Real Estate Investment in the US Under the Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act (“TCJA”) preserves and in certain cases enhances tax benefits for investments in real estate and partnerships. A tax deduction may be available equal to 20 percent of qualified business income to individuals who own income producing real estate through a partnership or S-corporation. The opportunity for foreign investors to invest in US real estate is enhanced with the reduction of the corporate income tax rate. There are also many other significant developments for real estate investing under the TCJA that are highlighted below.
Foreign Investment in US Real Estate
Domestic corporations are commonly used for foreign individual investors in US real estate due to their limited estate tax exemption of $60,000 and issues with the branch profits tax. To avoid the US estate tax, the foreign investor would form a foreign corporation to own a domestic US entity taxed as a C-corporation, which would then own the real estate. This structure prevents the possible application of the US estate tax at 40 percent and avoids the branch profits tax.
The trade-off for avoiding the US estate tax, the foreign investor was subjected to higher tax at 35 percent on long term capital gains instead of the individual capital gains rate of 20 percent. Under the TCJA, the corporate tax rate dropped to 21 percent, just one percent more than the individual long term capital gain tax rate. Foreign investors should be willing to pay one percent more in capital gains tax to hedge against the possible imposition of the US estate tax.
Similarly, a foreign corporation investing in the US will typically use a domestic entity taxed as a C-corporation to hold its interest in US based real estate. Again, this structure will avoid the branch profits tax. For the foreign corporation, its tax on any income generated dropped from 35 percent to 21 percent.
It is important to remember that foreign corporations and foreign individuals are not subject to tax on capital gains in the US with the exception of the sale of US real estate. This is an important consideration for the structures described above, because the foreign investor can sell the US real estate, which is taxable, but then liquidate the domestic US entity which is tax free, thus avoiding double taxation.
The portfolio interest exemption was not changed by the TCJA. Under the portfolio interest exemption, foreign individuals or companies can lend funds to US real estate projects and not be subject to tax on the interest income.
Tax Benefits for Carried Interests Continue
Carried interests in a partnership is a tax favored way to compensate sponsors, managers, developers, and other service providers involved in the creation and syndication of real estate or investment partnerships. The carried interest can be granted tax free as long as it is only an interest in future partnership profits and not existing partnership capital and if it meets certain other requirements.
Carried interests has been a target for change, however, the TCJA only made limited changes to the treatment of carried interests. Under the TCJA, the required holding period to get long term capital gain treatment increased from more than one year to more than three years. Since real estate is generally held for more than three years before it is sold, this change should have a limited impact.
Qualified Business Income Deduction
For individual investors in partnerships or S-corporations and sole proprietors, the TCJA adds a new deduction equal to 20 percent of qualified business income. Qualified business income is income from a qualified business. Since the maximum individual tax rate under the TCJA dropped to 37 percent, the QBI deduction would reduce the effective tax rate on qualified business income to 29.6 percent.
Rental property can be a qualified business if the leasing activity is an active trade or business. This will depend on the type of lease and the extent of the leasing activity. A qualified business would not generally include real estate management, brokerage, and other services performed in the real estate industry. There is an exception for services of architectures and engineers.
There is a general prohibition for taking the qualified business income deduction against services income, however, a moderate income taxpayer can treat service income as qualified business income. A moderate income taxpayer is an individual whose taxable income for the year is equal to or less than $315,000 for married filing jointly taxpayers and for other taxpayers the threshold is $157,500. When these thresholds are exceeded, the restriction on services income phases in and once taxable income for married filing jointly taxpayers reaches $415,000 and $315,000 for other taxpayers, the service income is fully excluded from qualified business income.
The qualified business income deduction cannot exceed an amount equal to a wage and property limitation. The goal is to have this exclusion mainly benefit pass through entities that employ many people and create jobs. While this limitation would seem to restrict the benefits to a real estate partnership, there is a second test that incorporates the value of property held by the partnership.
The 20 percent qualified business income deduction cannot exceed the greater of:
- 50 percent of the wages paid by the partnership; or
- 25 percent of the wages paid by the partnership plus 2.5 percent of the original cost basis of depreciable tangible property placed in service in the last 10 years.
The key is the partnerships investment in depreciable real estate can be used to avoid the limitation on the qualified business income deduction.
Real estate continues to be a favored investment under the TCJA. In many circumstances real estate investors will be better off under the TCJA then prior tax law.