SAN DIEGO—Although most real estate businesses are not structured as C or regular corporations, the Tax Cuts and Jobs Act reduces the highest corporate tax rate from 35% to 20%, which may cause some of these businesses to rethink their strategy, Phil Jelsma, a partner and chair of the tax-practice team at Crosbie Gliner Schiffman Southard & Swanson LLP, tells GlobeSt.com.

On Nov. 2, the House Ways and Means Committee released the act, which is its roadmap to tax reform. The Senate issued a mark-up of the Act on Nov. 9. The proposed tax-reform legislation is comprehensive, with many provisions that impact the commercial real estate industry directly. We spoke with Jelsma regarding the implications and potential impact of the proposed tax reform bill on commercial real estate professionals.

GlobeSt.com: Can you discuss the reduction in the corporate tax rate?

Jelsma: Although most real estate businesses are not structured as C or regular corporations, the Act reduces the highest corporate tax rate from 35% to 20%. As a result, real estate businesses currently C corporations considering becoming S corporations may want to rethink that strategy.

GlobeSt.com: Is there increased expensing, and what is the potential impact of this?

Jelsma: The Act allows taxpayers to expense immediately 100% of the cost of qualified property acquired in place and service after Sept. 27, 2017, and before January 1, 2023. This would apply to both new and used property. The property would be eligible for the increased expensing if it is the taxpayer's first use. However, qualified property would not include any property used in a real property trade or business. This would include any property used in a real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. This may cause businesses interested in this increased expensing to segregate their real estate and non-real estate activities. Being included in a real estate trade or business allows the business to avoid the limitation on interest deductions discussed below. Congress seems to be offering a tradeoff—increased expensing or unlimited interest deductions. The Senate version shortens the depreciable life of buildings to 25 years.

GlobeSt.com: Can you address the controversial limitations on interest deductions?

Jelsma: The deduction for business interest would be limited to the sum of business-interest income plus 30% of the adjusted taxable income of the taxpayer for a taxable year. Any interest not allowed would be carried forward up to five years. In effect, business interest income would be limited to 30% of the taxpayer's adjusted gross income. In the case of a partnership or LLC, the limitation would be applied at the partnership or LLC level, not at the partner or partnership level. Similarly, with respect to S corporations, the limitation would be applied at the corporate level, not the shareholder level. There is an exception for any taxpayer with average annual gross receipts for a three-year period less than $25 million. This interest limitation does not apply to a real estate trade or business that includes a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.

GlobeSt.com: Will the net-operating-loss deduction change?

Jelsma: Under current law, a net operating loss may be carried back two years and carried over 20 years. This is frequently used by real estate businesses during recessionary periods to recover previously paid taxes. The Act would limit the NOL deduction to 90% of taxable income for losses arising in tax years beginning after December 31, 2017.

GlobeSt.com: What about like-kind exchanges of properties—would this law change?

Jelsma: The Act would limit the application of Section 1031 to like-kind exchanges of real property and not personal property. Often, incidental personal property is included in the exchange.

GlobeSt.com: How are the repeal of rehabilitation tax credit and new markets tax credits affected?

Jelsma: The Act would repeal the existing 20% credit for qualified rehabilitation expenditures on certified historic structures and the 10% credit with respect to qualified rehabilitated buildings. In addition, it would repeal the new markets tax credit.

GlobeSt.com: Any impact on solar-energy credits?

Jelsma: The Act would phase down the 30% investment tax credit for solar energy and completely eliminate the credit where construction begins after 2027. In addition, the Act would require a continuous program of construction from the date construction begins until the property is placed in service.

GlobeSt.com: How is the proposed tax rate on business income affected?

Jelsma: The House version of the Act reduces the individual tax rates on qualified business income to 25%. Qualified business income is generally the net income derived from a passive business activity conducted through a partnership, LLC, S corporation or sole proprietorship. The Act would use the current definitions under the passive activity rules to determine whether the business was passive or active.

In general, 30% of the income would be attributed to capital and entitled to the 25% tax rate and the remaining 70% would be treated as compensation and taxed as ordinary income. Capital intensive businesses could elect a different formula. The election would determine the applicable percentage by dividing (1) the specified return on capital for the activity for the taxable year by (2) the taxpayer's net business income derived from that activity. The specified return on capital for any business activity is determined by multiplying a deemed rate of return times the asset balance for the activity for the taxable year reduced by interest expense deducted from the activity. The deemed rate of return is the short-term applicable federal rate (AFR) plus seven points. Only property subject to depreciation and used in a trade or business is included in the asset balance.

For example, if an individual's active business activity includes machinery with an adjusted basis of $100 and cash of $50, then the asset balance for the activity is $100. The Senate version allows a 17.4% deduction limited to 50% of W-2 wages paid by the business. Only property used in a trade or business subject to depreciation in real property is counted for this purpose. The capital percentage of certain trades or businesses would be zero including those in the field of law, health, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and any trade or business where the principal asset of the trade or business is the reputation or skill of the employees or investing, trading or dealing in securities, partnership interests or commodities. To the extent that a share of income is attributable to labor, it is taken into account in determining net earnings from self-employment. The Act repeals the existing laws exclusion for a limited partner share of distributable share or partnership income in determining net earnings from self-employment. Limited partners are treated as any other partner for purposes of self-employment tax.

GlobeSt.com: What about amendment to carried interests?

Jelsma: On Nov. 7, Ways and Means Committee Chair Kevin Brady offered an additional amendment with respect to carried interests. On November 16, a similar provision was added to the Senate version of the bill. This amendment imposes a three-year holding period requirement for partnership or LLC interest received in connection with providing services to be eligible for capital gain treatment. The change would triple the length of time an asset would need to be held to qualify for capital-gains rates.

GlobeSt.com: Ultimately, do you think the proposed tax reform benefits CRE professionals?

Jelsma: Clearly, the Act provides both benefits to some real estate businesses and detriments to others. Already, the lobbyists opposing some or all of these provisions have begun to exert influence on Congress. It remains to be seen which, if any, of these provisions will in fact be included in the final legislation.

Instant Insights /

How the Tax Cuts and Jobs Act Affects CRE Businesses

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