Tax Client Alert: New Year’s Resolution #1 – Understand Key Real Estate Tax Reform Changes

On December 20, 2017, the Senate and the House of Representatives passed the new Tax Cuts and Jobs Act (the “Act”) which the President signed into law on December 22, 2017. Many of the provisions take effect in 2018 and thereafter, but some provisions are retroactive to 2017. It has been more than 30 years since Congress passed such sweeping tax legislation that is likely to affect almost every U.S. person and those that are engaged in a trade or business in the United States or have U.S. investment activities, including the holding of U.S. real estate.

The new law is complex. Given the massive overhaul of the existing tax system, it will take time for the tax community at large to digest the intricacies of this extensive piece of legislation. As such, although this client alert discusses real estate related highlights, we will continue to provide updates on different aspects of the tax reform as we diligently work to dissect the more intricate components of the Act, which include vast changes to cross-border transactions, as the United States, for the first time in its history moves from a worldwide to a hybrid territorial taxing regime for corporate America.

One of the major highlights of the new law is the permanent reduction in the “statutory” C corporate income tax rate from 35% to 21%. The rate generally takes effect on January 1, 2018. For U.S. individuals, as well as non-resident aliens (“NRAs”), treated as engaged in a trade or business in the U.S., such as certain NRAs who own and rent U.S. real estate, the new law provides generally lower tax rates for all individual tax filers. For many (although not all), this will mean lower taxes, especially for many of our clients, who are within the top tax bracket, which has been lowered from 39.6% to 37% (for single filers with ordinary taxable income of $500k and $600k for married couples filing jointly). With that in mind, here is a summary of certain real estate provisions which may be of interest to you.

Provisions Affecting Real Estate Related Businesses

New 20% Deduction for Qualified Business Income. Under the new tax laws, many sole proprietors, such as independent contractors who receive their income on Form 1099, and other pass-through businesses, such as limited liability companies (“LLCs”), partnerships and S corporations, who are in certain real estate related businesses will not only benefit from lower marginal tax rates, but from the new 20% “above the line” (non-itemized) deduction for qualified business income.

Real Estate Brokers and Agents. In general, the new law significantly limits this deduction for personal service businesses, which includes “any business where the main asset of the business is the reputation or skill of one or more of its employees or owners”, which includes, but certainly is not limited to health, law, consulting, athletics, financial services and brokerage services. It appears, however, that real estate developers would qualify. Although most real estate agents and brokers will not be able to take advantage of the 20% deduction, there is a limited exception for our clients who meet the following criteria (for example, an NRA, perhaps who owns a condo in the U.S. that generates rental income under the below limits, has no other US income and does not anticipate using the profits to purchase additional rental properties):

  • For single taxpayers if their taxable income is less than $157,500, and for those who are married and filing jointly whose taxable income is less than $315,000.
  • For clients with taxable incomes above these amounts the 20% deduction is phased out over an income range of $50,000 for singles and $100,000 for couples. As such, the benefit of the deduction would be fully phased out for single individuals with taxable income levels above $207,500 and $415,000 for married couples filing jointly.
    Real Estate Developers and Professionals. Under the new law, real estate developers and those in other types of real estate related businesses whose taxable income exceeds the above thresholds (and would otherwise be subject to the phase-out) still may be able to claim the 20% deduction in full (or, if not, then on a partially reduced basis) based on another exception, which provides for a limitation on the 20% deduction to the greater of:
  • 50% of the businesses Form W-2 wages paid, or
  • 25% of the businesses Form W-2 wages paid plus 2.5% of the cost basis of the tangible depreciable property of the business at the end of the year.

This exception essentially would permit a real estate business paying significant wages or with substantial capital outlays to benefit from this deduction regardless of the owner’s taxable income.

Pass-Through Entities versus Statutory C Corporation

Entity Selection Under the New Tax Law. Under the new tax law, Statutory C corporations are now subject to a flat 21% corporate tax rate, which differs significantly from the effective rate for business income of individuals earned through a U.S. trade or business that is operated as a passthrough entity (such as an LLC, partnership or S Corporation), especially after giving effect to the 20% qualified business income deduction discussed above.

As discussed above, income from certain personal service businesses (and to a lesser extent, non-personal service business) that are operated through a passthrough entity will still be taxed at individual income tax rates, which under the new law have been reduced from 39.6% to a maximum tax rate of 37%. Under the new law, for purposes of applying the 21% tax rate there is no distinction between investment income and business income that a corporation earns. It is important to keep in mind, however, that the new law does not repeal the double layer of income tax that occurs at the time a corporation distributes profit to its shareholders, the effect of which may further subject such income to tax at the higher individual income tax rates in the hands of shareholders when distributed to them as dividends.

In advising our real estate and other clients as to whether to operate their U.S. trade or businesses and/or real estate holdings as a corporation or a pass-through, it is most important to consider the reduced corporate rates as compared to the pass-through rates couples with the 20% above-the-line deduction on qualified business income, as well as the limitations of such deduction and the impact of other changes to the tax laws.

Now, more than ever, making choice-of-entity determinations will heavily depend on individual facts and circumstances, such as whether you generate substantial income from a personal service business, and if not, whether your company incurs a large expense for wages or capital outlays. For example, if your business generates income completely below the phase-out thresholds ($315,000 for married couples and $157,500 for single filers) it may not make sense to operate as a statutory C corporation, as your net business income should qualify for the full 20% above-the-line deduction.

If you are considering setting up a corporation to take advantage of the 21% flat rate, you may not be able to benefit from this rate simply by making a check-the-box election to treat your existing LLC as a corporation for U.S. federal income tax purposes. Setting up as a statutory
C corporation may make the most sense if you expect to re-invest your profits, such as where a real estate investor intends to purchase more properties with any profit from the company, does not expect to pay out dividends to shareholders and ultimately plans to sell the stock of the company, thereby converting what would have been ordinary dividend income to capital gains.

Finally, for some of our clients, if possible, it may even make sense to consider segregating their business activities, to take advantage of the low 21% flat corporate income tax rate by, for example, shifting certain types of income, such as real estate consulting, to the C corporation, while leaving personal service businesses with income within the above discussed thresholds in a pass-through structure to avoid double taxation and taking advantage of the 20% above-the-line deduction.

Whatever business form you ultimately choose, given the intricate and sweeping changes to the tax laws, it is most important to regularly consult with your tax advisors to gain a better understanding of the complexity of the changes and how the structuring of your business operations via one business entity versus another may affect you.