On Dec. 22, 2017, President Donald Trump signed into law H.R.1, commonly referred to as the Tax Cuts and Jobs Act (Tax Act). (Pub. L. No: 115-97). This is the most sweeping change to the U.S. federal income tax laws since 1986. This and future articles will discuss the individual tax and business tax provisions that affect real estate investment and investors in real estate.

Corporate tax rate lowered to 21 percent; corporate alternative minimum tax repealed. The Tax Act changes the corporate tax rate from a graduated scale with a 35 percent maximum rate to a flat 21 percent corporate rate and repeals the corporate alternative minimum tax (AMT), effective for tax years beginning on Jan. 1, 2018. While most real estate businesses are organized as pass-throughs, large corporate real estate operating companies benefit greatly from this provision alone. Unlike many of the provisions of the Tax Act, the rate reduction is permanent.

Individual tax rates and state and local income tax deduction limited; individual AMT retained. The Tax Act reduced the top individual tax rate from 39.6 percent to 37 percent, effective Jan. 1, 2018 (there are some adjustments to the brackets as well). There are no changes to the current 20 percent maximum rate for net long-term capital gains (including qualified dividend income) and the 25 percent rate applicable to unrecaptured gain under §1250 of the Internal Revenue Code (Code) as well as the 28 percent rate on 28 percent rate gain. The 3.8 percent surtax on net investment income is also retained under the Tax Act.

The benefit of the reduction in rates has a cost including the elimination of or limiting certain deductions and increasing the standard deduction. In states that impose a high income tax rate, one of the costliest limitations is the $10,000 cap on the itemized deduction of state and local income and property taxes. Apartment owners may benefit from the changes that no longer favor home ownership over renting because the deduction for mortgage interest was lowered which is offset by the higher standard deduction. Moreover, in areas of high property taxes, rental apartments may be more attractive because of the $10,000 limit on the deduction of property taxes. However, property taxes that are incurred in the operation of a real estate business are not affected by this limitation.

The reduction in individual tax rates and the cap on the state and local tax deduction expire after Dec. 31, 2025.

The Tax Act retains the individual AMT, but increases the individual AMT exemption amount to $109,400 for married taxpayers ($70,300 for single taxpayers) from $84,500/$54,300 under prior law, and increases the AMT exemption phase-out to $1,000,000 (joint filers) and $500,000 (all other taxpayers) from $160,900 and $120,700, respectively.

Pass-through business deduction. (I.R.C. §199A). Subject to limitations discussed below, the Tax Act provides for a maximum effective tax rate of 29.6 percent on an individual's domestic qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. The reduced maximum rate arises from a 20 percent deduction ([100 percent – 20 percent] x 37 percent top individual marginal rate = 29.6 percent). Qualified business losses carry forward to the next tax year and reduce the amount of QBI included in determining the amount of the deduction for that year. The deductible amount is computed separately for each qualified trade or business and the amount of a particular qualifying trade or business may be negative (i.e., a loss sustained).

QBI is net income and gain arising from a qualified trade or business. A qualified trade or business is generally any business other than certain service businesses, (Specified Service Trades or Businesses).[1] Since most Specified Service Trades or Businesses do not include traditional real estate businesses, a qualified business should include a trade or business of the renting of real property and real estate development. Accordingly, rental income and ordinary income from real estate development should be subject to the new maximum 29.6 percent rate. However, rental income from the triple-net leasing of real estate is not generally considered a trade or business and is likely not entitled to the 29.6 percent pass-through rate, unless the real estate is held through a real estate investment trust (REIT).

QBI must be income that would be treated as effectively connected with a US trade or business if earned by a non-US person, and does not include certain forms of investment income (e.g., capital gain, most dividends, and interest that is not allocable to a qualified trade or business).[2] Thus, real estate rental income will qualify for the 29.6 percent rate; long-term capital gain income will continue to be taxable at 20 percent, and short-term capital gain will now be taxable at the maximum 37 percent individual rate.

The deduction for QBI is effective for taxable years beginning after Dec. 31, 2017 and sunsets after Dec. 31, 2025.

The amount of the deduction available to a taxpayer from a partnership, S corporation or sole proprietorship cannot exceed the greater of (1) 50 percent of the taxpayer's share of the W-2 wages paid with respect to the qualified trade or business or (2) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. Qualified property is defined as depreciable tangible property that is held by and available for use in a qualified trade or business at the close of the taxable year and is used in the production of QBI for the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (1) the date 10 years after that date or (2) the last day of the last full year of the applicable recovery period that will apply to the property under Code §168 (without regard to Code §168(g)). This period is the depreciable period.

Note that the W-2 wage/qualified property limitation will not apply to individuals with taxable incomes at or below $315,000 for married individuals filing jointly or $157,000 for single individuals, but phases-in completely over the next $100,000 or $50,000, as applicable, of taxable income. QBI earned through a publicly traded limited partnership (MLP) and otherwise eligible for the deduction, as well as REIT dividends also will not be subject to the limitation.

By limiting the deduction in a manner that is connected to a pass-through entity's payment of W-2 wages and its acquisition of depreciable business assets, the Tax Act creates incentives for pass-through entities to hire employees and/or to purchase new business property as illustrated by the following example. Assume Partner A's share of the AB partnership's 2018 QBI is $1 million. The AB partnership pays wages of $600,000 in 2018 ($300,000 of which is allocable to A as a 50 percent partner) and owned qualified property with an unadjusted basis immediately after acquisition of $400,000 ($200,000 of which is allocable to A). In the example, A's deduction is limited to the lesser of $200,000 (20 percent of QBI allocated to A)), or the greater of (1) $150,000 (50 percent of W-2 wages allocated to A) or (2) $80,000, which is the sum of $75,000 (25 percent of the $300,000 of W-2 wages allocated to A) plus $5,000 (2.5 percent of the $200,000 of unadjusted basis of qualified property allocated to A). A's deduction is limited to $150,000, even though A's QBI was $200,000. Under the Tax Act, A pays federal income tax on only $850,000 of the $1 million of AB partnership income allocated to A. Under prior law, A would have paid tax on the entire $1 million of income allocated to A.

The 25 percent of the W-2 wages plus 2.5 percent of unadjusted basis test is beneficial to the owners of a pass-through business with no employees that is engaged in a qualified trade or business which can benefit from the deduction (and the 29.6 percent effective rate) with respect to its investments in depreciable tangible property. To illustrate, a taxpayer (T) with a $1,000,000 qualified property investment is eligible for a deduction of up to $25,000 (2.5 percent of $1,000,000). If T earned a 12.5 percent return on its capital investment, resulting in qualified business income of $125,000 (12.5 percent x $1,000,000), T could deduct 20 percent of the entire return (20 percent x $125,000 = $25,000) without exceeding the cap, thereby being taxed at a maximum effective rate of 29.6 percent on the $125,000.

Endnotes:

[1] The traditional service businesses are (1) a trade or business involving the performance of services in the fields of health, law, accounting, actuarial services, performing arts, consulting, athletics, financial services, or brokerages services and (2) any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. Note that architects and engineers are specifically excluded from the definition of Specified Service Trades or Businesses.

[2] QBI does not include guaranteed payments made to a partner for services rendered or reasonable compensation paid to the taxpayer with respect to any qualified trade or business (i.e., salary paid to an S corp. shareholder).

Peter M. Fass is a partner at Proskauer Rose.