You already know tax reform will affect your real estate company. But surely some effects are still unclear.
To provide explanations and insights, Grant Thornton, in cooperation with Bloomberg, hosted the webcast Tax Reform’s Impact on the Real Estate Industry.
Replay it for complete coverage of the discussion.
See the following for an overview of the webcast’s main topics and answers to questions you might have been asking. In just a few minutes you’ll know more about potentially significant favorable and not-so-favorable impacts, and learn about opportunities for tax planning.
Does it make sense for my pass-through entity to convert to a C-corp?
Though the 21% corporate rate is attractive, the fact that most real estate companies have distributions should give pause to a conversion. As a C-corp, a real estate company making the distribution out of cash would be subject to double taxation.
A C-corp pays $21 in tax on $100 of taxable income. Then if earnings are distributed in full, the $79 distribution is taxed as a dividend at the individual level at up to 23.8%. So the total tax paid is $40. A pass-through has only one layer of tax at the top individual rate of 37%, or $37 in tax on the $100.
The analysis should start with how much of the earnings will be distributed, but there are other important considerations such as exit plans and potential international investments. See the comparisons and do the math — “Should pass-through owners switch to C-corp status?
We’re a REIT C-corp — can we avoid distributing capital gain income?
Investment in growth
“There’s a play in the future for REITs to retain some cash, pay the toll price of the 21% tax and deploy that cash for growth.”
Lorraine White, Partner, Tax Services
Real estate investment trusts (REITs) aren’t obliged to distribute their capital gain income. Your company pays the corporate rate on this kind of taxable income, but it doesn’t have to distribute all of that income. Capital gain proceeds can be deployed for additional investments.
Are losses from my pass-through activities netted against income for the new pass-through deduction?
Yes, all the qualified business income (QBI) reported from pass-throughs on K-1s must be aggregated, even if some are negative loss amounts. The new Section 199A deduction is available to pass-through entity owners and sole proprietors, without distinction between passive and active owners. It reduces taxable income but not gross income or adjusted gross income (AGI). Section 199A doesn’t affect AGI-based phase-ins and phase-outs, and is not expected to reduce state income in the vast majority of states. To determine the 199A deduction, conduct a walk-through calculation for each qualified business activity. Combine the separate results to produce the net final 199A deduction. If overall QBI is negative, you won’t have a deduction, but you can carry the loss forward for a potential deduction in the future.
REITs and NOL changes
As a REIT, are my NOLs treated differently from before?
In applying net operating losses (NOLs), REITs now have rules similar to those of corporations. Starting in 2018, the NOL deduction is limited to 80% of REIT taxable income. NOL carrybacks are disallowed, but carryforwards are unlimited. However, in contrast to other C-corps, REITs can deduct from their corporate taxable income the dividends they distribute to shareholders.
Business interest expense limitation
If we elect to opt out of the new business interest expense limitation, is the decision permanent, i.e., irrevocable?
Yes, for now.
At this point, it appears that irrevocable means that once you make the election, it’s final. You’ll have no annual election on your tax return. But taxpayers are still awaiting Treasury guidance in this area; this could affect the answer.
If we are not limited under the new Section 163(j) but have a change in the future years, can we make our election then?
Yes, for now.
“These companies can use the cash method and percentage-of-completion methods, and are exempt from UNICAP and relieved of inventory accounting.”
Karl Seemer, Managing Director, Tax Services
You can wait until a future year to make the election. Then it will be irrevocable, absent new guidance from Treasury.
But the election is moot if you’re a small business taxpayer. You won’t be subject to the new Section 163(j) interest expense limitation until your company has average gross receipts of more than $25 million in the prior three taxable years.
What do I need to do from a business entity perspective to opt out of the limitation?
Consider a carve-out.
Model the potential of bifurcating real estate from regular operations. In investigating this option you must first understand if your business interest expense will be limited so you need to calculate your threshold amount. Calculate earnings before income tax for the first four years, starting in 2018, as you would from a gap perspective. The twist is you’ll need to roll in your tax adjustments for an adjusted taxable income (ATI) calculation of earnings before interest, taxes, depreciation and amortization (EBITDA). In 2022, the calculation will become more stringent. At that point the threshold amount would be EBIT with tax adjustments.
There’s a quid pro quo to electing out of the limitation — you can’t take bonus depreciation.
Would my company be better off by taking the bonus depreciation and foregoing the irrevocable election?
In the short term, possibly.
Putting off the election gives you time to put a framework in place to model the short- and long-term consequences. This is important; what makes sense in year one might not make sense in year two, three or four, or further down the road.
Forfeiting bonus depreciation to elect out of the limitation would also require you to depreciate residential and commercial real estate property over the alternative depreciation system (ADS) recovery period. REITs already run ADS depreciation for earnings and profits (E&P) purposes.
The choice between interest expense limitation and bonus deprecation is made more complicated because of state tax considerations. This is really no change from when bonus depreciation was a 50% deduction versus 100% expensing. The difference is in that most states are expected to decouple from 100% bonus depreciation. You’ll shoulder a greater burden in keeping track of the various books of depreciation. And you can expect additional state tax consequences in the sale of underlying property to create state tax consequences.
A trade-off to consider
“It’s a huge opportunity — especially at this time of year but also going forward — to take advantage of tangible property regulations.”
Chris Young, Senior Director, Tax Services
Giving up bonus 100% depreciation doesn’t necessarily mean giving up on all immediate deductions. Under the favorable tangible property regulations, many building costs can now be deducted immediately as repairs or partial dispositions. These deductions are separate from bonus depreciation, so you can still immediately deduct them even if you forego bonus to avoid the limit on interest deductions.
Weighing the tax planning factors
Given the interconnection of these key factors in tax decision-making, there’s no better time for modeling. In tax planning, pulling one lever affects another. Do the analyses necessary for strong positioning through the tax reform era and into the next stage, when tax reform has become simply business as usual.
For a detailed analysis of key tax reform provisions, see “Tax reform law transforming business and tax planning
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