The Tax Cuts and Jobs Act of 2017 (TCJA) was a major overhaul of the tax law.
Real estate businesses were significantly impacted as a result of the changes. For the most part, the new rules mean a positive outcome for REITs.
Section 199A – QBI deduction
Section 199A entitles eligible taxpayers to deduct 20 percent of qualified REIT dividends and qualified publicly traded partnership (PTP) income. The term “qualified REIT dividends” does not include capital gain dividends.
In addition, Section 199A allows eligible taxpayers to deduct up to 20 percent of their qualified business income (QBI) from a domestic business, such as a partnership, sole proprietorship, S Corporation, trust, or estate. In order to take the 20 percent QBI deduction, income must be from a qualified trade or business under Section 162, which does not provide an explicit definition of what it means to be a trade or business. Furthermore, under the final Section 199A regulations, the Treasury declined to provide a bright line test for whether a rental real estate activity is considered a trade or business. The Treasury did, however, provide a safe harbor for qualifying rental real estate activities as a trade or business. Unfortunately, Revenue Procedure 2019-38 excludes owners of triple net lease property from using the safe harbor. The revenue procedure indicates that “a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities.” As a result, triple net lease property is not eligible for the QBI deduction, since it is not deemed a trade or business.
On the flip side, a REIT may own a triple net lease property and the qualified dividends from that REIT are still eligible for the 20 percent QBI deduction. In essence, taxpayers can get around this limitation on triple net lease property by holding it through a REIT. In addition, the 20 percent QBI deduction for qualified REIT dividends is not limited by W-2 wages or UBIA of qualified property.
Section 163(j) Interest Expense Limitation
Section 163(j) limits the interest expense a taxpayer can deduct to the sum of:
- The taxpayer’s business interest income
- 30 percent of the taxpayer’s adjusted taxable income (ATI); and
- The taxpayer’s floor plan financing interest expense
A real property trade or business can make an election out of the Section 163(j) interest expense limitation and deduct all of its interest expense, but electing out of Section 163(j) means adopting ADS depreciation, which has longer useful lives and does not allow for bonus depreciation. The election is irrevocable. The current proposed regulations provide for a safe harbor for REITs to make the election out of Section 163(j) as a real property trade or business if it holds real property, interests in partnerships holding real property, or shares in other REITs holding real property.
contact a member of the Real Estate Services Group.
In addition, ATI is calculated without reducing taxable income for the dividends paid deduction, which is favorable. The dividends paid deduction usually offsets all of a REIT’s income, so without including it in ATI, the REIT will be left with a higher ATI and threshold for the interest expense. The higher the ATI, the less the limitation will be.
REITs are already required to use the ADS method for calculating earnings and profits in determining dividend income to shareholders. Many REITs opt to use ADS depreciation to calculate taxable income anyway for varying reasons, including adding back bonus depreciation for state tax purposes. This addback could result in a REIT having no taxable income for federal purposes, but having taxable income and paying tax for state purposes. For this reason, many REITs opt not to take advantage of bonus depreciation. Unless a REIT needs to use MACRS to lower taxable income to meet its distribution requirement, the change from MACRS to ADS most likely will not have a significant impact.
Mortgage REITs most likely will not be impacted by the limitation since interest expense can be deducted to the extent of interest income.
Lower Tax Rates
REITs are required to distribute at least 90 percent of taxable income and pay tax on the remaining undistributed income. Under TCJA, the corporate income tax rate was lowered to 21 percent, so REITs will benefit from the lower tax rate if they are left with taxable income. Many REITs distribute 100 percent of taxable income to avoid tax altogether, but a taxable REIT subsidiary, which is taxed as a C Corp, will now also benefit from a lower 21 percent tax rate.
Additionally, the FIRPTA withholding tax rate on REIT capital gain distributions was lowered from 35 percent to 21 percent. FIRPTA is the Foreign Investment in Real Property Tax Act and applies to the gain on dispositions of an interest in US real property by a foreign person. This is a significant benefit to foreign taxpayers, who usually invest in US real estate through REITs to limit tax liability.
Net Operating Losses (NOLs)
REITs will mostly benefit from the changes to the new tax law, but there are also some negative impacts. NOLs created in 2018 or later can now only offset up to 80 percent of taxable income. TCJA removed the option to carryback an NOL to 2 years prior, so new NOLs can only be carried forward, but they can now be carried forward indefinitely instead of being limited to a 20-year carry forward period. The new 80 percent limitation could be problematic for a REIT because it can no longer offset all of its taxable income with NOLs. The 80 percent limitation is applied before applying the dividends paid deduction, so in order to avoid tax altogether, REITs will need to distribute the remaining 20 percent.
In conclusion, most of the changes under TCJA have a positive impact on REITs, with only a few negative impacts. There are additional provisions under TCJA that affect all real estate businesses that are not specifically unique to REITs, so they are not mentioned above. Some of these provisions include like-kind exchanges and opportunity zones. Please visit Withum’s Opportunity Zones Resource Center to learn more.
Opportunity Zones Resource Center