Berdon Tax Team
01.30.2018 | Berdon Industry Insights
The Tax Cuts and Jobs Act (TCJA) is generally favorable for real estate investment trusts (REITs). Below is a brief overview of some of the more relevant changes and their impact on REITs:
Reduced Income Tax Rates
The TCJA reduced the tax rate applicable to C corporations from 35% to 21%, effective for taxable years beginning after December 31, 2017. It also reduced the highest marginal income tax rate applicable to non-corporate taxpayers (i.e., individuals, trusts and estates) from 39.6% to 37% (excluding the 3.8% Medicare tax on net investment income), effective for taxable years beginning after December 31, 2017 and before January 1, 2026. The lower corporate tax rate will generally reduce the tax burden on taxable REIT subsidiaries (TRSs).1 Moreover, the lower corporate and individual rates will result in lower foreign withholding under the Foreign Investment in Real Property Tax Act (FIRPTA).
REIT Dividends Eligible for Pass-Through Deduction
The TCJA allows individual investors, including trusts, to deduct up to 20% of ordinary REIT dividends (excluding capital gain dividends and qualified dividend income, which continue to be subject to a 20% rate). Ordinary REIT dividends are eligible for the pass-through deduction regardless of the REIT’s source of income (or the level of the REIT’s wages or depreciable property, which are limiting factors for pass-through business income from other than REITs and PTPs). REIT capital gain dividends continue to be subject to lower capital gains tax rates. With the new pass-through deduction, (discussed below) an individual investor that is eligible for the full pass-through deduction would have a maximum marginal tax rate on REIT dividends of 29.6%.
Depreciation of Real Property
The TCJA reduces the recovery period under the modified accelerated cost recovery system (MACRS) for qualified improvement property (QIP). QIP includes any improvement to the interior portion of a building (other than elevators, escalators, or internal structural framework) which is non-residential real property if such improvement is placed in service after the date the building was first placed in service.2 The TCJA made no change to the MACRS recovery period for non-residential real property or residential real property. While the TCJA also reduced the alternative depreciation system (ADS) lives of residential real property and QIP, it made no change to the ADS life of non-residential real property.
The changes to depreciation on real property apply to property placed in service after December 31, 2017. Changes made to real property depreciation are summarized in the following chart:
|Nonresidential||39 Years||39 Years||40 Years||40 Years|
|Residential||27.5 Years||27.5 Years||40 Years||30 Years|
|QIP|| Same as the|
|15 Years|| Same as the|
The shortening of the MACRS recovery period for QIP, and the shortening of the ADS lives for residential real property and QIP, are favorable changes for REITs because of the increased depreciation deductions.
Limitation on Deductibility of Business Interest
Under the TCJA, the deductibility of net interest expense for a business is limited to 30% of the “adjusted taxable income” of the business. Adjusted taxable income is defined as business taxable income, computed without regard to business interest income or expense, net operating loss (NOL) deductions and, in the case of taxable years beginning before January 1, 2022, deductions for depreciation or amortization. Disallowed interest can be carried forward indefinitely.
A “real property trade or business” is permitted to elect to deduct 100% of its interest expense but, by making this election, the taxpayer is required to use ADS to depreciate real property used in its trade or business, regardless of when the property was placed in service. For this purpose, a real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. How the change to ADS will be implemented for existing depreciable property of electing taxpayers requires guidance from the Treasury. The limitations on deductibility of net interest expense for a business under the TCJA apply to taxable years beginning after December 31, 2017, including interest paid or accrued on indebtedness incurred prior to December 31, 2017. For REITs that already use ADS to calculate their taxable income, making this election should not affect depreciation expense.
Mortgage REITs may not be impacted by the 30% interest limitation because business interest expense can be fully deducted to the extent of business interest income. Equity REITs will need to determine whether their net interest deductions exceed the 30% limit. An equity REIT that is subject to the limitations on interest deductions will need to analyze whether to elect out and use ADS, based on the new recovery periods after the TCJA, for its buildings and improvements, which will decrease the depreciation deductions for purposes of computing REIT taxable income.
For more on the 30% interest limitation, see: New Business Interest Expense Deduction Limitation is a Game Changer
Prior to the TCJA, like-kind exchanges applied to both real and personal property. The TCJA now limits like-kind exchanges to exchanges of real property not held primarily for sale, effective for exchanges completed after December 31, 2017. In general, built-in gain in a REIT’s properties is attributable to real property, not personal property. Thus, the limitation of like-kind exchanges to real property not held primarily for sale should not adversely impact most REITs. Those REITs planning like-kind exchanges of assets that contain both real property and personal property (for example, hotels) should be aware that any gain attributable to the personal property component will no longer be eligible for like-kind exchange treatment.
As with most aspects of the TCJA, the provisions noted above are generally complex and leave many open questions. To determine how these provisions may affect you, please contact your Berdon advisor.
Berdon LLP New York Accountants
1 TRSs, however, will be subject to the new limitation on the deduction of net business interest expense, which is described below.
2 The TCJA eliminated the special rules for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.