination of qualified and nonqualified businesses What if a partnership has two different businesses, one qualified and the other nonqualified? Do you need to bifurcate? On what basis do you bifurcate? How do you bifurcate employees/assets? Consulting What if consulting is an ancillary part of the business? Does it taint the qualifying business? How significant must it be before it taints? Doing business with a specified service trade or business If a business provides permissible services on an arm s length basis to a specified service trade or business, does the business qualify for the 20% deductions? Skill and reputation as a principle asset What does this mean? 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 25

26 Issues: Pass-through business deduction & REIT Dividends Reasonable compensation exclusion from qualified income Does the reasonable compensation exclusion from qualified income only apply to S corporations? Are partnerships and sole proprietors required to designate a certain amount of net business income as reasonable compensation? Aggregation of activities: Can businesses aggregate all of qualified trades or businesses at the partner level for the purposes of the wage and basis limitations? 1031 exchange impact on deduction limitation Does exchanging property in a 1031 transaction reduce a business basis for purposes of the basis limitation? REIT interests through a mutual fund If an investor holds its REIT shares through a mutual fund (as is the case for approximately half of all REIT shareholders) does the investor get the benefit of the deduction? 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 26

27 Business interest deduction Business interest deduction (Generally): Business interest = any interest paid or accrued on indebtedness properly allocable to a trade or business, excluding investment interest New Code Section 163(j): for most taxpayers, the Act disallows the deductibility of business interest to the extent that net interest expense exceeds 30% of EBITDA (2018 through 2022) or EBIT (beginning in 2022) EBITDA = taxpayer s earnings before interest, taxes, depreciation and amortization EBIT = taxpayer s earnings before interest and taxes EBITDA is the bigger number 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 27

28 Business interest deduction Business interest deduction (Generally): The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely This provision applies to existing debt and applies at the entity level The limitation does not apply to taxpayers whose average annual gross receipts for the three-tax-year period ending with the prior tax period does not exceed $25 million 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 28

29 Business interest deduction Business interest deduction (Real Estate): A real property trade or business can elect out of the new business interest disallowance regime. Any business engaged in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business The real estate exception extends to (1) the activities of corporations and REITs, and (2) the operation or management of a hotel. The election out is irrevocable 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 29

30 Business interest deduction Business interest deduction (Partnerships): The limitation on the deduction is determined at the partnership level, and any deduction available after applying such limitation is included in the partners nonseparately stated taxable income or loss from the partnership Any business interest that is not allowed as a deduction to the partnership for the taxable year is not carried forward by the partnership but, instead, is allocated to each partner as "excess business interest" in the same manner as nonseparately stated taxable income or loss of the partnership 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 30

31 Business interest deduction Business interest deduction (Partnerships): The partner may deduct its share of the partnership s excess business interest in any future year, but only against excess taxable income attributed to the partner by such partnership A partner s share of excess taxable income is determined in the same manner as nonseparately stated income and loss Any disallowed interest expense allocated to a partner immediately reduces the unitholder s basis in its partnership interest, but any amounts that remain unused upon disposition of the interest are restored to basis immediately prior to disposition 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 31

32 Example 6: Business interest deduction In 2018, Jim s Business, LLC paid $2,000,000 in net interest expense that is properly allocable to its trade or business to Lender In 2018, Jim s Business, LLC s earnings before interest, taxes, depreciation and amortization is $5,000,000 The business interest expense limitation is $1,500,000 (30% of $5,000,000) Jim s Business, LLC can only deduct $1,500,000 in business interest in 2018 Jim s Business, LLC can carry forward the $500,000 in disallowed business interest indefinitely 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 32

33 Example 7: Business interest deduction Same as Example 6, except Jim s Business, LLC is a real property development business Jim s Business, LLC can make an election out of the business interest deduction Jim s Business, LLC would then be able to deduct the full $2,000,000 in net interest However, the election does have an impact on Jim s Business, LLC s ability to take advantage of the new cost recover provisions 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 33

34 Example 8: Business interest deduction Same as Example 6, except Jim s Business, LLC is taxed as a partnership and Jim owns 20% of Jim s Business, LLC Jim is entitled to $300,000 of Jim s Business, LLC s $1,500,000 allowed business interest deduction which the partnership will include in Jim s nonseparately stated taxable income or loss from the partnership Jim will be allocated $100,000 of Jim s Business, LLC s $500,000 disallowed business interest deduction as excess business interest which he can deduct against Jim s Business, LLC s excess taxable income in 2019 that is attributed to him The $100,000 in disallowed business interest reduces Jim s basis in Jim s Business, LLC 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 34

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36 Cost recovery (Generally): Bonus depreciation Cost recovery The Act permits businesses an immediate write-off of the full cost of qualified property After 2022, the bonus depreciation percentage is phaseddown to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026 The Act removes the requirement in current law that the original use of qualified property must commence with the taxpayer Thus, immediate expensing applies to purchases of used as well as new items 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 36

37 Cost recovery (Real Estate): Cost recovery Taxpayers that elect to use the business interest real estate exception will be permitted to fully expense land improvements and tangible, personal property used in their real property trade or business from 2018 to 2023 However, such taxpayers must depreciate real property using ADS under slightly longer recovery periods: 40 years for nonresidential property, 30 years for residential rental property, and 20 years for qualified improvement property (interior) The switch to ADS applies to all nonresidential rental property, residential rental property, and qualified improvement property, not just property placed in service beginning in 2018 The Act did not adopt the Senate proposal to reduce the MACRS depreciable lives on residential and nonresidential depreciable property 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 37

38 Example 9: Cost recovery In 2018, Jim s Business, LLC purchase equipment (either new or used) for $1,000,000 and places the equipment into service the same year Jim s Business, LLC can deduct its full $1,000,000 basis in the equipment in Seyfarth Shaw LLP. All rights reserved. Private and Confidential 38

39 Example 10: Cost recovery Same as Example 9, except Jim s Business, LLC elected out of the business interest deduction limitation Jim s Business, LLC cannot fully expense its equipment in Seyfarth Shaw LLP. All rights reserved. Private and Confidential 39

40 Implications: Business interest deduction & cost recovery Real estate trades and businesses will need to decide which is more important to their business Companies that rely heavily on leverage, may choose to elect out of the business interest deduction limitation Companies that do not rely heavily on leverage may find that the shorter depreciable lives of real property (and expensing for qualified improvement property) may outweigh any detriment from the limitation on interest deductions The interest limitation will be less onerous initially because adjusted taxable income will not include deductions for depreciation, amortization, or depletion until to This may mean that the depreciation and expensing benefits could justify deferring the election for exemption from the interest limitation until Seyfarth Shaw LLP. All rights reserved. Private and Confidential 40

41 Issues: Business interest deduction & cost recovery Debt incurred to capitalize an entity that engages in a real property trade or business If a taxpayer borrows money and uses the money to capitalize an entity that is engaged in a real property trade or business, can that taxpayer elect out of the business interest deduction limitation and deduct the interest? If the debt is used to capitalize several businesses, some of which are real property trades or businesses and others are not, does the taxpayer need to allocate debt/interest among the businesses? Corporations borrowing to invest in REITs If a corporation incurs debt to purchase REIT shares, can the corporation elect out of the business interest deduction limitation and deduct the interest? 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 41

42 Like-kind exchanges The Act permits taxpayers to continue to defer gain on real estate like-kind exchanges. Improved real estate and unimproved real estate will continue to be considered property of a like kind. However, the portion of any exchange that includes personal property will no longer qualify for tax deferred treatment under Code Section 1031 General Implications: This is very good for real estate because it will continue to generate interest in real estate investments Not a significant change from current law Cost Segregation Implications 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 42

43 Carried interest holding period requirements Holders of a carried interest in certain types of partnerships, including hedge funds, private equity funds, and real estate, must hold the interest for 3 years in order to receive long-term capital gain treatment. The 3-year holding period applies to the partnership interest and to the assets held by the partnership If the holder disposes of the interest before the 3 years, they receive short-term capital gain treatment Implications: this is unlikely to have a significant impact Most carried interest holders hold their interest for more than 3 years anyways 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 43

44 Sales of partnership interests by foreign partners The Act added a provision that treats gain or loss from the sale of a partnership interest by a foreign partner as effectively connected income ( ECI ) that is taxable in the U.S. if the gain or loss from the sale of the underlying assets held by the partnership would be treated as ECI This provision statutorily reverses the Tax Court s recent decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA vs. Commissioner, 149 T.C. No. 3 (Jul. 13, 2017) and returns to a rule similar to Revenue Ruling ( C.B. 107) The Act also requires the purchaser of a partnership interest from a partner to withhold 10% of the amount realized on the sale or exchange of the partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or a foreign corporation Implication: Return to status quo; must account for new withholding 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 44

45 State and local tax deduction The Act continues to permit pass-through entities the ability to deduct state and local taxes paid or accrued in carrying on a trade or business or in an activity related to the production of income Implication: Status quo However, for individuals, the property and SALT tax deduction is limited to a combined $10,000 Implication: This may have an impact on residential property values in high-tax states 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 45

46 Section 179 expensing The Act increases the maximum amount that a taxpayer may expense under Code Section 179 to $1,000,000, and increases the phase-out threshold amount to $2,500,000 The provision also expands the definition of Code Section 179 property to include: Certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging, and Any of the following improvements to nonresidential real property placed in service after the date the real property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems Implications: Helpful for smaller real estate businesses 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 46

47 Historic preservation and rehabilitation tax credits The Act preserves the 20% tax credit for the rehabilitation of historically certified structures, but now requires that taxpayers claim the credit ratably over a 5-year period. The Act repeals the 10% credit for the rehabilitation of pre structures 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 47

48 Overall Impressions Benign to favorable for real estate New pass-through deduction is helpful for bringing in new investors Real estate businesses will need to choose between avoiding the new business interest deduction limitation or enjoying the new full and immediate bonus depreciation May cause a shift away from debt financing towards equity financing Retention of 1031s for real property is critical Carried interest left largely unharmed 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 48

49 Questions? 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 49

50 Thank you Steven R. Meier John P. Napoli 2018 Seyfarth Shaw LLP. All rights reserved. Private and Confidential 50