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The Effect of Tax Reform on Real Estate: Tax Cuts and Jobs Acts (TCJA)

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Roger Royse's presentation on the effect of tax reform on real estate. This part covers Tax Cuts and Job Acts (TCJA). This is part 1 of 3.

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The Effect of Tax Reform on Real Estate: Tax Cuts and Jobs Acts (TCJA)

  1. 1. THE EFFECT OF TAX REFORM ON REAL ESTATE Roger Royse rroyse@rroyselaw.com www.rroyselaw.com Research Assistant: Natalie Ryang Part I. Tax Cuts and Job Acts (TCJA) Part II. Foreign Partners in the U.S. Partnerships Part III. Foreign Investment in the U.S. Real Estate
  2. 2. No information contained in this presentation is to be construed as legal advice. No information contained in this presentation is intended or related to any particular factual situation. Nothing herein forms an attorney-client relationship. If legal advice or other expert assistance is required, the services of a competent professional should be sought. 2 Disclaimer
  3. 3. Summary of Tax Cuts and Jobs Acts (TCJA) 1. Rate change: TCJA reformed both individual income and corporate income taxes • Top Corporate income tax rate reduced from 35% to 21% • Top Individual income tax rate reduced from 39.6% to 37% 2. Section 199A Deduction: Established a 20% deduction of qualified business income in the U.S. Part I. Tax Cuts and Jobs Acts 3
  4. 4. Summary of Tax Cuts and Jobs Acts (TCJA) 3. Interest Deduction: Limits the deductibility of net interest expense to 30% of earnings • Adjusted taxable income based on EBITDA until 2022, then EBIT 4. Interest Deduction in Real Property Business: Election out for real estate • Election is irrevocable and requires use of straight line method depreciation and longer recovery period than under usual depreciation method Part I. Tax Cuts and Jobs Acts 4
  5. 5. Summary of Tax Cuts and Jobs Acts (TCJA) 5. 100% expensing for qualifying property including real property improvements 6. Limit NOL deductions to 80% of taxable income 7. Business losses for individuals limited 8. Like-Kind Exchanges: Retains the current 1031 Like-kind exchange rule for real property 9. Carried interest: 3 year capital gains holding period for carried interests in partnerships Part I. Tax Cuts and Jobs Acts 5
  6. 6. 10. Technical Termination: termination of partnership after material ownership change is repealed 11. 10% withholding on sales proceeds of non-resident aliens (NRAs) from a disposition of interest in a partnership that owns a US business or real property Part I. Tax Cuts and Jobs Acts 6 Summary of Tax Cuts and Jobs Acts (TCJA)
  7. 7. 1. Tax Rates Individual Income Tax Rates Corporate Income Tax Rates • Maximum rates lowered from 39.6% to 37% • 3.8% Net Investment Income Tax (NIIT) retained for unearned income • Rate reduction set to expire after 2025, unless renewed • Corporate tax rate permanently reduced from 35% to 21% • Graduated corporate tax rate structure is eliminated • Corporate AMT (Alternative Minimum Tax) is eliminated Part I. Tax Cuts and Jobs Acts 7
  8. 8. 2. Section 199A: 20% Deduction • Deduction of up to 20% of domestic “qualified business income” (QBI) from a partnership, S corporation, or sole proprietorship – sunsets after 2025 • Reduces top marginal rate to 29.6% for QBI [(100%-20%) * 37%] • QBI is income effectively connected with a qualified U.S. business, but excluding professional services businesses, including investing services • Deduction is subject to limitation based on wages paid, or on wages paid plus a capital assets factor (i.e., value of tangible, depreciable property) Part I. Tax Cuts and Jobs Acts 8
  9. 9. 199A Deduction • 20% deduction for pass-through entities through 2025. • Up to 20% of “qualified business income” (QBI”). • 199A deduction is the lesser of: (1) the taxpayer’s “combined qualified business income amount,” or (2) 20% of the excess of (i) the taxpayer’s taxable income for the taxable year, over (ii) the taxpayer’s net capital gain for such taxable year. 9Royse Law Firm PC
  10. 10. Qualified Business Income • QBI is the net amount of qualified income, gain deduction and loss with regards to a qualified trade or business. • Must be effectively connected to US trade or business • Included or allowed in determining taxable income. • Qualified Business Income does not include the following: • Investments-dividends, interest capital gains. • Compensation paid to an owner for services rendered with respect to the trade or business. • Guaranteed payments • Reasonable Compensation • Payments to a partner for services rendered • W-2 Income 10Royse Law Firm PC
  11. 11. Limitation on 199A Deduction • For taxpayers over the thresholds, 20% deduction limited to the greater of: • 50% of W-2 wages paid, or • 25% of W-2 wages paid plus 2.5% of the original basis of “Qualified Property” • S Corps must pay W-2 wages • Partnerships cannot pay W-2 Wages to partners • Guaranteed payments under Section 707(c) and payments not in capacity of a partner under Section 707(a) are not W-2 wages or QBI 11Royse Law Firm PC
  12. 12. Limitation on 199A Deduction • Taxpayers whose taxable income is less than the “threshold amount” not subject to wage limits • Threshold amount is • $157,500 or • $315,000 in the case of a joint return. • Phase out of the wage limits for QBI between $207,500 and $415,000, 12Royse Law Firm PC
  13. 13. 3. Interest Deduction • Deduction for business interest expense limited to 30% of “adjusted taxable income” • Adjusted taxable income based on EBITDA until 2022, then EBIT • Utilization in future years subject to applicable interest deductibility limitations • Limitation applies at entity level • Exception from 30% limitation: • Small Business Exception: revenues of less than $25M • Electing Real Property Trade or Business Exception (RPTB Exception) Part I. Tax Cuts and Jobs Acts 13
  14. 14. 4. Interest Deduction for Real Property Business • Real property trade or businesses (RPTB) may elect to be excluded from the interest deductibility limitation • RPTB includes real property development, redevelopment, construction, rental, management, leasing trade or business. IRC 469(c)(7)(C) • Election is irrevocable • Election generally requires use of straight line method depreciation and longer recovery periods than under usual depreciation method • Recovery periods extended • Nonresidential depreciable real property: 40 years • Residential depreciable real property: 30 years • Qualified improvements are extended: 20 years Part I. Tax Cuts and Jobs Acts 14
  15. 15. Passthroughs • Applied at partnership level: a partner can only include business interest income from a partnership to the extent it exceeds business interest expense of that partnership • Carryforward of excess interest expense • No carryforward of excess limitation • Corporate and non corporate taxpayers • S corporation similar to partnership treatment . Part I. Tax Cuts and Jobs Acts 15
  16. 16. 5. 100% Expensing: First Year Bonus Depreciation • 100% of cost basis of qualifying property placed in service can be expensed in that tax year from September 2017 through 2022 • After 2022, percentage phases down to 80% for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026 • No “original use” requirement – applies to purchases of used and new equipment • Excludes property acquired from affiliate or in a tax free transaction (i.e., like kind exchange) • Qualified property generally includes assets with recovery periods of 20 years or less • Real estate related property eligible for 100% expensing includes heating, lighting, plumbing, cooling, fire protection, and alarm systems Part I. Tax Cuts and Jobs Acts 16
  17. 17. 179 Deduction - Taxpayer can deduct cost of 179 property - Increased deduction from 500K to 1Million - Includes: Qualified Improvement property, roofs, HVAC fire systems, alarm + security systems Recovery Periods Real Property - TCJA- Keeps 39 years for non residential real-estate - 27.5 years for residential rental from 40 to 30 years - Qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property given 15 years life Part I. Tax Cuts and Jobs Acts 17
  18. 18. Part I. Tax Cuts and Jobs Acts 18 • Qualified Improvement Property Purchase: $1,500,000 • 179 Deduction $1,000,000 • 100% first year bonus for qualified property $ 500,000
  19. 19. 6. NOL Limitation • Corporate NOLs arising in a taxable year after 2017 can offset up to 80% of current year taxable income • No NOL carry-back, but unlimited carry-forwards Part I. Tax Cuts and Jobs Acts 19
  20. 20. 7. Individual Losses • “Excess business losses” (business loss in excess of $500k for married/$250k for individuals) now disallowed, but can be carried forward as an NOL for future years Part I. Tax Cuts and Jobs Acts 20
  21. 21. 8. Like-Kind Exchange • “Like-kind” exchange provisions are limited to real property • No dealer property (property primarily held for sale) • No domestic-foreign property exchanges • Personal property transferred as part of a larger like-kind exchange of real property no longer qualifies for tax deferred treatment Part I. Tax Cuts and Jobs Acts 21
  22. 22. 9. Carried Interest • 3 Year Holding Period for Long Term Capital Gain rates • Partnership interests held by individuals in exchange for performance of substantial services for an “applicable trade or business” (“carried interest”) must be held for at least 3 years to qualify for long term capital gain rates • Applicable trade or business includes one conducted regularly, continually, and substantially and may include real estate development for rental or investment • Holding period applies not just with respect to sale of the partnership, but also regarding the flow through gains upon sale of assets by the partnership • Holding partnership interest through a S-corporation Part I. Tax Cuts and Jobs Acts 22
  23. 23. 10. Technical Termination • Termination of partnership after material ownership change is repealed for partnership tax years beginning after December 31, 2017 • Under prior law, technical termination resulted from sale or exchange of 50% or more of the total interest in partnership capital and profits during a 12-month period • Partnership ownership changes will no longer restart partnership depreciation or allow new partnership level tax elections to be made Part I. Tax Cuts and Jobs Acts 23
  24. 24. 11. Residential Real Estate • Deduction for state and local property (and income and sales) taxes is limited to $10,000 per year • Limitation does not apply to taxes incurred in connection with a trade or business • Deduction for interest incurred on debt used to acquire, construct or improve a principal residence is limited to interest on up to $750,000 of debt (down from $1,000,000) • Deduction for interest on home equity debt eliminated • Exception for home equity loans used to buy, build or substantially improve the taxpayer’s qualified residence • Caps apply beginning in 2018 and expire after 2025, unless renewed Part I. Tax Cuts and Jobs Acts 24
  25. 25. Qualified Opportunity Zones
  26. 26. Qualified Opportunity Zones Part I. Tax Cuts and Jobs Acts 26 Geographic-based tax incentives for economic development Empowerment zones Enterprise communities Renewal communities Gulf opportunity zones New markets tax credits Census tracts Based on NMTCs Income levels of individuals residing in the census tract For opportunity zones generally limited to 25% of the NMTC eligible census tracts as designated by governors
  27. 27. Tax Consequences • Rollover of Gain into a Qualified Opportunity Zone Fund • Capital gain on stock or real estate assets deferred until the earlier of the date of sale or 12/31/2026 • 10% of the gain is forgiven for investment held for at least 5 years • Another 5% of the gain is forgiven for investment held for at least 7 years • No capital gain on the post reinvestment appreciation after 10 years 27
  28. 28. Rollover of Gains • Within 180 days after the sale of stock or real estate, the capital gain (not tax basis) must be invested in a Qualified Opportunity Zone Fund • IRS proposed regulations issued October 19, 2018 • 90% of the assets of a QOF must consist of Qualified Opportunity Zone Business Property or Qualified Opportunity Zone Partnership Interests or Stock Interests (“QOF Subsidiary”). 28
  29. 29. Election to Step-Up Basis in QOF • If held for at least 10 years, can step up basis to FMV on sale or exchange. • Must elect by December 31, 2047 29
  30. 30. Qualified Opportunity Zone Funds • The QOF has to invest its cash contributions in Qualified Opportunity Zones. • A QOF must self-certify. May elect QOF status at the beginning of any calendar month. • Elect by filing Form 8996. Form 8996 requires organizing documents include a statement of the entity’s purpose of investing in a Qualified Opportunity Zone Property and description of Qualified Opportunity Zone Business. • Must file annually to confirm status as a QOF. Test six months after elect QOF status and last day of tax year. For example, if elect as of April 1, 2019, then test on September 30 and December 31. 30
  31. 31. Qualified Opportunity Zone Funds • 90% of the QOF’s assets must be invested in Qualified Opportunity Zone Property (QOZP) • QOZ Partnerships • QOZ Stock • QOZ Business Property Part I. Tax Cuts and Jobs Acts 31
  32. 32. Qualified Opportunity Zone Business Property The QOF can meet its 90% asset test by owning Qualified Opportunity Zone – tangible property including real estate used in a trade or business: A. Purchased after December 31, 2017 from an unrelated party after 2017 (20% relatedness threshold) B. Original Use commences with the Qualified Opportunity Zone Fund or is substantially improved by the Qualified Opportunity Zone Fund; and C. Substantially all of the Property’s use is in the Qualified Opportunity Zone during substantially all of the Qualified Opportunity Zone’s holding period. 32
  33. 33. Qualified Opportunity Zone Business The QOF can meet its 90% asset test by owning Qualified Opportunity Zone Businesses: A. Stock in a domestic corporation obtained after December 31, 2017, if the corporation is engaged in a trade or business in the Qualified Opportunity Zone. B. Partnership or LLC Interests if acquired after December 31, 2017, if the partnership or LLC is engaged in a trade or business in the Qualified Opportunity Zone C. At least 50% of gross income is from active conduct of a business in Opportunity Zone. D. Substantially all (70%) of tangible property is in Qualified Opportunity Zone. E. Substantial portions of the intangible property are used in the active conduct of the Qualified Opportunity Zone trade or business. 33
  34. 34. Qualified Opportunity Zone Business 1.Less than 5% of the aggregate adjusted tax basis of Qualified Opportunity Zone Business is non-qualified financial property – such as stock, debt, partnership interests, options, futures, swaps and similar property; 2.Not a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, race track or other facility used for gaming, or store whose principal business is the sale of alcohol for off premises consumption; and 3.For an opportunity zone business, tangible property that ceases to be opportunity zone business property will continue to be treated as such for the lesser of: (a) 5 years after the date the property ceases to be Qualified Opportunity Zone Business Property, and (b) the date such property ceases to be held by the Opportunity Zone Business. 34
  35. 35. Original Use • The original use must commence within the Qualified Opportunity Zone Fund or • the Qualified Opportunity Zone Fund must make substantial improvements to the property which means additions or improvements to the property during the 30-month period after acquisition that exceeds its basis or purchase price. 35
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  37. 37. ROYSE LAW FIRM, PC For questions , Contact PALO ALTO 1717 Embarcadero Road Palo Alto, CA 94303 LOS ANGELES 11150 Santa Monica Blvd. Suite 1200 Los Angeles, CA 90025 SAN FRANCISCO 135 Main Street 12th Floor San Francisco, CA 94105 Palo Alto Office: 650-813-9700 CONTACT US www.rroyselaw.co m @RoyseLaw MENLO PARK 149 Commonwealth Drive, Suite 1001 Menlo Park, CA 94025 SANTA MONICA 520 Broadway Suite 200 Santa Monica, CA 90401 SAN FRANCISCO 135 Main Street 12th Floor San Francisco, CA 94105 Menlo Park Office: 650-813-9700 CONTACT US www.rroyselaw.com @RoyseLaw ORANGE COUNTY 135 S. State College Blvd Suite 200 Brea, CA 92821 rroyse@rroyselaw.com 37Part I. Tax Cuts and Jobs Acts

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