On November 2, Chairman of the House Committee on Ways and Means, Representative Kevin Brady R.-TX), introduced the Tax Cuts and Jobs Act and an accompanying section-by-section summary (together, the House Proposals). The House Proposals represent the latest effort to comprehensively reform the U.S. tax code for the first time since 1986. While this tax reform is not focused on “real estate investment trusts” (REITs), the House Proposals are nonetheless significant for REITs.
The most significant House Proposals affecting REITs and real estate are:
- Reduction in Corporate Tax Rate
- Under current law, corporations are subject to a maximum tax rate of 35 percent. The House Proposals would reduce the corporate tax rate to a flat 20 percent. While the reduction in corporate tax rate makes REITs relatively less attractive, they remain very beneficial given that the corporate tax rate is still set at 20 percent.
- Maximum 25 Percent Rate on Dividends Received from REITs
- The House Proposals would limit certain business income distributed by pass-through entities to owners or shareholders to a maximum tax rate of 25 percent, instead of ordinary individual incomes tax rates. Under current law, dividends received from a REIT other than capital gain dividends and qualified dividends (e.g., dividends funded out of rental income) are subject to ordinary income tax rates. The proposed maximum 25 percent rate would also apply to such dividends received from a (public or private) REIT. The concept equalizes the tax rate on rental income earned through a (private) real estate investment partnership or through a (public) REIT. It should be noted that the rule is not limited to dividends funded out of rental income. Accordingly, dividends funded out of interest would also benefit from this reduced REIT dividend tax rate. As a result, this change could make (public and private) mortgage REITs significantly more attractive investments for investors in the highest tax rate bracket.
- Limitation on Interest Deduction Not Applicable to Real Property Trade or Business
- Section 1631 generally allows business interest as a deduction in the taxable year in which the interest is paid or accrued. The House Proposals would amend Section 163 to disallow as a deduction net business interest expense in excess of 30 percent of the sum of the taxpayer’s adjusted taxable income and business interest income. In the case of partnerships, this limitation would apply at the entity level. Any interest disallowed would be carried forward to the succeeding five taxable years and, in the case of corporate taxpayers, preserved as a tax attribute in certain asset acquisitions. This limitation, however, would not apply to a “real property trade or business,”2 with the result that (public and private) REITs, which would generally constitute real property trade or businesses, would generally retain the ability to fully deduct interest. This is a very beneficial rule for public equity REITs.
- Immediate Expensing Not Available to Real Property Trade or Business
- The House Proposals would generally permit taxpayers to fully and immediately expense 100 percent of the cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. However, immediate expensing would not apply to a “real property trade or business.”3 As a result, because most REITs would generally constitute “real property trade or businesses” they would generally not be able to avail themselves of such additional depreciation. This rule is the quid pro quo for REITs to retain the unrestricted ability to deduct interest (described above). From a broader perspective, the logic of this rule appears to be that the “100 percent expensing” is intended to help manufacturing businesses (i.e., facilitate their capital expenditure investments thereby allowing to upgrade existing U.S.-based production facilities or, possibly more importantly, to support the setting up of new manufacturing facilities).
- Repeal of Like-Kind Exchanges Limited to Personal Property
- Under current law, no gain or loss is recognized pursuant to Section 1031 when a business or investment property is exchanged for “like-kind” business or investment property. This currently applies to both real and personal property. The House Proposals would modify this rule to allow for like-kind exchanges only with respect to real property. Importantly for REITs, Section 1031 non-recognition of gain would continue to apply to real property regardless of the specific nature (e.g., office, warehouse, malls, data centers, cell phone towers, farm land) and value of the real property (i.e., the US$1 million cap proposed by President Obama’s Budget Proposal for 2015 was removed).4
- Gross Income Tests and Participation Exemption System for Taxation of Foreign Dividends
- Under current law, a U.S. corporation generally is not taxed on the income earned by a foreign corporation until the income is distributed as a dividend. Upon such distribution, the U.S. corporation is entitled to a credit for foreign income tax paid by its subsidiary. The House Proposals would replace the current regime with a participation exemption system for dividends. Under this system, a U.S. corporation that owns 10 percent or more of a foreign corporation would be able to deduct the foreign-source portion of dividends paid by such foreign corporation. Given that the participation exemption for foreign dividends is implemented by way of a 100 percent deduction (as opposed to an exclusion from gross income), it appears that such distributions received by REITs (e.g., from a foreign taxable REIT subsidiary) would still be taken into account for the purposes of the REIT gross income tests. If enacted, this participation exemption system would be effective for distributions made after 2017.
- Taxation of Deferred Foreign Income Upon Transition to Participation Exemption System
- Under current law, a U.S. shareholder is generally not taxed on the income earned by a foreign subsidiary until the income is distributed as a dividend. To ensure that the adoption of a participation exemption system does not result in foreign corporations’ previously un-taxed deferred earnings (estimated to be approximately $2 trillion) escaping U.S. tax entirely, the House Proposals would cause a U.S. shareholder to include, as subpart F income, its share of the foreign corporation’s earnings that have not been previously subject to U.S. tax. The earnings would be classified as either cash or cash equivalents, or reinvestment in the corporation’s business (e.g., property, plant, and equipment). The former would be taxed at a rate of five percent and the latter at a rate of 12 percent. A U.S. shareholder would be able to elect to pay the tax liability in equal installments over a period of up to eight years. This transition rule creates several issues for REITs. First, REITs are not excluded from this rule even though REITs are not the target of this rule. Second, the deemed Subpart F income inclusion under this transition rule creates the question whether this would be good income for the 75 percent or the 95 percent gross income tests. This is not clear under the House Proposals. Third, it is not clear whether REITs are supposed to pay tax on these foreign earnings like other C-corporations or whether this simply means that REITs may need to increase their distributions under the 90 percent minimum distribution requirement.
- REIT Gross Income Tests Expanded to Include Foreign High Return Amounts
- Section 951 requires U.S. shareholders of a controlled foreign corporation (CFC) to include in their income their share of the CFC’s subpart F income. Additionally, the House Proposals would impose current tax on, additionally, 50 percent of “foreign high return amounts,” which would generally be defined as a shareholder’s net CFC income over a routine return (seven percent plus the Federal short-term rate). The House Proposals would expand the REIT 75 percent and 95 percent gross income tests to include foreign high return amounts includible in income. It is surprising that REITs are not exempt from this rule given that the rule appears to be intended to address aggressive international tax planning in respect to intellectual property.5
- Repeal of Technical Termination of Partnerships
- Section 708 provides for a “technical termination” of a partnership if there is a sale or exchange of 50 percent or more of the total interests in partnership capital and profits within a 12-month period. When a technical termination occurs, the business of the partnership continues in the same legal form, except that the partnership is treated as newly formed and must make various new elections (e.g., accounting method, depreciation lives). The House Proposals would repeal the technical termination rule, thereby treating a partnership as continuing even if more than 50 percent of the total capital and profits interests of the partnership are sold or exchanged. New elections would not be required or permitted. If enacted, this could be beneficial for REITs with respect to restructurings of real estate portfolios, including in connection with forming Up-REIT structures or REIT M&A transactions.
- No Modernization of REIT Gross Income Tests
- The House Proposals do not include any proposals to modernize the REIT gross income tests to reflect the evolution of the U.S. real estate market. So, for example, the House Proposals do not include proposals that would facilitate investments of mortgage REITs in “credit risk transfer” securities issued by certain government sponsored entities.
- FIRPTA Unchanged
- Under current law, disposition of a U.S. real property interest by a foreign person is subject to taxation as if such gain or loss were effectively connected with a U.S. trade or business pursuant to Section 897 (FIRPTA). The House Proposals make no change to the FIRPTA rules, including with regards to domestically controlled REITs and IRS Notice 2007-55.
We expect that the House Proposals will be subject to significant scrutiny and commentary and, as a result, we would expect the House Proposals will see numerous changes. However, whether the House and the Senate can pass any version of the House Proposals is subject to significant doubt given the strictly partisan approach to tax reform and slim majority of the Republican Party in the Senate. We will continue to monitor the development closely.