President Donald Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017, enacting comprehensive U.S. tax reform with most provisions becoming effective starting on January 1, 2018 (generally until 2025).
The summary below describes, in general terms, the principal effects of the tax reform bill on real property investments and developments by U.S. and non-U.S. corporations and individuals, including the following:
- Reduction of the U.S. federal corporate income tax rate from 35 percent to 21 percent
- Minimum 10 percent U.S. federal corporate income tax on foreign related-party payments by U.S. corporations (aka the Base Erosion Anti-Abuse Tax or BEAT)
- Reduction from 39.6 percent to 37 percent of the maximum U.S. federal income tax rate on ordinary income (including real property income) derived by individuals directly or through "pass-through" entities
- Up to 20 percent additional deduction for ordinary income (including real property income) derived by individuals directly or through "pass-through" entities
- "Carried Interest" preferential long-term capital gain tax rate not eliminated but requires a more than three-year holding period
- Interest deduction limited to 30 percent of earnings before interest, taxes, depreciation and amortization (EBIDTA) or 30 percent of earnings before interest and taxes (EBIT) starting in 2022
- Net operating loss deductions become limited to 80 percent of taxable income
- U.S. estate tax exemption amounts for U.S. individuals doubled (no change to U.S. estate tax exposure for non-U.S. individuals)
- Like-kind exchange tax-deferral treatment limited to exchanges of U.S. real property
I. Reduction in Tax Rates for Corporations Holding Real Property
1. Reduction of the U.S. Federal Corporate Income Tax Rate from 35 Percent to 21 Percent
- Starting in 2018, U.S. corporations and non-U.S. corporations with U.S. business income (including real property business income or gains) are subject to U.S. federal corporate income tax of 21 percent (instead of 35 percent under current law).
- No Change to the U.S. Withholding Tax on Dividends from U.S. Corporations to Foreign Shareholders – As under current law, dividends from U.S. corporations to foreign shareholders are generally subject to a U.S. withholding tax of 30 percent (or a reduced treaty rate, if applicable).
- This results in a combined U.S. federal income tax of up to 44.7 percent for non-U.S. shareholders with respect to U.S. corporation's income or gain that is distributed to the foreign shareholder.
- No Change to the U.S. "Branch Profits" Tax for Non-U.S. Corporations – As under current law, non-U.S. corporations are generally also subject to a U.S. "branch profits" tax with respect to their U.S. business income or gains (irrespective of distributions). The "branch profits" tax rate is 30 percent (or a reduced treaty rate, if applicable) and it applies to the after-tax earnings derived by the non-U.S. corporation (either directly or through "pass-through" entities such as partnerships or limited liability companies that are treated as partnerships for U.S. federal income tax purposes).
- This results in a combined U.S. federal income tax of up to 44.7 percent for non-U.S. corporations with respect to their U.S. business income or gains.
2. Minimum 10 Percent U.S. Federal Corporate Income Tax on Foreign Related-Party Payments by U.S. Corporations (aka the Base Erosion Anti-Abuse Tax or BEAT)
- Starting in 2018, U.S. corporations are required to pay a minimum 10 percent U.S. corporate income tax on their taxable income without taking into account deductions for payments made to foreign related parties (such as interest, royalties, service fees with a markup above cost, etc.).
- This is in fact an alternative minimum tax. The regular tax liability on the corporation's regular taxable income applies if it is higher than the 10 percent minimum tax.
II. Reduction in Tax Rates for Individuals Holding Real Property (Directly or Through "Pass-Through" Entities)
1. Reduction from 39.6 Percent to 37 Percent of the Maximum U.S. Federal Income Tax Rate on Ordinary Income (Including Real Property Income) Derived by Individuals Directly or Through "Pass-Through" Entities
- Starting in 2018, U.S. individuals and non-U.S. individuals who derive U.S. real estate income (either directly or through "pass-through" entities such as partnerships or limited liability companies) are subject to U.S. federal income tax at new graduated tax rates with a maximum tax rate of 37 percent (instead of a maximum tax rate of 39.6 percent under current law).
- The additional 3.8 percent "net investment income" tax remains in place with respect to "net investment income" (e.g., passive rents) derived by U.S. individuals with income in excess of certain thresholds.
2. Up to 20 Percent Additional Deduction for Ordinary Income (Including Real Property Income) Derived by Individuals Directly or Through Pass-Through Entities
- Starting in 2018, non-U.S. individuals who derive U.S. trade or business income (either directly or through "pass-through" entities such as partnerships or limited liability companies) are eligible for an additional special deduction of up to 20 percent against their ordinary income.
- This would in effect reduce the maximum U.S. federal income tax rate on such income down to 29.6 percent (i.e., 37 percent multiplied by 80 percent, assuming that the full 20 percent deduction is available to the taxpayer – see below).
- The 20 percent deduction is capped by the higher of the following:
i. 50 percent of W-2 wages paid by the business to employees; or ii. 25 percent of W-2 wages paid by the business to employees plus 2.5 percent of the acquisition cost of depreciable property (including depreciable real property) used in the business which has not been fully depreciated for U.S. federal income tax purposes.
- This means that the full 20 percent deduction is allowed if the business has sufficient W-2 income payable to employees and/or sufficient depreciable property (including depreciable real property).
3. Maximum Long-Term Capital Gain Tax Rate for Individuals Remains at 20 Percent (Plus 3.8 Percent "Net Investment Income" Tax for U.S. Individuals)
- There is no change to the maximum 20 percent U.S. federal long-term capital gain tax rate for individuals, i.e., capital gains from a sale of a capital asset after a holding period of at least one year (but see change to definition of "carried interest" capital gain below). Gain attributable to depreciation recapture of real property is subject to a 25 percent tax rate as under current law.
- The 3.8 percent "net investment income" tax remains in place with respect to "net investment income" (including capital gains) derived by U.S. individuals with income above certain thresholds.
4. "Carried Interest" Preferential Long-Term Capital Gain Tax Rate Not Eliminated But Requires a More Than Three-Year Holding Period
- Starting in 2018, capital gains allocated to a "carried interest" in a partnership (or in other "pass-through" entities) that is held by an individual is eligible to the 20 percent long-term capital gain tax rate (plus 3.8 percent "net investment income tax" for U.S. individuals) only if the capital asset was sold by the partnership after a holding period of more than three years (instead of one year under current law).
- If the capital asset is sold by the partnership after a holding period of three years or less, the capital gain is subject to U.S. federal income tax as short-term capital gain at the ordinary U.S. federal income tax rates, with a maximum rate of 37 percent.
- Exceptions from partnership "carried interest" are set forth for a partnership capital interest (or a portion thereof) attributable to capital contributed by the taxpayer.
III. Changes to Taxable Income Determination
1. Interest Deduction Limited to 30 Percent of EBIDTA or 30 Percent of EBIT Starting 2022
- Subject to the Small Business Exception or Electing Real Property Trade or Business Exception described below, starting in 2018, deductions of any net interest expense for the year, whether paid to a related party or not, are limited to 30 percent of "Adjusted Taxable Income" of the taxpayer (see below), which is intended to resemble EBIDTA until 2021 and EBIT from 2022. Amounts of disallowed interest deductions are carried forward (indefinitely) and treated as interest expense in succeeding taxable years.
- "Adjusted Taxable Income" means the taxable income of the taxpayer relating to the business increased by (i) the deduction for net interest expense relating to the business, (ii) deductions for non-business items, (iii) the deduction of net operating losses from other years, (iv) the 20 percent deduction for qualifying pass-through business income, and (v) depreciation and amortization deductions.
– Starting in 2022, the 30 percent limitation becomes stricter because the Adjusted Taxable Income is not increased by deductions for depreciation and amortization for purposes of calculating the limitation.
- In the case of partnership or limited liability company structure, the limitation generally has to be determined at the level of each partnership or LLC.
- Small Businesses Exception – the limitation on interest deductions does not apply to businesses with average gross revenue of $25 million or less for the past three years.
- The Small Businesses Exception does not apply to partnerships or LLCs where 35 percent or more of its losses are allocated to limited partners or limited entrepreneurs.
- Electing Real Property Trade or Business (ERPTOB) Exception – Real property investors or developers may elect to be exempt from the limitation on interest deductions if they elect to depreciate their residential rental real property over 30 years using the straight-line method (instead of 27.5 years) or their commercial real property over 40 years using the straight-line method (instead of 39 years).
2. Net Operating Loss Deductions Become Limited to 80 Percent of Taxable Income
- Starting in 2018, net operating losses of corporations or individuals are only allowed to offset up to 80 percent of taxable income for that year.
- Net operating losses may no longer be carried back but they can be carried forward indefinitely (instead of two-year carry-back and 20-year carryforward under current law).
IV. Changes to U.S. Estate Tax
1. U.S. Estate Tax Exemption Amounts for U.S. Individuals
- Starting in 2018 through 2025, the amount exempted from U.S. estate tax and U.S. gift tax for U.S. citizens or U.S.-domiciled individuals is increased to $10 million per individual ($20 million for married U.S. individuals).
2. No Change to U.S. Estate Tax Exposure for Non-U.S. Individuals
- Non-U.S. individuals remain subject to the U.S. estate tax upon death or U.S. gift tax upon lifetime gifts with respect to "U.S.-situs property" in excess of $60,000.
V. Changes to Like-Kind Exchanges
1. Like-Kind Exchange Tax-Deferral Treatment Limited to Exchanges of U.S. Real Property
- Starting in 2018, the tax-deferral treatment of like-kind exchanges is limited to exchanges of U.S. real property for U.S. real property (excluding an exchange of U.S. real property for non-U.S. real property). Exchanges of personal property for other personal property will no longer qualify as like-kind exchanges.
Note: This publication does not address the U.S. tax reform changes with respect to investments in U.S. real property through real estate investment trusts (REITs) or other regulated investment companies.